Why the Wealthy Are Betting Big on Private Credit with Peter Sack – EP 229

Justin Donald: Hey, Peter. Welcome to the show.

Peter Sack: Thanks for having me, Justin.

Justin Donald: Well, I'm excited to dig in to all things and everything private credit here today as you are a specialist in that arena. And I'm curious how you got into this space.

Peter Sack: Yeah. I kind of stumbled into finance. I never thought that I would be running a finance company or an asset management firm. I thought in college that I would be a professor or perhaps a lawyer. I spent my first year out of college doing fieldwork in South China as a labor organizer under the Fulbright program and really loved doing fieldwork. There's no more exciting place to be than China in the 2000s and early 2000-teens. But for better or worse, mostly for worse, the political environment in China got a lot more difficult for social science research.

And I pivoted into a private equity investment firm that focused on investing in struggling industrial companies and was able to leverage my experience in China, work in factory towns in China, and really build an expertise and turnarounds in distressed and challenging underwrites. And that ultimately led to distressed and special situations credit and that led to the wonderful and wacky world of cannabis investing.

Justin Donald: Yeah. Well, I mean, we have a lot to talk about. So, a few things. I'm really glad that you used your incredibly impressive resumé for the side of investing as opposed to just, I guess, being more on the theory side or the studious side. But you went to Yale and then you went to Wharton for your MBA so two of the most prestigious programs for undergrad and graduate, MBA. And so, it's neat seeing your pivot, your journey from private equity to private credit, the distressed opportunities, how that's kind of been the connector. But what I'd love to discuss, private credit is one of my favorite things to invest in.

So, of every asset allocation that the family offices track, and I try to teach people that we want to be modeling what the wealthiest people in the world do and the wealthiest people in the world have part of their portfolio in private credit. Usually, you'll see about 5% to 15% right now. What is private credit and why should people consider having an allocation to private credit, in your opinion?

Peter Sack: Yeah. Private credit is one of the most fundamental and oldest institutions in the world of finance. It's simply people making loans to other institutions and companies and individuals making loans to other companies to support growth, to support economies, to support businesses. And it's as old as people have been exchanging shells and shekels. And so, what's really different about private credit today is, A, the level of scale and institutionalism that's happened in the last 15 years, most of which came out of the Dodd-Frank Act and how our economy in ways of allocating capital changed after the Great Recession. And what this did is took ordinary lending, particularly to medium and smaller-sized businesses from the purview of large commercial banks into a private marketplace of institutional asset managers.

Justin Donald: Yeah. And so, when you think about private credit, and in layman's terms I would say on the public side, you always hear people talking about stocks and bonds and having like a 60/40 split, even though that's not what the wealthiest families do. But that's what the Wall Street types say and financial advisors and really just the financial industry. But the bond side would be the public side of fixed income. And then you've got the private side, which would be private credit. And you're starting to see people with a larger position now on this private credit side than you are even on having the fixed income, the bond portion of the portfolio.

And my question to you on that is, why do you think we are seeing such a rise? Like, I study the family office data and if you look back at 2022, let's even go back to 2020, it was much lower than it is today. So, private credit has really been on the rise. It's been around for a long time, but it's been on the rise probably the last four or five years, probably five years. There's a ton of players in the space. Not all of them are great, but there are plenty of good ones. So, I guess my question is why now? Why are people looking to this? Why is private credit becoming so big?

Peter Sack: Part of it, just a larger segment of our economy is made up of large private companies. And many of these are private equity or sponsor-backed businesses. But really, it's that a larger segment of our economy is made up of private companies that when they want to raise debt, the bond markets are either inaccessible to them or just not practical to them. And so, the loan market or the private debt market is made up of loans that unlike bonds, they're pieces of paper that aren't traded publicly. They're not technically securities and they are contracts between an investor, a lender, and a borrower.

And this has filled the need of this big segment of our economy that's really large companies that are privately held, whether that's simply large private companies or private equity-backed companies. And so, the private credit market has grown to fill that need specifically in the absence of banks' ability to do so.

Justin Donald: Yeah. And I think the banks are really failing on a lot of different levels with the regulation, with the terms, with, I mean, really what a lot of them had to deal with based on what their balance sheet look like with bonds. Bonds are supposed to be no risk and all of a sudden they're one of the riskiest things out there. Now, banks that are household names are struggling financially because they were over-allocated in them. And it's a fascinating display of what having an improper asset allocation can look like and what it can do to your business, right?

Peter Sack: Yeah, absolutely. Absolutely. And what this creates is opportunity for investors to get exposure to a part of the economy that they wouldn't have otherwise in a risk profile that's really unique and has a risk profile that at least builds itself to create equity or close to equity-like returns that hopefully will exceed the long-term average of the S&P with stronger downside protection than you might expect from equity markets and from private equity investing.

Justin Donald: Yeah. And when you think about investing, in general, so you've got the stock market that basically has 4,000 public equities so companies that you can invest in via the stock market, right? 20, 25 years ago is 10,000 companies, right? So, the number is dwindling. You have tens of millions of private businesses compared to 4,000 publicly traded companies. And so, you wonder, first and foremost, why that out of all the business, that's just in the US. I mean, if we're looking, it's actually probably over 100 million in the US. And so, it's hundreds of millions worldwide.

So, people that are investing in public equities are investing, you know, it's less than 1% of total businesses out there, which is mind-boggling when you really think about it that of all the investments out there, most people who are only investing in the stock market are literally missing out on 99.9% of all the other companies, all the other offerings. And when you have banks that can't serve these companies, it creates an incredible opportunity for private credit for people to come in and say, "Hey, I can provide what the banks won't do. I can provide terms that are reasonable, and we can create a winning situation."

And some of the things that I like that you guys do specifically with Chicago Atlantic is you also, besides the private credit side negotiating your terms, you guys do a lot of equity kickers where you negotiate some equity or warrants for free on the deals that you do. And I'd love to hear you talk about that because I referenced this a lot in my book, The Lifestyle Investor.

Peter Sack: Yeah, exactly. On about a third of our transactions, in addition to really strong fixed returns that we achieved through interest rates and upfront fees and exit fees, we're able to also receive what we call equity kickers, which are warrants or membership interest that are granted or a conversion feature that allows the lender the ability to participate in the upside of the company. And we're able to do that usually because we're offering something really unique that the borrower might not be able to achieve elsewhere, whether that's some flexibility or we've done the work to really understand the nuanced specific risk or transaction that other people won't do.

And it allows us to give our investors both significant downside protection, but also a little extra kick that we don't necessarily underwrite as part of the fundamental risk-reward because it is more uncertain. But then when you do enough of them over time, A, they build up in your portfolio because the loans get refinanced but you keep the warrants or the equity forever and, B, when they do get realized, they can provide that extra jolt of returns that's really attractive.

Justin Donald: Yeah, there's no doubt. And so, another thing that's really interesting about your company with Chicago Atlantic is you have and, by the way, we should probably have you even talk a little bit about your role there and all that you oversee because you oversee virtually everything. But before we do that, I think it's neat to show how Chicago Atlantic started really as a cannabis company. You had 100% of the investment capital. And for a while, it was just on the private credit side. So, private credit for cannabis companies then you opened up an equity arm in that space. Now, you've actually opened up the playbook so much so that you invest in all different types of companies. It's not just cannabis companies, but the space is still attractive.

And I'd love to hear you speak a little bit about the edge that you get in kind of like a restricted class, right? Banks can't lend because it's not federally legal. It is legal state by state. And there's many states or 15 states, probably close to 30 states that have legalized in some way, shape, or form now. But banks still can't lend. They can't participate so it creates this opportunity for companies to come in and satisfy that need.

Peter Sack: Yeah, that's exactly right. We launched in 2018 with an aim to identify areas, particularly in private credit, where we could develop really differentiated returns due to there being a supply and demand imbalance of capital. And we found that in cannabis for a couple of reasons. Well, we found that in cannabis but I think besides just a mismatch of supply and demand in capital, we also wanted to find a space where the more we invested in resources in people and knowing the industry and having boots on the ground enforcing the best deals, the more alpha we could generate for our investors. And that's actually the harder part.

Now, there's always going to be industries that are cyclically not very attractive to investors, whether that's oil and gas at different times in the cycle or you could say that about commercial real estate today. But I could have a hundred-person organization spending all their time investing and owning commercial real estate for the next five years, and I still would be a marginal player. Now, cannabis is a space that they've had both a big supply and demand of capital and was a space where the more you invest in the industry, in building relationships, in growing across what's really fragmented space, the greater differentiation you can create for your investors.

And so, if you bought cannabis space that banks have been very reluctant to lend into and the broader private credit space has been extremely reluctant to lend into because of this mismatch between legality in now 40 states either on a medical or recreational basis and illegality under federal law. And because of that rather arbitrary challenge, there's very little debt capital available in the space, even though there's dozens of publicly traded companies and hundreds, if not thousands, on very attractive cash-flowing cannabis businesses with strong asset bases, strong equity backing that have very fundamentally strong credit quality but can't get access to credit capital.

And so, that allows us to operate in the space and deploy capital at much lower risk levels than the broader private credit space and much higher returns simply because we have much less competition.

Justin Donald: And you guys now are the largest lenders in the cannabis industry, period. I was reading some of the numbers you guys, I mean, what are you now? Like, $4 billion or $5 billion?

Peter Sack: We've deployed about $2 billion into the cannabis space since inception.

Justin Donald: Yeah. And more beyond that.

Peter Sack: And more beyond that. Since then, we've taken the same approach. Again, the whole cannabis industry, the legal cannabis industry in the US at least, only existed for around ten years. We're private credit, special situations lenders, and entrepreneurs by background. And so, as we grew our cannabis business, we also continued to make small amount of loans into other niche areas of the private credit space where we saw a mismatch of supply and demand of capital, some of which are opportunistic and some of which are more sustained. And that's always been a small portion of our private funds and some of our public funds’ portfolios. There's really the mindset and the underwriting approach is the same across each of these ideas. The question is where and when to deploy it appropriately.

Justin Donald: Yeah. What are some of those niches and sectors outside of cannabis?

Peter Sack: We've done a lot of work in lower middle market recurring revenue, safe businesses looking for growth capital. And in particular, the sub-$10 million EBITDA range, this is a segment of the private credit space that gets much less attention. But when you can devote the resources even to these smaller deals, you can generate some pretty differentiated opportunities. And so, we're generally working on non-sponsor-backed, non-private-equity-backed, directly originated transactions. And the second space has been in, I think what, since the rise of interest rates post-COVID, the venture debt world has really dried up and disappeared.

And that leaves a space of some very strong I wouldn't even say early-stage, maybe middle-stage growth companies with recurring revenue features and strong downside protection that are either in the early stages of their profitability phase or just on the cusp of it. And oftentimes we can underwrite businesses that may not have a strong cash flow profile simply because they're investing in their own growth. And so, you can underwrite downside scenarios to say this business is so recurring and so sticky that if they just decided that they were going to grow at 3% a year instead of 15% a year or 20% a year, that that cash flow profile will look a lot differently. And so, those types of things we love to back because when you take the time to peel apart the onion and understand what are the fundamentals driving it, the risk-reward really makes a lot of sense.

Justin Donald: And I know you guys have had some success with digital mining companies as well, right? That's a whole another vertical that you've paid extra attention on and even have specialized investments into. So, I'd love to hear your thoughts on that, too.

Peter Sack: Yeah. And this is another space that because it's relatively new, it's both a space that requires a lot of capital and is relatively new that there are some niche opportunities where you can support the build-out of these assets on a really low-risk level. And in part to do that, we leveraged a lot of our experience in finding low-cost power locations relative to the cannabis industry and developing low-cost power locations for the cannabis industry and saw a lot of parallels in that in terms of how you develop digital mining infrastructure. And so, we found a number of cool opportunities to deploy in back projects that are really sort of arbitraging cost of mining and really low-cost power niches.

Justin Donald: Yeah, where you have a power contract that is locked in, it's secure, your rates are low and there's that arbitrage opportunity, which I love that you guys do that. You have had now three different exposures or opportunities to take either all of a fund from private to public or part of a fund private to public. And I'd love to hear your thoughts on that and why it makes sense and when you make the decision because you guys have one of the best performing and most interesting public, I guess, tickers to invest in under refi. But at one point in time, that was your private credit fund.

So, the original private credit fund went public and now people that are interested in this space that maybe they're afraid of alternative investments or afraid of private credit, they actually could do this on the stock market under refi. So, talk a little bit about that.

Peter Sack: Yup. So, the investment and deployment thesis is more or less the same across public vehicles or private vehicles, particularly for our cannabis loans. We're making loans at very low leverage levels. Our target loan profile is 1 to 2 times EBITDA. Because of limited competition in the market, we can negotiate strong covenant packages that protect the downside. And we can generate returns that are nearly twice the broader private credit market.

And so, when we took a step back and looked at what we were doing in our private fund in the cannabis space and then compared it to what's available in publicly-traded lending vehicles or just the broader private credit industry more broadly, we realized that we created something really special, that our loan portfolio is made up of entirely first lien debt, whereas much of the broader private credit industry is made up of mix of first lien, second lien, unsecured, more risky vehicles, and that we're generating returns in the high teens that have fees for loan portfolios that are completely un-levered, whereas many other private credit vehicles are taking back leverage, which adds risk to the portfolios.

And so, when we looked at that and compared, we said, "Gosh, this should be, if placed and made available in the public markets, this should be received really well and trade really well." And so, we took our first fund public as a REIT on the NASDAQ in 2021 under the ticker 'REFI' and that's Chicago Atlantic real estate financing. And that portfolio of loans, in fact, did comps very well in the mortgage REIT market that our portfolio is nearly entirely first-lien debt, whereas other mortgage REITs are made up of a mix of different risk level of securities. Our portfolio is very low leverage and the broader market mix on much higher back leverage than we do. And our dividend yield compares very well, even though our portfolio is much less risky, according to these types of metrics.

And so, that's really what's driven us to be among the best-performing mortgage REITs on a total return basis since inception on the public markets. And then in 2024, we launched the second public vehicle on Chicago Atlantic BDC under the ticker 'LIEN.' And we're really looking to replicate what we've done in the mortgage REIT market for the BDC market. And it's a very similar thesis. We think our portfolio of loans compared very well on a risk-reward basis and that we're going to be able to generate a really differentiated dividend yield and return profile relative to on an absolute basis and especially when compared relative to the security profile of our portfolio and the leverage profile of our portfolio.

Justin Donald: Yeah. And why don't you break down what a BDC is? So, it's a business development company but explain what that is so people understand that.

Peter Sack: Business development companies are regulated under the 1940 Investment Act. And it's a type of company that Congress created in order to spur investment and innovation among privately held US-based businesses. And so, BDCs, they're both public BDCs and private BDCs, are required to invest the majority of their investments in private US-based companies or public companies that have less than a $250 million market cap. And then the SEC puts in place very strong regulatory restrictions that require strong diversification and other investor protections, including much stronger reporting than you might see from a private investment company or even many public investment companies. It has some differentiated tax treatment too. Similar to a REIT or an MLP, a BDC does not pay corporate income tax.

Justin Donald: Very good. And this year, 2020, well, I guess it would have been also in 2024, you would have had another foray with the public markets with the pipe that you guys did. And I'm not sure if we can get into that, but that's a private investment in public equity. So, if we can discuss it, I mean, everything's public now so we should be able to, right?

Peter Sack: Sure. Yeah. And so, this is a unique transaction that we put together. We've been a lender to a public company called Vireo for some time now. And it's been a really strong relationship. We helped them grow in three very well-performing exciting markets: Maryland, Minnesota, and more recently, New York. The stock didn't trade as well as I think anyone would like. It's been a difficult market for the equities. And so, we spent much of the last year partnering with the management team and the board to help them put together a transaction to acquire a handful of other operators across the industry in an all-stock transaction that increased the size and scale of business significantly, ultimately, for the benefit of Vireo shareholders, of which our funds were a significant shareholder.

And so, this is one instance where over the course of the lending relationship, our funds have built up a significant warrant and equity position through those equity kickers and we took an active role working with management to make those equity positions realizable by helping bring this transaction together. And so, the company raised equity and put together this really transformative transaction. And these are the types of things that you can do when you focus on one industry and work really hard to build really in-depth relationships in that space over a long period of time and so that you can put together some really transformative transactions.

Justin Donald: Yeah, no doubt. Where do you see the cannabis industry going? I feel like there's been a huge lull. I think a lot of people thought it would perform better than it has. I mean, on the private credit side, it's performed really well, right? That's been just an absolute home run. But on the actual private equity side and public equity side, it's a little bit of a different story. So, do you see a rebound in '25, '26? Or where do you think it's going?

Peter Sack: We founded Chicago Atlantic to give investors access to what is a very volatile and uncertain industry in a manner that would have extreme downside protection and strong current income and equity-like total returns. And in part, we did so from the beginning by ignoring market cap and equity valuations that were extremely high back then and focusing our underwriting on cash flow, on profitability, and growth. And particularly from a growth standpoint, the industry continues to grow well. Last year we saw the rollouts of states like Ohio, Missouri, continued rollout of Maryland. We've seen continued growth in the New York market. We've seen the beginnings of growth in Minnesota. We saw Kentucky launch a medical program. We saw Nebraska approve a medical program.

And so, while progress is slow, it does continue. And that's the sort of leading edge that we've followed. And in the lending space, in particular, because we can shift our portfolio and do new loans in new markets and not necessarily deploying to old markets as loans mature, we can sort of constantly be shifting our portfolio in the most attractive places. On the equity side, I think there's been two large challenges. One has been an overhang of simply valuations that were based on the expectation for federal reform that has been very, very slow to come. And so, [indiscernible 26:43] when it's going to come. And it's been impacted by the maturation of some of the oldest markets in the US, like California, Colorado, Oregon, and Washington that are very competitive markets and have seen price and profitability declines amongst those operators.

But I think when you look at the equity index as a whole, valuations are extremely low, especially when you compare them to comparables in mature pharmaceuticals, alcohol, beverages, and CPG. And it's even when you compare them, especially when you compare them for companies and industries of considerable growth profile. So, the fundamentals are there but we do need some regulatory catchup at the federal level. It'd be extremely helpful to have tax relief from what's a really punitive tax treatment of cannabis companies. It would be extremely helpful to have these companies be able to list on the New York Stock Exchange and the NASDAQ. It'd be extremely helpful to have acts like the SAFE Banking Act that would make it easier for banks and custodians and insurance companies to provide services to these cannabis companies.

Many do today, but not to the same level and degree. All of these things would make it easier for these companies to be invested in but open capital markets make it easier to do business. And I think it's a question of ‘if not when’ but it's always going to be slow and that's why we base our investing assuming that nothing gets better from a regulatory standpoint.

Justin Donald: Yeah. I think that's the only way to do it. So, you're making smart decisions on behalf of your investors and then if things do get done, it's just going to amplify that return, right? So, I think that's smart. It's amazing to me that only ten states have not passed some form of recreational or medical marijuana use, and it just seems like it's due really soon, based on a small minority of the states that haven't moved in that direction. I just think every year you're going to have a few more to the point that they're all there and hopefully, it becomes federally legal prior to all the states being legal. But the government is so slow, slower than anyone would like on so many levels.

Peter Sack: Yeah. The federal government is extremely slow, but the laboratory of the states is in some ways moving surprisingly fast.

Justin Donald: Yeah.

Peter Sack: In the span of ten years, 40 states have a medical or adult use program for cannabis. It's pretty darn amazing.

Justin Donald: Yeah. And the amount of revenue that they're bringing in from legalizing is incredible, helping to solve a lot of state issues.

Peter Sack: Exactly. And I think the more people see the impact of this, the more people see the impact of that tax revenue, the more people see the impact of communities when you have less incarceration rates, it becomes very valuable.

Justin Donald: Yeah, I agree. So, I'm curious where people can learn more about you and Chicago Atlantic Group.

Peter Sack: So, we have a lot of publicly available information via our public companies, Chicago Atlantic Real Estate Finance under the ticker 'REFI' and Chicago Atlantic BDC under the ticker 'LIEN.' And then folks can feel free to reach out to investors at ChicagoAtlantic.com to learn more about our private funds and to meet our investing team.

Justin Donald: Awesome. Well, thanks for sharing some time with us here today, Peter. This was awesome. We learned a ton and, obviously, you're a wealth of knowledge, so thank you for that. I like ending every episode that I do with our audience with asking one simple question, and that question is the same every week. But what is one step that you can make today towards financial freedom and towards living a life that you desire that's on your terms so, again, not a life by default, but a life by design? And hopefully, there's one thing, if not many, but at least one thing you can take from what Peter and I talked about today that can move you in that direction. Thanks so much. And we'll catch you next week.

Peter Sack: Thank you, Justin.