Private credit, increasingly public problems

50% growth in the past four years has seen private credit become a $2-3 trillion-a-year asset class impacting every sector of the global economy, but behind this remarkable expansion lies the potential for serious risk.

Broadly defined, private credit covers commercial loans extended by non-bank financial institutions, chiefly investment firms such as Apollo and Blackstone. These firms typically obtain capital from institutional investors and extend loans on a long-term basis, directly to borrower companies .   However, private credit's ongoing growth has been coupled with increasing diversification of fund strategies, structures and investor-base.

Notwithstanding this diversification, loans usually involve high, floating interest rates and a privileged position in the borrower's capital stack: an attractive combination for lenders of superficially low risk and high reward. The debt is not usually traded - although a significant secondary market has developed in recent years - but rather held by the lender from issuance to maturity. The lender/borrower relationship is therefore usually close, with bespoke terms common. This balances lender interests with the unique needs and risks of the borrowers, who are typically unable to access traditional bond markets and in need of more patient funding than that provided by a bank  .

The financial alchemy which advertises high returns for limited risk relies on an in-depth assessment of each borrower's financial position. For outsiders this is complicated by the lack of mark-to-market valuations of this largely untraded asset class: rather than periodically revaluing the loans based on the likelihood of recovery, a private credit lender can keep them on their books at full value until it accepts them as non-performing.

Flexibility or Short-Termism?

Any novel and rapidly expanding asset class will give rise to emerging risks. Private credit is no different. The most obvious risk is of a lender-borrower dispute, although there is also significant scope for disputes with investors.   The very attributes which make private credit attractive to investors, lenders and borrowers   can also cause serious difficulties. 

While insulated from public markets, the lack of mark-to-market valuation over the life of a long-term debt instrument creates opacity.   If a borrower becomes distressed, it is relatively easy for a private credit lender to ignore. The lender is largely insulated by its typically privileged position in the capital stack and the lack of immediate impact (such as on its AUM) that would be created by a periodic mark-to-market revaluation.   Meanwhile, investors will need to consider the reliance that can be placed on pre-subscription information, the scope of their own due diligence and the contractual representations, warranties and/or undertakings provided by the fund. 

If the interest burden on the borrower becomes too great to service, payment-in-kind (PIK) notes are a temporary solution  . Pejoratively known as 'extend and pretend', issuing PIK notes allows the borrower to defer interest payments by taking on additional debt. A generous view is that this gives fundamentally strong, high-growth companies the chance to weather short-term cashflow issues or adverse macroeconomic conditions. In return for this patience, the lender receives a greater return on maturity. A bearish commentator would be concerned that this increases both the lender's  (and, ultimately, investors’) exposure to the borrower and the borrower's overall debt burden, while doing nothing to alleviate the underlying issues. An inevitable default may be delayed and ultimately intensified.  Recent reporting by the Financial Times on so-called Business Development Companies (BDCs), which are publicly traded and therefore required to disclose more information on the performance of their portfolios, shows that BDCs' impressively low default rates become significantly less so once non-payment events such as the issuance of PIKs are taken into account[1].   There are also suggestions that BDCs may be relying on PIK notes to enhance accrued income.        

Until relatively recently, private credit's boom has been in a period of historically low interest rates and benign macroeconomic conditions  . As benchmark interest rates have increased globally, so has the interest burden on floating-rate private credit borrowers. Despite the use of PIKs and similar solutions, we would expect to see an increase in counterparty disputes over issues such as covenant breaches and other events of default. These disputes are likely to be intensified where a borrower (or fellow creditor) perceives, rightly or wrongly, that the lender is pursuing a 'loan to own'-type strategy, potentially in conjunction with the lender's private equity arm.   

Across a diversified loan portfolio, a private credit lender would expect to see variably performing borrowers, with their underwriting standards hopefully ensuring that the overall picture remains healthy. The systemic risks of such disputes should therefore be limited. However, a widespread macroeconomic shock may place a wide range of borrower companies under stress beyond the worst-case scenarios envisaged by the lenders' underwriting policy  . This could give rise to strains on liquidity and related tensions with investors - particularly in open-ended funds.

The pressure to deploy the industry's vast stocks of dry powder, estimated to be in the trillions of dollars, and the often-unusual characteristics of borrowers resorting to the private credit market will not have helped. Sudden aggressive enforcement of covenants driving a wedge between lender and borrower would be no surprise. Equally, wrapping private credit deals into ETFs (itself an interesting recent innovation) which may be subject to heavy redemption requests in a downturn, will place great pressure on liquidity providers to avoid triggering covenants where a longer, more forgiving view might have been taken in a more traditional private credit structure.

Take it to the (Non-)Bank

Despite private credit's fundamentally non-bank nature, banks are increasingly seeking exposure to the asset class. Typically, this has come by entering into origination partnerships with private credit managers, allowing banks to combine their client relationships with investment firms' massive undeployed capital reserves.

Disappointing results, such as in the case of Barclays' partnership with AGL Credit Management, which reporting suggests has struggled to attract investors[2], show the limits of this approach. However, banks' appetites remain undiminished. Going a step further, they are also seeking to gain exposure to the transactions themselves by back leverage, where the private credit provider borrows money from the bank, combines this borrowed money with investor funds and then lends it on in a private credit transaction. As with all leverage, this increases potential returns to investors while magnifying the (considerable) risks. It also introduces a further relationship with the potential to sour if the underlying loan defaults.

Conclusion

Private credit is not the one-size fits all, low-risk and high-reward panacea that its most enthusiastic proponents promote. It is an asset class with a key role to play in the global economy going forward, but also an asset class with increased scope for friction and disputes. Economic headwinds will take private credit into uncharted territory, placing stress on the bilateral relationships which are key to it. Market participants should seek advice to protect their positions in any emerging disputes which will set precedents and norms for this new era.