Why Marathon's Richards Is Worried About Direct Lending
Summary
- Sees a major, multi-year correction unfolding in the direct lending market, specifically within loans made to software companies.
- Expects default rates for software loans to reach 15%, with double-digit default rates persisting for three consecutive years.
- Anticipates very low recovery rates for these defaults, averaging only 15-20 cents on the dollar, leading to massive losses for lenders.
- Attributes the problem to excessive leverage (8-10x EBITDA) lent to software companies based on inflated ARR (Annual Recurring Revenue) models and high valuation multiples.
- Believes the distress is in its "early days" as loan maturities are concentrated in 2027-2028, and current transaction prices for these loans are deeply discounted (40s-70s on the dollar).
- Views this dislocation in direct lending as the primary driver of opportunity in opportunistic credit strategies, which focus on capital solutions, dislocation, and distress across the broader economy.
- Praises fund structures with redemption gates (e.g., 5% per quarter) as "perfect" for direct lending's liquidity profile; the real problem is underlying portfolio losses, not the structure.
- Strongly favors "HALO" (Hard Assets, Low Obsolescence) or asset-based lending over software lending, as it offers hard collateral, lower loan-to-values, and better principal protection in the current environment.
- Argues the next vintage of direct lending will be better due to wider spreads (~75 bps), stronger covenants, and lower leverage, improving the risk-reward.
- Identifies Business Development Companies (BDCs) as a market signal, noting they trade at deep NAV discounts due to software exposure.
Trade Ideas
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.
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