NT: Private Credit
Taking a break from writing about the train wreck in the USA, I’ll write a brief intro to a favourite topic: private credit. I say it’s a favourite because it has been interesting to have a ringside seat as the market and its stature has grown by leaps and bounds over the past six years. When I started Migrations.ml, we tried to address credit research, analysis and surveillance across the public markets, mainly because that’s where the data was, but also because I wasn’t particularly aware of the changes happening in the private markets. Starting in mid-2020 it was mentioned more often by industry-specific news sites, and about a year later it became a regular topic on Bloomberg and other mainstream sites. By mid-2023 I was hearing about hedge funds either adding the asset class, or in some cases switching outright from equity to credit-focused. It was quite a makeover for what was the traditional role of the main street bank: lending money to qualified borrowers.
The metamorphosis was driven by both sides: borrowers wanted to access funds more quickly than traditional bank lending, and the regulatory changes forced the banks to reduce their lending capacity. Private credit also tends to be more hands-on when dealing with poor-performing loans, which appeals to borrowers. Where there is demand, market participants with access to capital will get creative to meet that demand, resulting in private credit deals (i.e. loans) getting bigger and bigger, to the point that they not only replaced traditional bank lending, but also equity financing. It continues to grow, with the same drivers in place.
This post is becoming a bit long, so I’ll jump to my concerns about this growth. Having lived through the fun and games of the securitization industry in 2007 - 2008, I’m always worried when everyone wants to join the game. Just as with mortgage securitization, eventually the good credits are taken, and asset managers have to allocate capital to progressively weaker assets. In private credit, there are new entrants all the time, and those entrants will have raised funds to lend and start earning that sweet 200+bp floating rate honey. If they are too prudent, their investors or LPs will starting asking “when are you going to start doing your job?”, or words to that effect. Hence, they’ll start lending where other fear to tread, taking outsized credit risk, and not necessarily being paid for that extra risk.
Private credit is a more diverse asset base than mortgages: lending is done across all manner of industries, regions and company sizes. However, never underestimate the willingness of market participants to forego warning signals, or conventional credit risk methods in order to keep earning and building up the asset base. The main provider of liquidity to private credit lenders is…traditional banks. If a strata of banks have gone all-in on lending to mid-market companies in one particular industry or region, and something happens, like say a trade war, or strange pronouncements from a commander-in-chief, then those banks could find themselves being drawn on to provide liquidity that was supposed to be “dry powder”, but in reality is needed to prop up a private credit lender. Or they find that the security on the loans that they have made to the private credit lender is now weakened, and they now have more complex workouts, or are taking on board assets that don’t fit their regulatory profile. This won’t ripple across the whole private credit industry, but it could slow the growth in demand, which will cause funds to close, and investors to lose their money.
I’ll write more on this topic, particularly from the retail side. If you’ve made it this far, thanks for reading!