Bruce Richards 6.6 38 ideas

Speaker stated that default rates for software companies in direct lending will reach 15%, with recoveries as low as $0.20 on the dollar. Software companies were lent at 8-10x leverage based on ARR, and with valuations halved, refinancing is impossible, leading to massive defaults. Avoid exposure to software sector credit due to impending losses and poor risk-reward. A rapid economic recovery or government intervention could mitigate defaults, but structural overleverage makes this unlikely.

The speaker calls Blackstone's $10 billion capital raise for opportunistic credit "exactly the right move" and "brilliant," directly linking it to the problems emerging in direct lending. Dislocation and distress in direct lending (particularly software) create the need for capital solutions, which is the core mandate of opportunistic credit strategies. LONG because the firm is strategically positioning capital to capitalize on the dislocations the speaker has identified as severe and lasting, aligning with Marathon's own activity in the space. The timing of the opportunity may be later than expected, or the fund may struggle to deploy capital at attractive returns if the distress is less severe than forecast.

The speaker explicitly states the "biggest problems in direct lending" are in the software sector, forecasting a 15% default rate there for three straight years with recovery rates averaging only 15-20 cents on the dollar. Loans were made at 8-10x leverage based on inflated ARR models and high valuations. Now, with valuations cut in half, companies cannot service this debt, leading to a wave of defaults with massive losses for lenders. SHORT because the sector faces a multi-year period of severe credit distress, defaults, and deep losses. The pig is still "early" in the python, implying significant pain is yet to be realized. A rapid, unforeseen acceleration in software company profitability or a surge in refinancing capital could mitigate default pressures.

The speaker explicitly advocates for "HALO" (Hard Assets, Low Obsolescence) or asset-based lending, stating "we love it" and it's a "great opportunity," strongly preferring it over software lending. Lending against hard assets (e.g., equipment, infrastructure) provides solid collateral protection (LTV basis), ensuring better principal recovery and is more appropriate in the current environment of reset valuations. LONG on the asset-based lending segment of finance because it offers superior risk-adjusted returns, principal protection, and is insulated from the "air" in software valuations that is causing massive losses elsewhere. A severe economic downturn could impair the value of the underlying hard assets, reducing collateral coverage.

Richards argues public software companies have "0.5 turns of leverage" and strong free cash flow, whereas private software companies are leveraged 8-10x. In an AI disruption cycle ("creative destruction"), companies with cash (public) can pivot and survive. Companies with high debt (private) cannot afford the capex to transition and will default. Long Public Software (via ETF IGV) as a flight to quality away from private software credit. AI disruption is so severe it kills public incumbents regardless of balance sheet.

Richards coins the acronym "HALO" (Hard Assets, Low Obsolescence). He specifically cites aircraft engines and cranes/turbines as examples of assets with a "margin of safety." In an inflationary, conflict-prone world where AI disrupts knowledge work, physical assets that are mission-critical and hard to replicate become the safest store of value. AerCap (AER) is the proxy for aircraft leasing; XLI for industrial machinery. Long Hard Assets. Global recession reducing demand for travel and construction.

Richards provides a specific model: $100 oil = 1% US GDP growth. $120 oil = 0% growth (Recession). 20% of global oil moves through the Strait of Hormuz. If the conflict in the Middle East escalates to shut down the Strait for more than 2 weeks, oil hits the recession trigger price. Watch Oil (USO). If it breaks $100, it is a signal to short the broader economy. Conflict de-escalates quickly; US production offsets supply shock.

23% of the Direct Lending market is exposed to software, compared to only 3% of the High Yield market. Richards predicts a 15% default rate for these highly levered software loans. Business Development Companies (BDCs) are the primary vehicle for retail exposure to direct lending. If a "software default cycle" hits private credit, BDCs with heavy tech exposure will suffer NAV markdowns. Avoid/Short the BDC sector (BIZD) or specific BDCs with high software concentration. Fed cuts rates aggressively, bailing out levered borrowers.

Richards explicitly promotes the "HALO" trade: "Hard Assets, Low Obsolescence." He cites specific examples: Concrete, Rebar, Sod, Aircraft, Maritime, Turbines, Cranes, and Engines. He argues the economy is fine, but the *software* sector is broken. Capital will flow away from intangible, high-leverage tech into tangible industrial assets that are critical for infrastructure and have high recovery values in default scenarios. LONG. Buy the industrial and material base of the economy. Global recession reduces demand for heavy machinery and construction materials.

Richards predicts a 15% default rate in software companies, comparing the sector to Energy in 2016. Kapnick notes that 2021-2022 vintage software deals were priced too high and will struggle. AI is a technological disruption that destroys the "moat" of legacy software companies (pricing power collapses). Private credit lenders leveraged these companies 20x; as growth slows and AI takes over, these companies cannot service debt, leading to a liquidity crunch. SHORT. Avoid the broad software indices, specifically those exposed to mid-cap/legacy SaaS. Fed cuts rates aggressively, bailing out highly leveraged growth companies.