Episode 5: Hello Aristotle Pacific Capital
Host: Alex Warren, CFA, CAIA
Guest: Dominic Nolan, CFA, CEO of Aristotle Pacific Capital
May 11, 2023
Episode Length: 17:55
In this episode, we speak with Dominic Nolan, CFA, CEO of Aristotle Pacific. Dominic discusses the recent addition of the liquid credit specialist to the Aristotle family and what he believes makes Aristotle Pacific unique. He also discusses the Federal Reserve’s battle against inflation, the current state of fixed income markets in 2023 and where he sees potential opportunities for patient investors.
- Disclosures (00:00 to 00:34)
- Episode introduction (00:35 to 01:16)
- Introduction to the episode’s guest: Aristotle Pacific’s Dominic Nolan (01:17 to 01:50)
- History of Aristotle Pacific (01:51 to 02:41)
- Genesis of the acquisition of Aristotle Pacific (02:42 to 03:53)
- Cultural and organizational fit with the Aristotle Family (03:54 to 05:35)
- Background of Aristotle Pacific’s investment team (05:36 to 07:47)
- What makes Aristotle Pacific unique (07:48 to 10:21)
- The battle against inflation: discussion on inflation and Federal Reserve Policy (10:22 to 13:23)
- Discounting the headlines: discussion on fixed income markets in 2023 (13:24 to 14:14)
- Areas of the market that may warrant caution (14:15 to 15:37)
- Outlook and opportunities for credit in the next few years (15:38 to 17:17)
- Conclusion (17:18 to 17:55)
Alex Warren: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, Aristotle Atlantic Partners, and Aristotle Pacific Capital, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor registered under the Investment Advisors Act of 1940, as amended. Welcome to the Power of Patience, Aristotle’s podcast, where we share our views on topics actively explored by our investment teams and across the organization. I’m Alex Warren, product specialist at Aristotle, and I’ll be your host today. Coming up on today’s episode, we’ll be speaking with Dominic Nolan, CEO of Aristotle, Pacific Capital. If you enjoy this podcast, please like and share it on LinkedIn to help us spread the word. Today on the show we’ll discuss the introduction of Aristotle Pacific Capital to the Aristotle family, what makes Aristotle Pacific Capital unique, inflation and Federal Reserve policy, and opportunities today for fixed income investors. Without further ado, let’s get started. Dominic, thank you so much for speaking with me today. To lead off the discussion, can you introduce yourself and provide a brief overview of Aristotle Pacific Capital?
Dominic Nolan: Happy to; Dominic Nolan, CEO of Aristotle Pacific Capital, formerly Pacific Asset Management. Joined the firm in 2008, about a month before Lehman Brothers, so it was a bit of dubious timing on our side, and been with the firm since. We started with about a billion in traditional credit, and at the time of acquisition, a little over $20 billion. As it relates to the origin of Aristotle Pacific Capital, it really starts with Pacific Asset Management. I would say even before that with Pacific Life and their relationship with PIMCO, Pacific Life was the parent company of that very large firm for a number of years. In the late 90s, it was sold to Allianz, and there was ownership still retained by Pacific Life, and essentially that was called away. Knowing that was taking place, there was a group from the general account of Pacific Life that approached the parent company, and said we’d like to start an asset manager with a focus on corporate credit, bottom-up corporate credit. Understanding that there was no longer an active ownership stake in PIMCO anymore, granted that, and Pacific Asset Management was born in January of 2007.
So as they built out the team, I believe I was number 10 or so, there was half a dozen from the general account, and then the rest external hires and again, joined in mid-2008.
Alex Warren: Absolutely. You touched on the recent acquisition from Pacific Asset Management. What was the genesis of the acquisition?
Dominic Nolan: We had been in existence now for a good 14, 15 years, and grown from a billion to over $20 billion. One of the catalysts for the sale was an operating agreement between Pacific Asset Management and Pacific Life coming to an end. The timing of that was that we needed to reevaluate that operating agreement, so that’s one. Two, at a high level, the firm had reached scale, I think within asset management, and that’s a very difficult thing to do, but with $20 billion, the momentum of the business was quite strong. We had hit $10 billion in 2018 and had doubled within two to three years. So again, the high growth rate there. Three, Pacific Life was evaluating their businesses and determined they wanted to remain focused on balance sheet centric businesses. And then when you incorporate that, our business model, even though we’re financial services, is really slightly different than the insurance business model. I think you add all that together. Again, timing of the agreement, wanting to focus on balance sheet centric businesses, us reaching scale, it just led to a decision that they wanted to find us a new partner.
Alex Warren: That makes sense. Now, in your opinion, how is the cultural fit, and what did the two organizations bring to the table?
Dominic Nolan: We went through this process really for most of 2022, and as it relates to things that our team and I wanted was first and foremost, we wanted to keep the team together, so finding a partner that was willing to do that was paramount. Number two, we wanted to find a partner that could help us grow. It’s easy to say, doesn’t everyone want to help you grow? There were entities we were speaking with where we were the second or third fixed income team, and I think they just wanted to increase assets, but not really help us grow.
Alex Warren: Got you.
Dominic Nolan: And then the third element is we wanted to maintain our owner operator mentality. Having the proverbial skin in the game was important to us when we struck our deal in the mid-2010s with Pacific Life. We wanted to maintain that, and it was pretty evident, I would say early in the process, that was Aristotle’s operating model. Certainly, welcoming the team, the ability to help us grow, and that owner operator construct was exactly what we were looking for.
And to add to that, then you start to dig into the values of the organization, and how they operated. And I felt Aristotle was very like-minded. They understood it is a people business, not a balance sheet business. And the track record of success with senior management stood out to us, on top of being like-minded. The investment disciplines were very complementary, and distribution had little to no overlap in my opinion. And then all of that wrapped in an experience of eight years of knowing senior management of Aristotle. It worked well, and again, it got to be where there was really only one clear choice in my opinion.
Alex Warren: Those are important considerations, and it makes sense. For the benefit of the listeners, we’re actually in the same building, so it’s a bit of a hand in glove relationship right there.
Dominic Nolan: Yes.
Alex Warren: Now I understand Aristotle Pacific Capital has a deep bench of credit investors. Can you provide some background on your investment team?
Dominic Nolan: As alluded earlier in our discussion, we were founded in 2007. The focus there was corporate credit, and the investment disciplines were around investment grade credit, high yield bonds, floating rate loans. Those disciplines anchor our business today. So back in ’07 when we had about a billion, that’s what we invested in. Fast-forward 15 years, those are the areas we invest in today. Now, we have added structured credit, or CLOs, on top of those disciplines, but the underlying collateral of that business line are floating rate loans. So I’d say 99 plus percent of our business is focused on corporate credit. Now that element as far as how we invest, first and foremost, the portfolio managers make the decisions on their respective strategies. In other words, there is not a firm-wide view on macroeconomics, risk tolerance, sector preferences. That is done at a portfolio management level.
At the same time, our portfolio managers for each strategy, we have more than one portfolio manager, and in our view, a well-executed team can outrun any individual, that’s our view. And that has been in place since the beginning. Another element is from an analyst standpoint, a research standpoint, they really cover an industry. And I’d say many firms in our industry will separate the investment grade team and the leverage finance team, leverage finance is high yield and floating rate loans. Our structure is that our retail analyst is looking at the investment grade companies all the way through, and the thesis there is if you’re going to research retail, you’re best to know what Walmart’s doing in retail as you dig deeper and get to understand that marketplace.
Alex Warren: Yeah.
Dominic Nolan: So we’ve incorporated that since our beginning. So when you look through, it’s a focus on liquid credit. The portfolio managers really are responsible for their strategy. There isn’t a firm-wide macro view or preference of sectors, and our research structure is done on an industry level, and that’s how we’ve approached investing in credit since the beginning.
Alex Warren: That’s fascinating. I know a top-down view is something that you see in many fixed income shops, so that leads well into my next question. What do you believe makes the firm unique?
Dominic Nolan: We have been focused on an area of the market that I think a lot of other firms don’t focus on. That was something that we discovered over the past year or two, and just to give you a sense of that. When you’re a really large fixed income manager, your predominant benchmark is the Bloomberg U.S. Aggregate Index, and that’s the bellwether index for most investors. The breakdown of that index in high level, it’s about a third U.S. treasuries. It’s about a third mortgage-backed securities, about 25% corporate credit, and the rest is asset-backed securities, and maybe some sovereign debt. When Fannie and Freddie were taken into conservatorship post-crisis, that meant the benchmark was going to be 60% to 70% quasi-government or government, U.S. government backed securities, and as a large fixed income shop, if that’s your benchmark, that means getting that call right on top-down macro duration, etc. It’s going to drive performance.
Our focus has been on the 25% of the benchmark, that investment grade corporate, and then with that, you also have high yield and leveraged loans. Now, when you go below investment grade, that’s a marketplace that has developed uniquely since the crisis, and that the bank constraints post-crisis and the regulations, Dodd-Frank, etc. a lot of lending had changed or the face of lending had changed, and then private markets have become quite prevalent for small and mid-size corporations. Meanwhile, we stuck to the liquid part of the leverage finance market. So as it relates to the firm, we’re actually focused on the third-largest sector in the investment grade world, and we’re focused on the most liquid sector in the below investment rate world. That’s the space we’ve played in, the area we’ve been in for 15 years. As a large firm, we are going to be different, because of our focus on liquid credit relative to a small firm.
A lot of small firms have come about with their focus on private credit. The economics tend to be a little heavier for them, the spreads are higher. Meanwhile, we were plugging away in liquid markets, so fast-forward $20 billion in assets. What we found is very few firms have maintained that focus. I think there have been pressures, whether it be business or on the investment side to deviate, and that’s something that we have remained, I think, well positioned for, because now, again, we have some scale, so we’re not too small, but we’re not a battleship. We’re still able to move pretty quick.
Alex Warren: I think your comment about the Bloomberg Aggregate is fascinating. I didn’t appreciate how little credit was actually in the index itself, so that’s a fascinating point to take away. I’d love to shift gears and get your thoughts about markets. Inflation and Federal Reserve policy have recently presented challenges for fixed income investors. What are your thoughts on the battle against inflation?
Dominic Nolan: Well, it’s been a brutal journey getting here. And just some perspective, last year, the index was down 12%, 13%, around there. Up until last year. The worst year ever was 1994 when it was down about 3%.
Alex Warren: Oh, wow.
Dominic Nolan: So down last year four times.
Alex Warren: Yeah.
Dominic Nolan: The worst year ever. However, there’s a much different rate environment now, so people do get paid to be in investment grade assets, or even paid to be in short-term assets or cash. As it relates to the battle against inflation, obviously, the core of this was one, the Federal Reserve being very aggressive in raising rates, but two, the money that was printed during COVID. So from the standpoint of where it sits right now as we record, the Fed futures are anticipating one more rate hike in May, and actually forecasting a cut in December. So the expectation is the Fed will be cutting before the end of the year. Now that is different than what you’re hearing out of the Fed. Most of the rhetoric coming through is that the Fed intends to leave rates where they are, and the market has been in and out of belief as it relates to what the Fed will do, and there are many market participants that believe inflation’s going to decelerate at a greater pace than what the Fed’s anticipating.
The economy’s going to slow down at a greater rate than the Fed’s anticipating, so thus the Fed will be quasi forced to cut by the end of the year. There’s certainly a camp of investors that believe that, and then there’s a camp of investors that believe inflation’s going to be sticky. The Fed is uber determined to stick to their guns, and they’re going to leave rates where they are. We’ll see. That’s a bit dynamic. Personally, I think the economy is going to slow down more than what the Fed believes. However, where I have pause on the cut is the Fed continues to anchor to a 2% long-term inflation mark. That’s the same level they anchored to prior to COVID. To me, there should be, I think, an adjustment to reflect all the M2, all the money supply that went into the system.
Maybe the long-term rate should go from two to two and a half or three, I don’t know. It’ll take a few years to really get a sense of what should a long-term rate be. However, the Fed has not made that adjustment, so thus it leads me to believe that they’re going to stick to their guns, right or wrong, and leave rates where they are and not cut. However, the new information, and by new, I mean in the past 60 days are the banking issues. We have the second and third-largest failure in our banking history, and as a result, most banks up and down the size, so from money center banks to super-regionals, regionals, community banks, credit unions, etc. I would expect those banks to begin tightening their lending standards, which that tightens monetary policy as well. So if you incorporate that, and fast-forward six to nine months, I believe the economy will slow down. I believe the job market will get worse. Is that enough for the Fed to cut? Right now, it doesn’t seem like it, but it sure would surprise me if it got to that point.
Alex Warren: Broadly speaking, fear and volatility were hallmarks of 2022. Do you think fixed income investors have done a good job in 2023 with discounting the headlines?
Dominic Nolan: In general, I do. And the reason I say that is spreads have held in and rates are moving because the economy’s very difficult to underwrite right now. The recession element has been debated for the past year, and we have not gone into recession. First quarter print on GDP was around 1%, so technically the economy’s holding in, and the job market has been very resilient. So you’ve seen positive returns from a fixed income standpoint. So in general, I’d say they have. Fear and volatility to me from 2022, which is certainly the case, I think has been replaced with just a tremendous amount of uncertainty on the banking situation, and the economic situation.
Alex Warren: Given those uncertainties, are there any areas of the market that give you pause right now?
Dominic Nolan: For me, it’s really the private markets, and when you think about the repricing of assets. So the thing about liquid assets is they’re reflected in their risk premium daily. And when you had a tightening cycle last year, the first thing to reprice were liquid assets. The equity markets repriced, the fixed income markets repriced, those are liquid. Then you start to get into semi-liquid assets, things like office, retail, single family. There’s a lot of uncertainty in single family. I think there’s a lot of certainty that there are struggles happening in the office, commercial property, in particular with office and retail. Certainly, uncertainty on single family and multifamily, but that’s also going through the repricing element. We haven’t quite seen the full repricing in private markets. Private markets are not transparent, and a lot of times they’ll mark the same value, because no one has traded out of it.
And essentially, if you think about what’s the value of your house, well, you arbitrarily assign a number, but you really don’t know unless you sell. In liquid markets, things are selling every day. So you have that transparency. In private markets, I think there’s a lot of price discovery going on, and I don’t believe that’s been, certainly, not fully reflected. I think there’s more to go on the private side, so that gives me pause.
Alex Warren: That’s fascinating, and that’s certainly food for thought. It has been a great conversation and we have time for one final question. What is your outlook for corporate credit over the next few years, and where do you see opportunities?
Dominic Nolan: I’m very much constructive on corporate credit. A few reasons: one, there was a repricing. In investment grade bonds, a year, year and a half ago we were yielding 2%, now they’re yielding 5 plus percent. High yield was yielding sub 5%. Now it’s yielding 8 to 9%. Floating rate loans, with the Fed being aggressive, has discount margins or rate yields of around 9 to 10%. So from an investor’s standpoint, I feel the compensation you’re getting for that risk is substantially higher today. So that’s one. Two, when you look through to implied default rates versus forecasted rates, the markets are already pricing in defaults that are really higher than what Moody’s and S&P are forecasting. Now, that doesn’t mean we won’t get there, but it’s already discounting that in.
So you have that element and then, just when you look through the coupons, those coupons offer significant protection against capital loss, as it relates to credit relative to other asset class, private assets to me haven’t been repriced fully. Meanwhile, you have tightening conditions in an economy that’s slowing down, from an equity standpoint. I think that’s a lot of pressure on the economy and thus equities, whereas at least now in corporate credit, you have coupons to help offset that volatility. So I’m very much in the camp that, structurally, corporate credit, I think, feels pretty good after a decade plus of kind of being secondary to equity returns and private market returns. So I feel the time is quite nice right now for corporate credit.
Alex Warren: A good setup and a challenging environment. Well, that brings us to the end of this episode. Thank you so much, Dominic, for joining us today. We hope you’ve enjoyed it and learned more about Aristotle. Thank you for listening to the Power of Patience. To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed the show, please rate and review us on Spotify and Apple Podcasts. Be sure to come back next time for discussion on bio-agriculture with Aristotle Capital Portfolio Manager and Senior Global Research Analyst, Geoffrey Stewart. Until then, this is Alex Warren, and thank you for listening.