The private credit ‘golden moment’

Another day, another asset manager jostling for a bigger slice of the investment industry’s hottest neighbourhood. From MainFT’s new hedge fund correspondent Costas Mourselas:

Hedge fund manager Man Group has acquired a controlling stake in $11.8bn credit fund Varagon Capital Partners, signalling its ambitions to grow in the private credit market.

The group paid $183mn in cash to Varagon’s existing owners Aflac, Corebridge Financial, AIG and former senior executives at Varagon. The three companies will be eligible for an additional payment of $93mn if they maintain existing capital commitments, Man Group said.

It’s not hard to see why Man Group wants to bulk up in private credit. As Blackstone president Jonathan Gray said earlier this year, this is a “golden moment” for the fast-growing industry. BlackRock’s alternatives investment supremo Edwin Conway is “confident about (its) future”. Apollo’s Marc Rowan sees “a good time for the private credit product set”.

Basically:

The sellside is also scrambling to get involved. Goldman Sachs and JPMorgan are setting up dedicated private credit trading teams in case a more robust secondary market develops. Underscoring the rising investor interest, the former last month launched a regular “Private Credit Monitor” research service focused on the industry.

As Morgan Stanley’s asset management industry analyst Michael Cyprys said in a recent report:

The rise of non-bank lending in recent years has been turbocharged by private credit players’ ability to scale both deal size and deal quality. The $1.5tr Private Credit industry has grown at ~10% CAGR over the last 10 years, in-line with the overall $10tr Private Markets industry. However, growth over the last few years, particularly since 2018, has evolved from historically a targeted middle market lender to what is now a viable full-blown competitor to the broader leverage loan market. Boosted by larger fundraising vintages and expanded origination capabilities, private credit players are now able to compete on both deal size and quality, and to provide competitive lending terms compared to the syndicated loan markets.

Let’s unpick this a little though. By ‘private credit’ or ‘private debt’, we’re mostly (but not only) talking about direct loans between an investment fund and a corporate borrower, usually a small or mid-sized company.

These sometimes struggle to get traditional banks interested in their custom — for big banks it’s more attractive to lend to big blue-chip companies that you can also sell M&A advice, derivatives and pension plan management etc — but remain too small to tap the bond market, where you realistically need to raise at least $200mn in one gulp, and ideally over $500mn.

Private credit funds therefore often depict themselves as helping bread-and-butter ma-and-pa small businesses that mean ol’ banks are shunning. In reality, most of the lending is done to private equity-owned businesses, or as part of a distressed debt play. So it can arguably be better seen as a rival (or complement) to the leveraged loan and junk bond markets.

Here’s a breakdown of what kind of private debt funds have been raising money lately, from Goldman Sachs/Preqin.

As you can see from the fundraising bonanza, private credit has morphed from a cottage business mostly focused on distressed debt into a massive business over the past decade. And after starting out overwhelmingly American it is beginning to grow a little in Europe and Asia as well.

Morgan Stanley estimates the overall assets under management at about $1.5tn (of which about $500bn was money raised but not yet lent, aka ‘dry powder’ as the industry loves to call it).

That makes it bigger than both the US high yield and leveraged loan markets for the first time, says Cyprys:

Why has it been growing? Well, for investors it is the promise of both smoother and stronger returns, in an era where even the high-yield bond market for a long time made a mockery of its moniker. Remember when some European junk-rated companies could borrow at negative rates? Happy days.

Direct loans are also more attractive when interest rates are rising, because they are floating rate, as opposed to the fixed rates that public market bonds pay. At the same time, since these are private, (mostly) untraded assets, their value doesn’t move around as much leveraged loans or traditional bonds.

Here is a good Goldman Sachs table showing the respective volatility-adjusted annual returns of direct lending versus classic high-yield bonds and leveraged loans.

Here’s what that looks like in a chart format. Check out that nice smooth ride upwards. What’s not to like right?

But the pick of the recent bunch of sellside reports on private credit is this humdinger of a total addressable market slide from Morgan Stanley. With the tech industry hammered in 2022, it’s been far too long since we saw a really good TAM slide.

That said, it’s hard to see how private credit won’t be significantly larger in a decade’s time, given the megatrends of bank retrenchment, capital market expansion and investor thirst for opacity.

In many respects the growth of private credit is a healthy development. It is arguably far better that an investment fund with long-term locked-up capital takes on the associated credit risk than a traditional deposit-taking commercial bank.

But as we wrote earlier this year, there are a lot of reasons to be wary of the current private credit boom. Things have basically gone a bit nuts as money has gushed in.

Using data on business development companies — publicly listed direct lenders, often managed by one of the private capital industry’s giants — Goldman has put some meat on one of our skeleton arguments: floating rate debt is great for investors, but only up to a point.

At some point the rising cost of the debt will crush the company, and we may be approaching that point.

UBS predicts that the default rate of private credit borrowers will spike to a peak of 9-10 per cent early next year as a result, before falling back to about 5-6 per cent as the Federal Reserve is forced into cutting rates.

Default rates like that might seem manageable. It’s hardly Creditpocalypse Now. But the problem is that, as Jeff Diehl and Bill Sacher of Adam Street — a US private capital firm — wrote in a recent report, loss avoidance is the name of the game in private credit:

Benign economic and credit conditions over the last decade have allowed many managers to avoid losses, leading to a narrow return dispersion . . . The benign climate has changed with higher rates, wider credit spreads and slowing revenue growth, all of which is likely to put pressure on many managers’ portfolios.

The private credit industry makes a big deal out of how its bilateral nature means that it secures far stricter covenants and clauses to protect itself from losses than is usual in public debt markets. But covenants cannot magically protect you if a business blows up and the assets are de minimis. When there is a default, the recoveries are probably often going to be limited.

The private credit industry itself mostly thinks all this chatter is comically overdone. Here’s a lengthy comment from Michael Arougheti, CEO of Ares Management Corporation, from a talk at a Bernstein conference in May:

. . . I do think we should pause here, maybe just given our presence in the private credit markets and talk about this idea that private credit is somehow this shadowy corner of the financial markets where all of this opaque risk exists because that narrative has been in the market for as long as we’ve been doing this. 

You mentioned the GFC, but the team at Ares and some of our peers, we’ve been investing in this asset class for over 30 years. So not only do we get through the GFC and COVID and the taper tantrum, but we got through long-term capital, we got through the Asia debt crisis, we got through the dotcom blow. So this is a cycle tested, tried and true asset class. And the simple reason is, like I said earlier, it is a senior secured short duration floating rate asset.

And if you go back and audit the track record, you’ll see that private credit has actually outperformed high-grade fixed income and leveraged finance assets in every prior cycle. So I don’t know where that’s coming from. It could be a little bit of a FOMO or hey I wish I weren’t chock full of fixed rate — fixed income, high-grade bonds right now, but that there’s really no evidence to prove that.

And I think that by the big misunderstanding and this maybe as a segue into where there’s potential risk, the bulk of the private credit markets, whether we’re talking about corporates or infrastructure or real estate are underpinned by cash equity from a sophisticated institutional equity owner and a sophisticated management team and we are going into this current cycle with more equity subordination in all of these capital structures with better underwriting than we’ve ever seen. 

So if we’re going to have a conversation about risk in private credit, it has to start with a risk in private equity. It has to start with a discussion of risk in infrastructure equity and it has to start with a discussion of risk in commercial real estate equity because the math would simply tell you that if we’re talking about real losses in the private credit asset class, you will have blown through $2 trillion to $3 trillion of institutional equity, but people don’t like to talk about that fact. And that, I don’t really — I don’t know why.

We’d honestly love to talk about private equity dangers as well, but this post is already getting a bit long.

And to be fair, as our colleague Mark Vandevelde wrote in a fab recent column, the broader danger isn’t really that there’s been silly lending going on. These are investors and asset managers that (mostly) know what they’re doing, in an area people know is risky. People will lose money, the world will keep turning etc.

The issue, as Mark writes, is that private credit firms are now big and extensive enough to plausibly become shock conduits between investors, borrowers, and the broader economy:

In short, the biggest risks inherent in the rise of private credit are the ones that critics most easily miss. They arise, not from the misbehaviour of anyone on Wall Street, but from replacing parts of an imperfect banking system with a novel mechanism whose inner workings we are only just discovering.

This may seem like vague hand-waving by journalists, but the reality is that the complex interlinkage of private credit, private equity and broader debt markets is opaque. As the Federal Reserve noted in its latest financial stability report:

Overall, the financial stability vulnerabilities posed by private credit funds appear limited. Most private credit funds use little leverage and have low redemption risks, making it unlikely that these funds would amplify market stress through asset sales. However, a deterioration in credit quality and investor risk appetite could limit the capacity of private credit funds to provide new financing to firms that rely on private credit . Moreover, despite new insights from Form PF, visibility into the private credit space remains limited. Comprehensive data are lacking on the forms and terms of the financing extended by private credit funds or on the characteristics of their borrowers and the default risk in private credit portfolios.