Recently I’ve been getting a lot of emails and newsletters telling me not to worry about Private Credit.
So I’ve started worrying about Private Credit.
Private capital has raised trillions over the past decade – it is hard to be accurate given its nature. The major asset classes are private equity, private credit, venture capital, property and infrastructure. A survey from Northern Trust of pension funds (DB,DC and master trusts), insurers, multi-managers and others, showed that 94% now invest in private markets. Of those surveyed, 78% invest in private credit.
And it seems to be private credit that’s garnering most of the headlines currently.
For many it’s a new asset class, with the risks and opportunities that this brings with it. As bank lending became more disciplined after the financial crash, direct lending from fund structures filled the gap. And many of these funds have performed well. Direct lending returns have been comfortably ahead of broadly syndicated loans over 1, 5 and 10 years.
And there’s no doubt a huge appetite for the sector. Just this morning Citigroup and BlackRock announced a new partnership aimed at originating up to €15bn of private credit financings across Europe over the next five years. AUM in private credit is forecast to more than double by 2030.
Yet the headlines about stress in the sector and investors looking to exit persist. So alongside record sums being pushed at pace into the market, we have many questioning “is it a bubble”?
I don’t know.
The universal response against the bubble argument that I see from investment managers or brokers seems to be that current conditions are not remotely like the 2008 period because leverage is much lower. But it’s the quality of the underlying asset that matters.
The factors that investors need to be aware of are well rehearsed.
This is an illiquid asset. And there is no such thing as “semi liquid”. According to the Financial Times, private credit managers were hit with record levels of redemption requests in the first quarter, many of which could not be met. And these included many of the big names like Apollo, Blackstone and others. 60% of investors say that liquidity has become a larger concern over the past year. Many funds are capping redemptions. If you’re in, you’re in for the long haul.
Also, know what you’re invested in. Around 20% of loans in private credit funds are to software companies and much of the exposure matures in 2030 or later, leaving plenty of time for problems to emerge in the business models of these highly leveraged companies in a rapidly changing environment. Lack of transparency is a clear issue for investors.
Picking your manager is key. There is a wide range of outcomes between winning and losing managers in this space.
There have been a few canaries in the coalmine.
There were some high profile defaults in the US towards the end of last year. Default rates are rising. Historically the average default rate in private credit was in the 2-2.5% range. This week, Fitch recorded a record high of 6% for US private credit. In a downturn, Morgan Stanley warned this could rise to 8%.
And ultimately – the business cycle hasn’t been cancelled.
We are looking at more modest levels of economic growth globally, higher inflation with the potential for interest rates to creep up. The FSB states that private credit at its current size and scope has not been tested during a severe economic downturn, which could expose leverage and borrower credit quality vulnerabilities.
Financial regulators are very aware of the risks and are extremely vigilant on private credit. The Central Bank of Ireland and the Bank of England have highlighted the risks and vulnerabilities in the private capital sector. The Bank of England is to carry out stress tests to gauge the contagion risk. The Central Bank is very concerned about liquidity and this year will explicitly assess how firms manage the mismatch between investor redemptions and asset liquidity.
BoE governor Andrew Bailey has said “alarm bells” are ringing in the sector.
The question is are they loud enough, and is anyone listening?
Tradewinds 