A $45 billion credit fund manager believes the Fed is significantly behind on inflation.

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Lawrence Golub manages one of the largest private credit shops in the alternative finance industry. His company, Golub Capital, has $45 billion in assets under management. Despite the competition, private debt AUM is projected to reach $2.7 trillion by 2026.

Recently, private debt has increased rapidly, and inflation and rising interest rates may present new obstacles. Golub spoke with CNBC's Delivering Alpha newsletter about how these challenges affect his firm's lending strategy and where he believes the Fed made a mistake in managing inflation.

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How does the broader macroeconomic environment affect your investment decisions in private credit with floating rates?

Lawrence Golub: Our goal is to assess the borrower's resilience against potential risks. When interest rates rise, it reduces the margin of safety, but we must consider the broader economic context. The economy is doing well, and inflation is driven by strength, not weakness. Our portfolio has performed exceptionally well in this environment, with low default rates.

Your lending covers a portion of the economy that is not typically visible - private companies in the middle market and larger corporations. Can you provide insights into their resilience, particularly in the face of inflation? Is it beginning to impact their profit margins?

We are meticulous in selecting our partners and take great care in our decision-making process. While inflation has had an impact on the performance of companies, we closely monitor the various industries we lend to and have a quarterly report. In the industrial sector, despite strong demand, profits have not been as strong due to supply chain issues that have hindered companies' ability to meet customer demands. However, in the middle market, profits have increased by almost 20% year over year, indicating robust growth.

Is it your belief that the Fed is currently ahead of the curve in managing inflation, and will be able to effectively reduce it from its current levels?

According to Golub, the Fed has the ability to bring down inflation if it chooses to do so, but it is currently behind the curve. When inflation was at 1.7% and the Fed's target was 2%, they expressed concern and did not raise rates until they saw data with inflation over 2%. Now that inflation is over 7%, the Fed is taking slow action and not taking the necessary steps to address the issue. Larry Summers believes that the Fed should call an extraordinary meeting and immediately end quantitative easing.

The economy is closer to a historical unemployment rate of 2% or 3% when considering factors such as quit rate and open job rates. However, these rates are not accurately reflected in the CPI, leading to unmeasured inflation. Housing costs are also not properly reflected in the CPI. In the coming months, month-over-month comparisons with last year will be beaten, causing the headline inflation rate to rise further. As a result, the Fed will tighten and potentially taper off its balance sheet. It remains uncertain when the Fed will begin this process, and how soft a landing they will be able to engineer.

What is the likelihood that they make a mistake and we end up in a recession?

According to Golub, there is a good chance of an inventory recession occurring in the next five years. The question is more about when it will happen rather than if it will happen. The supply chain issues have caused businesses to increase their targeted inventory levels, which may lead to overshooting at some point. The United States hasn't experienced a classic inventory recession in over 30 years, but Golub believes that one may occur soon.

How does an inventory recession differ from a recession caused by a financial crisis?

Inventory recessions are typically characterized by more severe cuts in orders than weakness in retail sales. Historically, these recessions have lasted only a few months, and while they can still be painful to experience, they are not as long-lasting or as difficult to weather as other types of recessions.

Can you provide information about the private credit industry, specifically direct lending, which is a significant part of this industry? In 2021, you had a record year with $36 billion worth of commitments. Other companies have also entered this space, attracted by the potential for similar returns to fixed income investments. How does the competition look in this space, given its recent growth and its role in financing the LBO boom?

Private credit has experienced rapid growth and is currently larger than ever before. New entrants and long-standing players in the industry have contributed to this growth. The private equity ecosystem is valued at approximately $2 trillion, with private credit gaining market share at the expense of public credit and broadly syndicated loans. As the private credit industry has expanded, it has been able to offer larger solutions for a wider range of deals. There are two primary ways in which our industry is gaining market share: by replacing traditional first lien debt with private credit and by providing one-stop loans, which are beneficial for both investors and private equity firms.

Is it true that the increase in private credit has resulted in excessive leverage in the system? I inquire because a recent Moody's report stated that the leverage present in private credit's "less-regulated gray zone" poses systemic risks. Do you agree with these concerns?

Private credit is not intertwined with the financial system or banking system, so even if mistakes are made, it is unlikely to cause systematic risk. Additionally, private lenders are more knowledgeable about the fundamental value of the loans they make and have a lower credit loss rate compared to banks. This is due to the alignment of interest, long-term focus, and a real orientation on lending against value rather than credit metrics.

As enterprise values and stock market multiples continue to rise, private equity firms and lenders are increasingly leveraging their investments. However, there is no indication that these levels will decrease in the near future. As a result, businesses must balance high growth rates with profitability and value increases, while also considering the long-term sustainability of their leverage levels. Investors should carefully consider their investment managers' approach to leverage when making investment decisions. At Golub Capital, we prioritize lending for resiliency rather than perfection.

Picker: What’s the difference between resiliency and perfection?

Resiliency is crucial because perfection is unattainable. When lending against a financial model, it's essential to consider the possibility of a recession and not just focus on maximizing leverage. Underwriting a loan involves assessing the distressed sale value of a business if things go wrong, and lending within that range promotes resiliency by allowing for solutions to be developed.