Today I thought I would take a look at the world of private credit and see firstly what is going on and secondly what risks it poses. Let us start with what it is via Blackrock.
Private credit represents part of the broader alternative’s universe, referring to non-traditional assets that provide flexible lending solutions. Private credit generally offers higher returns compared to public corporate bonds and loans. This is because investors are compensated for investing in less liquid markets, known as the illiquidity premium.
I have highlighted what I consider to be the warning signs and as you can see there are quite a lot when you consider there are only a few sentences there. The first two points I have highlighted get more detail here.
Unlike traditional lending markets where banks arrange and syndicate loans to large groups of lenders, private loans are typically originated directly between a corporate borrower and a small group or a single lender.
The fact that the banks aren’t doing it is not necessarily bad but it does pose risks.
These loans are negotiated directly by companies that do not have, or have limited, access to public corporate bond and loan markets. Most of these companies are medium-sized and referred to as “middle market” companies.
As you can see this depends a lot on the people who provide the loan knowing what they are doing as lending to such companies is a specialist field. In good times this is unlikely to be much of a problem but in tougher ones there is the risk of a type of contagion where several fail together.Or a failure of diversification if you have assets in the same area or arena.
The word oppotunistic below also flashes a warning.
Private credit covers a broad spectrum of lending strategies, including opportunistic and distressed debt, and middle market or direct lending.
There is also an irony here in hat the reduction in risk for banks after the credit crunch means that the risk moved location rather than stopping. It was ever thus.
The asset class became more prevalent when banks reduced lending following the Global Financial Crisis of 2008-9. The introduction of new regulations (Basel III) required banks to hold more capital against loans, making it less capital-efficient to lend to certain businesses.
I suppose that in some ways we should be grateful that one element of banking regulation has worked. The problem is that the risk has scuttled into darker corners. Then we arrive in a area that does seem to have gone quiet which is that this is what for quite a while was called shadow banking which has frequently been represented as a bad idea. Again I have highlighted what I consider to be warning signs.
Consequently, private lenders have increasingly stepped in to fill the gap due to their ability to move quickly and provide bespoke, customised loans that can better meet some businesses’ needs.
Moving quickly is the opposite of know you customer which to my mind seems more important than ever when you are dealing with medium-sized businesses as it is easier for them to pull the wool over investors eyes. Those “bespoke customised loans” sound awfully like what in my career in the City of London has been called an over the counter trade and I have always considered these to be a specialist product and not for the unwary.
Why?
If we ask the Carly Simon question then the answer is provided by The Flying Lizards.
Your loving give me a thrill
But your loving don’t pay my bills
Now give me money (that’s what I want)
That’s what I want (that’s what I want)
That’sI what I want, yeah (that’s what I want)That’s what I want.
This is all about the Dollars, Euros, Yen and Pounds. Or what in the City of London is called edge where you get a higher return than from a more conventional return. The problem is the higher risk. There are more than a few parallels here with those who were lured by the Carry Trade into foreign currency mortgages in Eastern Europe. It works fine and looks great until it doesn’t. But by then it is too late.
Where does this take us?
I notice that Ken Griffin of Citadel has written a piece on this issue in the Financial Times.
Hedge fund billionaire Ken Griffin has questioned whether wealthy individuals truly understand the risks of investing in private credit and warned that they might struggle to access their money in the event of a downturn.
The last point reminds me of a situation in the past where investing in Italy via Milan was very popular in some circles. Until they wanted to get out when suddenly liquidity was zero.
To my mind this issue is exacerbated by the size of the private credit market.
As a result, the private credit industry’s assets have surged to more than $3.5tn, according to the Alternative Investment Management Association, with funds targeting wealthy investors emerging as one of the fastest-growing areas of the asset management sector.
Even in these inflated times a market size of US 3.5 trillion dollars is quite a lot of money.Should things go wrong there is a risk of a lot of money and people may be trying to get through the same exit door. At a time like this the exit door h as rather a habit of copying Alice In Wonderland after she takes the advice of the bottle labelled Drink Me and shrinks markedly. Or if you prefer liquidity goes from 100% on the way in to 0% on the way out.
“The real issue here is the liquidity mismatch between the retail investor and the duration of the investments,” Griffin said in an interview with the FT.
“We live in a world where retail investors have become accustomed to having immediate liquidity for their investments . . . investing in private credit is a different story.”
We have seen the beginnings of this in some cases.
Some cracks are beginning to emerge in the private credit industry. Blue Owl Capital, a private credit investment firm that aggressively tapped retail investors, has limited withdrawals from its two flagship funds amid billions of dollars of redemption requests and concerns over its exposure to software companies that are vulnerable to AI disruption.
As the Rolling Stones pointed out you can’t always get what you want. Sadly their next line that you get what you need is not always true.
Comment
To my mind there are a lot of factors here that are awfully familiar. People do not understand what they are investing in. Investment managers encourage them i as no doubt there are substantial fees for them in so doing. People invest because they hope for better returns. So in basic human psychology we see Greed which blinds people to so many things.
There is no reason why this has to go wrong. But if you think about it then it requires stability and hopefully growth in a world which is very unstable these days and sadly provides less growth than we used to get. Both concepts are on my mind as such issues are being discussed at the Better Statistics seminar I am presently attending ( although not everyone here seems to realise that). Also should it go wrong people’s psychology will then switch from Greed to Fear sometimes in an instance. In such a situation human behaviour in a herd will create its own crisis as the exit door I mentioned earlier is inadequate and this is before it shrinks.
Podcast
I recorded early this week due to my presence at the Better Statistics seminar.