In Conversation with Justin Hughes – A Market Structure Enthusiast Doubling as a Portfolio Manager

Justin Hughes:
This 110 million of EBITDA is supporting $2.6 billion of debt. How is this marketed to grandma when she buys her senior secured fund?
Peter Haynes:
Welcome to TD Cowen's podcast series, Bid Out, a market structure perspective from North of 49. My name is Peter Haynes, and today for episode 81, we are in conversation with Justin Hughes, portfolio manager at Karl Kapital in San Francisco. Justin's fund that he manages specializes in coverage of global financial services stocks, including exchanges and broker dealers, and Justin himself spends most of his time on capital markets related matters. And as such, he needs to understand how changes to market structure impact the companies in his universe. So Justin, I know we're going to have a lot of fun with this, but thanks for joining the show today.
Justin Hughes:
Yeah, thank you, Peter. And thanks for having me on as guest. I do want to just mention it is a team of research analysts here that manages the fund. So it's not just my views, and although today, we'll cover my views, but it is a six person research team that manages the fund.
Peter Haynes:
Is that your equivalent of an SEC disclaimer before you start a conversation?
Justin Hughes:
Yes. Yes.
Peter Haynes:
All right. Okay. Well, we won't hold you to or your firm to any of your views today. But you and I first met about 20 years ago. You were following the stock exchange space in particular and many of those exchanges were involved in demutualizations and subsequent IPOs around that time and that included in Canada, we had Toronto and Montreal exchanges, and in the US, there was New York, Nasdaq, CBOE, ICE, and others that came to market. As US regulators contemplate changes to Reg NMS rules that were the primary reason for the significant fragmentation of market share coming mostly from these markets that don't differentiate except for their fees, do you think it was right to allow exchanges to operate completely as for-profit entities or would the market be better off with the exchanges as CLOBs regulated as utilities?
Justin Hughes:
I think first of all, I think it's important to separate these two questions. One is should they be for-profit? That's an organizational question, corporate structure question. And I think that's separate from is a central limit order book better than competition because we do have exchanges with central limit order books. The futures exchanges are largely central limit order books. So I think one is about ownership and one is about market structure. So first of all, on the for-profit status, it's good to just have a reminder of where we came from and is for-profit better than not for-profit? I think the answer's pretty clear. For-profit has led to significantly more innovation. The New York Stocks Exchange and the NASD were both not for-profit organizations before they went through their transformation, but despite them being not for-profit organizations, they were basically monopolies. The New York Stock Exchange was a monopoly with 80% market share.
And what do we have of that monopoly? The monopoly was in the business of defending the status quo. There was no technological innovation. We still had a specialist floor based system. It really kind of unraveled when the CEO of the NYSE, Dick Grasso, tried to pull out his pay package, I think was pushing $30 million again for a not for-profit business. That didn't sound like a not for-profit status. The specialists, two of them were public, worth billions of dollars. When the markets went from fractions to decimals, somehow the specialists on New York Stock Exchange didn't lose any of their profitability, whereas over in the Nasdaq, at that point, was more competitive. The market makers, because Knight Securities was public back then, saw a significant decline in profitability and people started asking the question of why. And we found out because the specialists had a very privileged position because that monopoly was defended, they were pinning all the orders that came in.
They'd see order, they'd see a bid ask and they'd just do a penny better and that was illegal. I mean, there was also pretty rampant front running on the floor. People could see large orders coming in and rather than have a competitive bid on those large orders, the floor brokers were able to get in the way. So I think there's no question that the for-profit status has been good. It's led to more innovation. It's been led to significant technological advancement. And so introducing Reg NMS, Reg NMS was what broke the monopoly, really, the NYSE because then better bids had to be honored. So I think it was very good for the purpose at that time and dramatically changed the market for the better. You could send an order to the floor of the New York Stock Exchange, you wouldn't get a fill for several minutes. 15 years ago, Ameritrade was running ads like we can fill your order in 10 seconds. Now, it's instantaneous. So it's been dramatic improvement.
Peter Haynes:
I like to take that debate because I worked for the Toronto Stock Exchange when it was a mutual in the late '80s and early '90s before it was public. And I understand what the environment was like then versus now in terms of the difference and being for-profit versus being a mutual or not for-profit entity as it was. But then I look at where the markets are today and see when the term innovation is used, I see a bunch of markets that only compete based on their fees, which I think is why we're in a position now where the core tenant of Reg NMS, which was the order protection rule, is likely to be eliminated because all we're getting now is what I'll call me too markets that are just competing on price and carving out a small niche.
And then on the other side of that, Justin, as a shareholder of exchanges, I'm sure you've benefited where you've owned them from their monopoly on market data, but that's the other downside that I see to exchanges becoming public is the fact that they have a monopoly on data and we have to buy it. I just wished in this process we could have found a way for regulators to intervene in that. And it hasn't happened in 20 years and having been in the middle of that fight for most of my career, I don't think it ever is going to happen. So how do you circle that square?
Justin Hughes:
Well, the second part is I think we've gone too far. You really don't need this number of exchanges. And I agree with you that if you have to respect every quote, no matter how small that exchange is, you have to set up access fees. You have to set up communications line. That places a burden and an expense, and in most cases, a redundant expense. I do think we've gone too far. I don't know what the answer is. And again, if you're going to be on trading on that exchange, then you need direct data feeds and they can charge for that. And like I said, it's mostly redundant. So just some ideas, does one corporate parent need multiple exchanges? Probably not. Maybe you could limit the number of exchange medallions that one ultimate ownership group could own. That's one thing you could do. The other thing is you don't have order protection rule if you're below a certain market share.
So I think there's some other ways around it. I do think we've gone too far. I think the equities exchange is even more crazy when you look at the number of exchanges either there are in the equities exchange. Obviously the options exchanges have gone too far. So I do think there needs to be some reigning in, but I do think it's better than the alternative. And the other thing is we can see what central limit order books do when it's a monopoly. In the futures markets, as time goes by, the question is how much more are they going to raise their execution fees? And the equity markets as time goes by, how much more are they going to cut their execution fees? So a competitive market has lower execution fees. Now, we got debate about all in trading fees. Central limit order book over time has higher execution fees.
So overall, the increased competition is good for the consumer. The other thing is to tie this into the public markets, the publicly traded firms, matching up buy and sell orders isn't a big part of their business anymore, really. And if we're going to look at where they're exploiting their pricing, it should really be more on the open and close because that's when they get a monopoly again. The trading during the day can be subsidized by the incumbent exchanges by having higher trading on the open and close. So I'd look at that and maybe limiting if you're going to charge one price during the trading day, the open and close can only be a certain premium to that price. So I think that's an area I'd poke at a little bit more.
Peter Haynes:
Excellent point. I'm glad you brought up this idea that the stock exchange portion of these larger entities is only a small contributor. It's core to their business, but a smaller contributor, but we're going to experience in the next few months some activity like we've never seen before. And I really believe that with the SpaceX IPO and other events that are going to happen and we're going to come back to how important the exchanges are as a center point in capital markets and price discovery through these IPOs and subsequent trading that's going to take place. And I'm hoping that the exchanges will be able to handle what is going to be an incredible amount of activity coming soon.
One thing I should say about OPR that I've thought about, I was part of the first round table that the SEC did back in September and one of the things if you get rid of access fee caps and you go to an OPR elimination, I start to think about things just like you're talking about, instead of just charging more for the close, what about a primary saying, "You know what? If you're on our venue between three and four on any given day that you have to pay more to trade during that hour, because that's premium liquidity that's happening because it's all related to the closing auction, that's where everything's happening." So I would worry about that type of tailoring by the monopolies on the open and close, the primary listings venues. So I should ask you, just before we switch gears here, what are your thoughts on the third competitor Texas Stock Exchange? As you think about the exchange space, are you a believer that Texas will potentially carve into the duopoly on the listing side?
Justin Hughes:
I don't know enough about it, to be honest with you, Peter. I mean, I've been monitoring it, but it just hasn't really been a material part to any of the public companies. The history of trying to win listings is very poor. For a long time, Nasdaq was priced well below NYSE and they tried to gain market share that way and listings just didn't move. IEX offered listings for a while. I think IBKR was maybe one of a handful of people that moved. It makes no sense to me why somebody would pay a premium price because they want to say they're listed somewhere, but historically, price competition has not worked in that space.
Peter Haynes:
Agreed. And it is interesting. One of the things that is powerful right now is the draw of the Nasdaq 100. We're seeing issuers leave the NYSE to gain inclusion in that benchmark. Walmart, Thomson Reuters, Shopify, there's three names that the NYSE has lost and I'm sure part of that is the appeal of potentially being in the Nasdaq. Okay. So let's actually go back to when we were first meeting each other. That's 20 years ago. That's when Reg NMS was introduced around 2005. At that time, total consolidated volume traded in the US was about 3 to 4 billion shares per day. Today, the equivalent daily volume number is 18 to 20 billion shares. Now, there've been a few catalysts driving the parabolic increase in volumes and you think one of them is the move to zero commissions that occurred around the end of 2019. Why was this event so impactful?
Justin Hughes:
If we go back to the growth of volumes and just looking at the equity markets now, you said in '05, we had pretty consistent growth, double-digit teens from mid 2005 and then in the financial crisis because the volatility had accelerated, but from '05 into the financial crisis, high frequency trading was proliferating. We were moving to voice based to electronic and that was a really good investment theme during that time of any market that went from voice to electronic experienced a multiple times increase in their volume. And we saw that as NYSE went electronic. But then we started to get the point of saturation coming out of the financial crisis. Once things settled in, the VIX for a long period was in the low teens, high frequency trading had kind of saturated the market and there was a little marginal profit to be made there. Companies like Getco were started losing money, ended up merging with Knight. And so we really had a period of 2012 to 2019 with very little volume growth.
And for a long time, everybody just thought volume growth is debt. Everything's going to be passive, nobody's going to trade. And then COVID hit and a lot of people think, and obviously COVID did spike a lot of volatility, but right in front of COVID, we had IBKR went to zero commissions, Schwab, Ameritrade, E*Trade, everyone responded and everybody went to zero commissions. And I feel it's kind of been lost on everyone that what a dramatic change that did to the markets. I was looking at trading volume at IBKR expressed in DARTs, daily average revenue trades, is up 4 to 5X from peak-COVID levels. And I point to that because there's been some mergers in the space, so that's a cleaner comparison. There's a study done in 2007, actually, I think it was in a Malcolm Gladwell book called The Zero as a Special Price. And in this study, some academics went out to the park and they're offering candies and they had a very nice fancy candy, think like a See's candy for 15 cents and they had a See's candy, tiny little See's candy for a penny.
And well, the fancy candies really should have been more like a dollar. And so everybody saw what a great deal that was and they bought that. So then the next day, exact same candies, they went to 14 cents and zero. So the spread between the two was still the same 14 cents, still getting a good deal on both, but it completely flipped. Almost everybody took the See's candy for free. Free leads to over consumption. And I think that's what's happened with trading. Cash sorting has been a big conversation in the retail brokers. Well, you don't have to take zero from Schwab. You can buy a money market ETF or you can buy a investment grade ETF that utilizes your cash and you get paid on. And if you had to pay $5 for that trade, you'd think twice, at zero, you don't. The barriers to entry of $5 versus zero is significantly psychologically more important than people realize from just the $5.
Peter Haynes:
Do you feel like the intermediaries owe a detailed explanation to their customers that it's not free and that there are costs, bid-ask spread, payment for order flow, et cetera? That seems to be lost in this whole discussion. And I do worry that people do take zero and equate it to free.
Justin Hughes:
I think the dollar amounts we're talking about are so insignificant. I don't think it really matters. I mean, there are disclosures on this, right? There's 606 reports. We're talking about 0.0001 of a penny per share. It's just insignificant. And I don't think if I trade my car in to buy a new car and the dealer offers me $10,000 for my trade-in, he turns around and sells it for $14,000. Does he need to call me up and tell me he made $4,000 off that? No. I mean, people should expect that there are people motivated by profit. Nobody is doing a service for free. Market making is not risk-free. It's very, very competitive. And I just think it's insignificant. Nobody should be surprised. I think if it was fully disclosed, I mean, they already disclosed the payment for order flow and so there's some additional amount above that. I just don't think it's material.
Peter Haynes:
And that's actually a good segue into another aspect of the parabolic growth in market volumes is that the new product innovation that we're seeing by exchanges are more specifically by intermediaries that are creating products. So you have a lot of products now designed for short-term trading, and in that bucket, I'm going to include these prediction markets, which are going parabolic. There's now going to be prediction market ETFs and I'm not exactly sure how that's going to work. You are soon going to have daily option expiries on single stocks during the week, not just on Fridays. And eventually, you're going to have options listed on exchanges that have binary outcomes like prediction markets. And we might even get to the point where those are based on events that are not markets related or stock related. We have the ETF structures that have leverage and it goes on and on and on. Do you think these products should all be available to all investors via the click of an app or should exchanges or brokers add some sort of guardrails protecting investors from trading certain products that they don't understand?
Justin Hughes:
I'm very torn on this one because I'm a free market person and I feel like people should be able to trade what they want to and vendors should be able to provide products that people want. So to me, the real difference here is what does the consumer think they're buying? 10, 12 years ago, I did a SEC comment letter on retail FX trading because they're trying to legalize contracts for difference and they were reviewing the leverage on retail FX trading. So I went to some of these retail FX trading workshops and I saw the people that attended them and I saw the way they're pitched. The pitch to the unassuming retail FX trader is that this is this market that sophisticated institutions trade in and consistently make money and build wealth and you've been left out, and here, we're going to give you access to this.
Sophisticated people are trading the dollar versus the euro or the euro versus the pound. It sounds incredibly astute and you look at the people that are at these conferences and it does not match what they're marketing. Just talking with some of the people, they're using their retirement accounts, very blue collar people that scrap together enough money and they think this is a way to build wealth and it's not. It's a way to lose all your money in a very short amount of time. What Europe did for contracts for difference, contracts for difference are leveraged products similar to what we're talking about here. So you can trade a highly levered future on an equity move, a stock move, et cetera. What Europe has required is that when you open one of these accounts, they have to disclose the average loss rate. So the average person who trades contracts for difference in Europe loses money 75% of the time in any one quarter and those numbers are actually probably inflated a little bit because they could include some low balance accounts in there.
That's any one quarter. So that means over a year, you're almost guaranteed to lose money. I mean, because if you only have a 25% chance of making money this quarter and 25% next quarter and times the next one, you're getting almost next to zero chance of making money if you're trading these things actively over the course of the year. When somebody is placing a bet in a prediction market on how long the national anthem's going to take, I think that person knows that it's an investment product. That's pretty clear. Where I have a problem with it is if people think that they're buying an investment product and they're really gambling. I mean, we know betting on the Bears this weekend is gambling and most people lose money over time. Of course, people always think they're special, but you know you're gambling. I just don't want people taking their retirement money, their life savings, their kids' college fund and putting in a product that they think is to help their financial future and instead it's really just a gamble. So that's where I draw the line.
Peter Haynes:
Yeah. And the convergence between sports betting and market betting, you have Robinhood now offering access to sports betting and I'm sure at some point along the way, you're going to see some of the sports betting shops offer access to trade on the same platform and all of this is coming about with the convergence to app-based activities in the crypto market. So lots more to come on that. Along that same vein in terms of access to markets and to trading, US exchanges are planning to introduce 24 hour trading in December. 24 hour trading already exists. People don't really fully understand it. Some brokers allow some US stocks and ETFs to be traded at all hours and these trades are taking place either off exchange or on a few select ATSs that people don't fully understand.
Once the SIP carries all the trading information when the US exchanges start to trade 24 hours, it's expected that 24 hour trading will become more mainstream. In fact, I would say the whole idea of having a 9:30 opening will eventually disappear and no one will know the difference if they're trading at 9:00 or 10:00 in the morning. And the increased costs though of trading overnight, in my opinion, will likely outweigh any of the convenience factor. Do you think the positives of this move outweigh the negatives? And as you model out trading volume growth for exchanges, how impactful do you think this event will be for trading activity?
Justin Hughes:
Me personally, I would bring back the one-hour lunch break during the day.
Peter Haynes:
Love it. Japan.
Justin Hughes:
Yeah. Why do we need to be staring at the screen all day? But I'd be cognizant of just where the market's moving, where's the world's moving, right? I also have never used DoorDash in my life. I find it so offensive that somebody would pay a fee when they can walk down the street, but I look at the younger generation, I look at my kids, they use DoorDash all the time and I think it's very similar. They pay a lot more for a Big Mac than they would if they just walked down the street and got it themselves, but they're paying for that convenience. And I think if you're going to buy a security at 10 o'clock at night, you're going to have to pay for that convenience. Now, how much, if it's meaningful, I think it should be disclosed. I think similar to now, if you go on your retail account and you buy a stock in the pre-market, says, click here, you understand there's a pre-market trade.
There are different risks here. There should definitely be something like that. And maybe even over time, if there's data quantify, this is costing you X amount more. Again, if it's immaterial, no, but if it is material, yes, but I think we're going that direction. I mean, my 15-year-old son last year, I was explaining to him investing in ETFs and was showing him like, "You should really just buy the S&P and you're getting 500 stocks and et cetera." And we're on the internet and he says, "Well, let's buy it now." I'm like, "No, we can't." "Well, and why not?" I'm like, "Stock market doesn't open until tomorrow." And for a generation, you can order shoes at 10 o'clock at night, have a hamburger delivered at one o'clock in the morning to say you can't buy this intangible thing in the middle of the night doesn't make any sense. I do think it's going that direction.
I don't think it's necessarily good, but some people want to pay for convenience. I don't know if it'll be a noticeable difference on volumes. We can't take the trading day and just multiply it by 24 hours and think there's going to be multiple times more volume to move because I just don't think that's realistic. I think it'll be a niche market. I think it'll be maybe a couple percent on volume, and for the most part, I think it'll just be taking volume from tomorrow that gets transacted today. I think you're just moving it around. It's one of those things the industry might after a while just decide the cost's not worth it. How expensive is it to make markets overnight, never be able to take down our systems, update them, et cetera. So maybe it slows down. A lot of the trading you see at night now is actually overseas markets, which is a whole nother topic, but this phenomenon of US tech stocks is not just the US. US tech stocks are being traded globally and a ton of the overnight volume to see is really coming out of South Korea.
Peter Haynes:
Yeah. And once the exchanges are on board, apparently that's going to expand into other countries and probably expand in South Korea because the problems that were experienced on one of the ATSs a year or two ago on the technology side definitely left a stain. At the recent congressional hearings in Washington, the familiar refrain when discussing Reg NMS and OPR was retail investors have never had it better. In other words, don't change anything. The second half of that same sentence that nobody ever talks about should refer to as the institutions have never had it worse. And I'm wondering at what point, I don't know if you agree with that. You just made the comment earlier about shutting down at lunch because nothing's happening during that period of time. The longer we spread out liquidity, the more expensive it is for investors, institutional investors to trade. So when are we going to have the second half of that sentence matter as much as the first half?
Justin Hughes:
From my firm's perspective, I haven't seen much difference in trading in years. I mean, the early part commissions came down quite a bit. I mean, it was 20 years ago, was still heavily using a broker. They charge five cents. That five cents is now three cents. An electronic trade 20 years ago was a penny, when that sounded really, really cheap. Now, it's a quarter of a penny. But I think you have more of a question of is when you get in trading costs is small illiquid companies and that's just a function of size and liquidity and paying for that liquidity. And again, you can't come into the market, expect somebody else to take the other side of that trade and put capital at risk and not make some money off it. There is maybe less liquidity in the smaller stocks, but there's also just less interest in those stocks.
I mean, so much of the market now is dominated by these multi-manager models, the Citadels of the world, the Balyasnys, the Millenniums, they need $20 million of daily trading. If you're below that, you just lose kind of institutional relevance. I think institutional trading is fairly good. I mean, the liquidity's great. For our size fund, we can move in and out of a lot of stocks and a reasonable amount of time and the transaction costs are very low. So from my perspective as a user, I really have no complaints. It is the best market in the world. And we trade in overseas markets as well. I can tell you the US is a lot better than any of the four markets we trade in. Other markets have stamped taxes, financial transaction taxes, so you have to trade via swap. They have a lot more small companies that just don't trade at all. I haven't seen a better model anywhere in the world to get small cap liquidity.
Peter Haynes:
There's no argument whatsoever with the US representing over 60% of world market capitalization. You can't compare any other market to the US. That is absolutely a fact. It is a standalone market and I get frustrated when people try to draw those comparisons. We were talking about 24 hour trading. I noted that the CEO of ICE, Jeff Sprecher, made a comment recently about Hyperliquid, which is trading on weekends being a wake-up call to the primary exchanges, particularly Hyperliquid's activity. I think in the energy market trading around the start of the war, which occurred on a Saturday. It's interesting. I wonder whether or not he's prefacing the primary markets, the places like ICE that are trading crude oil products, whether or not they're prefacing the fact that those products are soon going to be traded 24/7, not 24/5.
Justin Hughes:
I mean, for a major commodity like oil, it could easily make sense. There could easily be demand for it. If there's consumer demand for it, the exchanges will offer it.
Peter Haynes:
Yeah. And that's the question is, is this field of dreams or not? And I think in the case of oil, there is probably going to be demand, but for every other product or most other products, they're building it and hoping people will come, not necessarily knowing they will. Okay. A really significant proposal came out from the SEC recently and this is where we move into debate mode a little bit and that was around the changing of the cadence of earnings reports for NMS names from quarterly to semi-annually. Importantly, this proposal was written as voluntary and I personally don't believe it will result in any material adoption save for perhaps some smaller pre-revenue companies. For the record, I'll take the side of completely agreeing with this idea of moving to semi-annual reporting. As I'm listening to the issuer concerns about public markets and the number one problem in every survey that the issuer's cite is managing to the particular quarter, getting the earnings right on.
It's a massive time suck to put together quarterly reports, go through board approvals and audits and the like. And it's a distraction for management that I believe would be better served if they were out trying to make their company better rather than trying to manage to the particular quarter. It's not like the companies are going to stop providing information for six months. They're still going to give regular updates, conferences, webinars, et cetera. In our pre-call, you indicated you're on the other side of this debate, you are totally opposed to this proposal. So why are you right and I'm wrong?
Justin Hughes:
I don't think it's right and wrong here, but it's definitely different opinions and maybe it depends on if you're a consumer of these financial statements or producer of the financial statements. But I can tell you as a consumer of these financial statements, I absolutely do not want quarterly reporting to go away. I think the agenda of it'd be really nice to not do quarterly and only half year. That's a debate at the coffee shop by people that don't actually use these financial statements or invest in the markets on a daily basis. Those of us that do really need this information and I'll give you a couple of reasons why. I have access to alternative forms of data, right? I can see payments data, other things I can track. The SEC filings on a quarterly basis are very... It's democracy. Everyone gets access to the exact same information.
Two, I can meet with companies on a regular basis and go to conferences with them and the average investor cannot. If you increase that gap between reporting of the public company, you're only giving me a bigger edge against people that rely on that financial reporting as their main source. So that's one thing. Two, the main thing we're looking at here is does quarterly reporting result in maybe under-investing in their business or trying to get short-term stock returns? Management is usually compensated on much longer periods. Investment managers are managed on one, three, and five-year basis, usually how they're judged. So can there be some vocal investors that get upset about a quarter, a couple pennies on the quarter? Sure there are, but it's not how management's really judged and it's not how investors are judged. And often you see a move on a quarter that doesn't last very long.
There's some decent academic research on this topic. The UK only went to semi-annual reporting in 2014. If you look at the capital expense of companies and how much they were investing in future CapEx, it did not change from before semi-annual reporting to after. If we look at the performance of the UK stock market, it's dramatically unreported from the US market, the report's on a quarterly basis. If it was so attractive for issuers to do semi-annual reporting, any company can list on the LLC, you don't have to be a UK company. An American company can go list there if they'd like, but they choose not to. Additionally, within the financial statements, there's two things that are very helpful, is MD&A, management discussion, analysis. So a lot of times it's not important of, did you make 35 cents, but why? And the management discussion analysis forces management to put in writing, "Here's why our revenues were up. Here's why our sales figures were down."
In a legal document that is binding and that can be much more eye-opening than the actual financial statements themselves. Also, academic studies show that a company with weak internal disclosures is more likely to be accused of fraud. So some of the regulation on these financial statements is very helpful. And finally, from functional standpoint, we build earnings models on companies that we invest in. If you're getting half your financial statements and disclosures, they still give you some quarterly points. And when you try to build a model where you have some half year things, some monthly things, it turns into a complete mess. So for functional statements, it's just not very helpful. So those are my main point on why, I think, it'd be a very bad idea.
Peter Haynes:
Why not go to monthly reporting then? Why is quarterly the right cadence?
Justin Hughes:
Well, actually, some companies do report key figures on a monthly basis. Progressive, one of the best insurance stocks, really one of the best large cap stocks in the market over the years gives us quarterly premiums loss ratios. Been a great long-term compounder. Companies in Taiwan give monthly revenue, hasn't held back their investment in future computer chips.
Peter Haynes:
What if the companies in your universe provided all that information just not in the detail with audited statements and lawyers and accountants? Why, if you still receive that information, call that on a voluntary basis? That's going to be demanded by shareholders. It's just not the formality of the actual quarterly report.
Justin Hughes:
We still need the why. We still need the MD&A, the management discussion, analysis.
Peter Haynes:
Can't a conference call solve that?
Justin Hughes:
If you want people that are really short-term focused, then you only give them, here's the income statement. If you want longer-term thinkers, you need to give them more information of what's behind the numbers. And that's what the 10Q provides.
Peter Haynes:
I did find it a bit humorous that WallStreetBets wrote a letter as part of the comment process here representing all the online retail investors on the Reddit platform. And they were, of course, very much in favor of keeping quarterly reports as they feel it's part of this democratization of markets and that that's taught the retail investor how to read a 10Q and I'm thinking to myself, how many retail investors have actually read a 10Q? Let's be serious here. I felt like that was a bit of a stretch there, but they have access to it as you say. So we'll finish up here and we'll let everyone who's listening decide who's right and wrong on that. And I do encourage people in the markets to comment on these various proposals, because if your voice isn't heard, then sometimes that's how the wrong decisions are made.
But as we finish up here, it's my understanding from well-placed sources and you listening right now know who you are is that you've been doing a lot of digging in on the private credit space, a growth area for the broader financial services industry, especially since the great financial crisis. What advice can you give to prospective investors in the private credit space in terms of what to look for and what data is important in analysis of the various credit products in existence?
Justin Hughes:
So I've been following the private credit space for quite a few years, and, of course, it only has really come to the headlines really since the start of this year because there were some concerns about credit and the sales load in the space. It's been a million podcasts on the topic. They talk about insurance companies exposure, but what I think would be most helpful is helping people understand what they're actually investing in. I have a couple examples of some actual deals of senior secured. These private credit funds typically market that they are making senior secured loans and you can invest in a fund as they market it in senior secured loans and earn a 9% yield. That sounds really attractive, especially in a much lower interest rate environment. Senior secured lending with a 9% yield. That sounds like grandma wants to buy that all day.
Now, let's look at the actual paper in these funds. And again, I don't want to pick on anyone, one issuer or anyone fund. So I'll just give them kind of generic generic names, but these are actual real deals. So I'll just call it software company C acquired in December of 2022. It was acquired a total enterprise value of $6 billion financed with 2.6 billion of debt. Now, this company was public, so we can actually look at the financials and we can see that the last 12 months debt EBITDA was a little bit over 100 million. It's called 110 million. This 110 million of EBITDA is supporting $2.6 billion of debt. How is this marketed to grandma when she buys her senior secured fund? She's told that this senior secured fund, and they say senior because there's no other debt in front of it, has a loan to value of 42%.
Loan to value is a term that's usually mentioned when there's a car behind it. What's the loan to value on your auto? A jet engine, a jet airplane. Here, the value is not an actual piece of equipment. It's not anything tangible. It's what the private equity firm outbid everybody to buy this company. So there's actually no hard assets in that loan to value ratio. And I would challenge anyone to show me a single public company that quotes their debt structure on a loan to value basis, which would be their debt divided by their enterprise value. Public companies use real metrics like debt to EBITDA, debt to equity, debt to tangible equity. So what's the debt to EBITDA on this company? 24 times. Debt to equity, the company doesn't have any equity. It's negative. Debt to tangible equity, it's even more negative. So this is a loan at 24 times debt to EBITDA that's marked as senior secured and there's even more.
The funds actually put leverage at the fund level. A BDC can take on two times more debt than equity, which means three times more loans. So this 24 times debt to EBITDA loan can be levered up at least two more times you're effectively putting equity into a loan at 50 times debt to EBITDA. That's what you're lending in and that's what you're getting your 9% yield on, which also doesn't reflect the capital losses you take because some of these loans go bad. So I think people just need to understand what they actually own here and that's why the public BDCs are trading at significant discounts to NAV and no one is now willing to invest or very few people are willing to invest in a privately held private credit fund that's trading at par when there's significant concerns about software space. It goes back to some things we've talked about before.
Are these products being sold as what they actually are? And in the case of private credit, I don't think they are. I think the use of the term senior secured is very misleading. I think that marketing private assets as a separate asset class is very misleading. Private markets are a different wrapper. If I took a Big Mac and put it in a Taco Bell bag, it doesn't make it a taco. It's still a hamburger. And if you're going to invest in private markets, you need to get paid a higher risk premium. And right now in the private credit space, you're paying a premium for illiquidity. Now, sometimes there's liquidity on the quarterly basis, but they decide when you have liquidity. And if you can't decide when you have liquidity, is it really liquidity? So that's my biggest concern about the private credit space right now is that I don't think the average investor, the average retail investor that came into these quarterly liquidity funds really understands the risk that they're taking.
Peter Haynes:
The term premium for illiquidity is something we hear in the private equity market as well and that's changed a lot lately as the private equity marks have caught up with public comps over the last couple of years. Do you think this can be solved through regulatory scrutiny on the marketing documentation? We've seen that in other parts of the business in the past where the regulator comes in and says, "I don't like how you're marketing this particular fund, the names you're using. I don't like how you're marketing this particular dark pool because of the language you're using." Sometimes that was through enforcement actions, other times through other actions. Do you think this can be solved through more scrutiny of the marketing?
Justin Hughes:
Definitely. I mean, when you look at these companies or these funds that are marketed senior secured debt, when you dig into their offering prospectus, which goes into the thousands of pages, literally the thousands of pages, how many retail investors are really reading that? And so people say, "Oh, well, it was right in the prospectus that the funds could gate." Well, if somebody's paying a financial advisor, do they then have to go read the 2000-page prospectus themselves? No. So you really have to focus on the marketing. And so these senior secured funds as they're marketed also say in their 2000-page prospectus, these are really junk bonds. These are really junk bonds we've levered up three times. So it's in the prospectus, but it's not in the marketing.
Peter Haynes:
Well, that'll be an interesting space to follow and we'll watch it with keen interest as it is getting a lot of attention in the media. Well, look, that brings me to the end of our series of questions here. We covered a lot of ground. We went across a lot of asset classes across geographies as well and I really enjoyed the conversation here today. Justin, thank you so much for coming on the podcast and I'll look forward to continuing to debate some of these topics with you in the future.
Justin Hughes:
All right, Peter, thank you very much for the time.