First (Brands) of many? US firm collapses rock private credit markets

Since we last wrote about private credit in early September, the market has been rocked by the collapse of US car parts company First Brands. The First Brands debacle, the similar demise of the subprime lender Tricolor and concerns in the US regional banking sector all appear set to cause billions of dollars in losses across capital markets. First Brands and Tricolor both collapsed with unnerving speed amid allegations of fraud, culminating in First Brands suing its own founder for allegedly misappropriating billions of dollars of company money. Litigators like us are watching the fraud allegations and related inter-creditor disputes closely, but the broader industry will be more concerned by what they say about private credit markets as a whole.

A slightly counterintuitive view is that these fraud allegations may reassure lenders, suggesting that the First Brands and Tricolor collapses arose from problems unique to these companies: First Brands' rapid growth and opacity and the disproportionate exposure of Tricolor's borrower demographic to recent changes in US immigration policy and enforcement. On this view, these are isolated events without wider implications. However, fraud can also be a reflection of wider market standards. The private credit market is inherently opaque and, at least in the short term, problems can be relatively easily deferred. This has led to a now widely acknowledged decline in underwriting standards. A former lender to First Brands was quoted in the FT as saying, "You're not paid to do due diligence in this market." It would be difficult to find a clearer example of misaligned incentives and therefore scope for fallings-out and ultimately litigation.

This is not just a private credit problem. Firstly, banks such as Jefferies and UBS have direct exposure of their own to First Brands. Secondly, JP Morgan has acknowledged that banks are exposed to the private credit providers themselves via back leverage.

Global institutions are now sounding warnings. October saw the International Monetary Fund, European Central Bank and Bank for International Settlements all deliver warnings about the potential risks to global financial stability.  Events in the US have seized the headlines thus far, but both the Bank of England and the FCA have confirmed that they too are concerned by the possibility of contagion.

The most high-profile intervention was made by the Bank of England governor, Andrew Bailey, in his appearance before the House of Lords Financial Services Regulation Committee on 21 October. He asked the Committee: "The big question today … is are these cases idiosyncratic, or are they the canary in the coal mine?" The Deputy Governor Sarah Breeden then observed to the Committee that First Brands and Tricolor illustrated "High leverage, opacity, complexity and weak underwriting standards." Unconfirmed reporting suggests that the Bank of England is now likely to launch a stress test across the private sector in an attempt to answer that "big question".

The FCA has also observed the linkages between the banking and private credit sectors, calling First Brands and Tricolor "case studies" of how those linkages function in a crisis. These comments follow on from the FCA's review, published in March this year, of private market valuation processes in light of the lack of regular price discovery. While the review's conclusions were broadly positive, finding that valuation processes were generally robust and consistent, it raised concerns around the use of unrealised performance in marketing materials aimed at new investors or for new vehicles. Firms justified this by the sophistication of their investors: institutions, high-net-worth individuals or other investment professionals. Still, attracting a potential investor through unrealised performance on an asset not subject to price discovery is inherently risky, with scope for disputes in relation to valuation methodologies, representations made and other similar issues if the investment ultimately goes sour.

It was also interesting to note that the FCA's deputy CEO, Sarah Pritchard, in a speech given to the Investment Association's Private Markets Summit, presented the review's findings as part of a national movement to increase risk appetites, especially for retail investors: "Now is the time to have this debate – particularly as we consider how retail investors might access private markets. Many argue that retail participation in our capital markets is too low. A ‘missing ingredient’ for our success compared to other jurisdictions."

In keeping with this, the Treasury has repeatedly floated plans to reduce cash ISA limits and expand stock market participation in an attempt to increase participation in equity markets and create a personal investment culture more akin to the US's. Private credit markets are in play too: while not quite as innovative as the private credit ETFs launched in the US, the ability to hold (from 2026) Long Term Asset Funds in a Stocks & Shares ISA shows the direction of travel.  Inevitably, the push into retail markets gives rise to new litigation risks.