7/7/23, 11:01 AM The private credit ‘golden moment’ | Financial Times

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The private credit ‘golden moment’
Let the good times roll?

Robin Wigglesworth YESTERDAY

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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:

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7/7/23, 11:01 AM The private credit ‘golden moment’ | Financial Times

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:

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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.

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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:

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7/7/23, 11:01 AM The private credit ‘golden moment’ | Financial Times

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.

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The volatility adjustment is performed by reducing the amount of notional amount on the HY and leveraged loan indices such that
their unconditional realised volatility equates that of the direct lending index
Here’s what that looks like in a chart format. Check out that nice smooth ride
upwards. What’s not to like right?

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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.

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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.

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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.

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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. 

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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:

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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.

Copyright The Financial Times Limited 2023. All rights reserved.

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