The nuances (ish) of private credit vintages

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You, a rube like Alphaville, may have noticed the looming economic downturn and think it’s a bad time to be lending to fast-growing but asset-lite Vapourware Inc owned by investment firms FaceRip Street and Creditor Bloodsport Capital.

Not so, says Pimco! Jamie Weinstein — the head of its $160bn alternatives business — has lead-written a report that argues these are in fact the best of times for private credit.

This may be hard to reconcile with very recent headlines of the same Weinstein warning that “risks are building inside the $1.6tn private credit market and regulators aren’t doing enough”, as Bloomberg put it.

However, Weinstein et al say they are excited to a large extent because those aforementioned risks are now materialising.

As private credit investors, this is the environment we’ve been waiting for. The unprecedented pace of interest rate hikes and resulting volatility are providing abundant potential opportunities in the liquid public markets now, and private opportunities are beginning to materialize in market areas where underwriting became lax. The next few years will be great vintages, we believe, across the private opportunity set for a wide range of investor objectives. With demand for capital outstripping supply, investors won’t need to take large risks, in our view, to generate compelling returns.

We at Alphaville Towers are suckers for investment firms talk about good vintages. Partly because of the imagery of investors sipping a chilled Château Industrials LBO Fund from 2009, and partly because of the usually unspoken inference that some vintages are undrinkable swill (hello Castello US Growth Equity 2021).

Basically, Pimco doesn’t think all those older private credit vintages are any good. There’s thick nasty residue at the bottom.

In less oenological terms, we are at the “nascent stage of the stress cycle” for private credit, Weinstein and team write. “Fundamental weakness is becoming apparent in areas of corporate credit,” they warn. These early stresses “will worsen and spread as fiscal policy turns contractionary and the economy softens”, Pimco cautions.

But this (conveniently) means opportunities for big public debt market asset managers unburdened with a large legacy private credit business that they need to reassure investors about. Or as Pimco puts it:

First we must distinguish between the existing stock of credit and future credit origination. We expect the current interest rate environment to put pressure on much of the existing stock of credit — particularly corporate and commercial real estate-related credit that was originated in an environment of abundant supply and low interest rates. Yet bank retrenchment has reduced competition in many markets, creating new origination opportunities and a stronger position for the remaining lenders.

Second, we must differentiate between technical pressures on banks facing liquidity challenges, and fundamental pressures affecting the assets themselves. Consumer balance sheets have proven remarkably resilient, having locked in historically low fixed mortgage rates, and many companies have refinanced higher-interest-rate bonds by issuing low-coupon, long-term, fixed-rate bonds. Thus, while banks face liquidity pressure in a variety of asset-based finance areas backed by both consumer and non-consumer collateral, the fundamentals of the assets themselves are actually quite solid. In contrast, fundamental weakness is becoming apparent in areas of corporate credit, where highly leveraged borrowers are straining to meet floating-rate interest payments or looming debt maturities. We believe the stress will worsen and spread as fiscal policy turns contractionary and the economy softens, which can create opportunities for private credit investors.

Real estate markets also face unique challenges: $3.6 trillion of commercial real estate (CRE) loans are maturing in the U.S. and Europe through 2025, many of which may not qualify for extensions. Compounding the issue of bank retrenchment has been similar declines by other lenders typically relied upon for financing, such as publicly listed mortgage REITs and CMBS issuers, which face their own fair share of challenges. As a result, we expect the opportunity set in real estate-related credit to remain outsized relative to real estate equity over the investing cycle.

Ok, sure, it does seem probable that some private credit firms will end up doing well out of stresses that we hear are starting to emerge. But there’s still over $400bn of dry powder in various private credit funds — with more money being raised all the time — so it seems wildly premature?