Private credit’s ‘naked swimmers’ are surfacing
Warren Buffett once famously said: “You’ll only know who’s swimming naked when the tide goes out.”
With some disturbing images coming to light, interest in private loans is now on the wane.
There has been an increasing outflow trend in private credit funds since last year. Funds are non-bank institutions that lend money at higher interest rates to borrowers who do not meet bank loan criteria. Typically, though not exclusively, these are private companies.
While initially most funds were designed to attract investments from large institutions such as insurance companies and pension funds that wanted assets that matched their long-term liabilities and were not deterred by the illiquid nature of loans, in recent years asset managers have established funds targeting individual investors.
The failure of two companies last year – First Brands Group And Tricolor – triggered a redemption crisis from private loan funds, not because they were directly at risk but because their bankruptcy pointed to poor underwriting standards in unregulated credit markets.
The biggest risk represented by the private credit sector […] It is a contagious disease caused by the fear that it may spread to other investment sectors.
More recently, fears about the impact of artificial intelligence on software companies, to which some private credit funds have large and intense exposure, have triggered a larger wave of redemptions and forced some of the world’s largest asset managers to limit their ability to withdraw investors’ money.
Most publicly traded funds have a 5 percent cap on the total quarterly redemptions they allow; This is a cap imposed at its discretion to prevent “escape” of its funds, which would force them into a fire sale of illiquid assets and insure and worsen the losses of investors trapped within the funds.
Blue Owl, Apollo Global Management, Blackstone, Ares Management, Carlyle, KKR and Goldman Sachs are among the major alternative asset managers experiencing this increase in redemptions.
Regulators are taking notice, concerned that instability in the private credit sector could trigger broader problems for the financial system, even though the sector represents only a fraction of the broader financial system, with assets estimated at between $1.8 trillion ($2.5 trillion) and $3 trillion ($4.2 trillion).
For example, the Australian Securities and Investments Commission, Supervision and regulations are intensified private credit like other issuers in the region.
Concerned about potential contagion, the US Federal Reserve Board is asking major US banks for details of their exposure to the sector. The UK’s Financial Stability Board is preparing a report on the sector’s vulnerabilities.
Insurance regulators, aware that insurance companies and pension funds are the most exposed to alternative assets, are also questioning their vulnerability.
Although comparisons have been made to the subprime mortgage crisis that led to the 2008 global financial crisis, the sector is not strong enough at this stage to threaten a financial crisis.
But what is not known is how much this relates to the regulated banking system, or indeed how fear in one corner of the system can spread to other parts of the system.
The US banking system has connections to private loans. US Treasury predicted Major US banks appear to have exposure of between US$410 billion and US$540 billion through loans to private loan funds, and these funds often transfer their loan portfolios to private companies to increase their returns.
To put the numbers in perspective, the US banking system has close to US$30 trillion in assets, and one bank (JPMorgan Chase) alone has approximately US$4 trillion.
Private credit funds are also often part of larger alternative asset management companies, and connections within these groups are not transparent.
They are part of an alternative universe of unregulated financial institutions that has grown significantly since banking regulators’ responses to the 2008 crisis; It has forced lenders to hold much more capital and high-quality liquidity, causing regulated institutions to withdraw from riskier and therefore more capital-intensive loans.
The “shadow” banking system is now significantly larger than its regulated counterpart.
Although a “flight” on funds would resemble the kind of bank runs that precipitate crises, investors are not depositors. If they make a loss, only the relevant investors will be at risk, not the financial system.
This is what regulators intended with their banking prudential reforms; They wanted to push the riskiest loans into unregulated markets, where individual investors would take on the risks and distribute them effectively.
This means that the main risk represented by the private credit sector is a spillover risk arising from fears that, if it poses a risk to the wider system, it could spread to other investment sectors, the wider non-investment-grade credit sector and the mainstream financial system.
It is also conceivable that if their funds are frozen behind locked doors created by redemption limits, investors may be forced to divest other assets to create liquidity and perhaps service or repay any debt related to their private loan investments. There is leverage within funds, and almost inevitably there is some investor leverage outside of funds as well.
However, the industry remains significantly quarantined from the rest of the financial system due to these redemption limits.
This points to a controversial aspect of alternative assets more generally. The expectation of premium returns in return for the illiquidity of investments attracted the attention of institutions leading the sector.
Another attraction was that the underlying investments were valued by financial markets not continuously and objectively in real time, but only periodically and based on conceptual, subjectively assessed net asset values; Although this was an illusion, it provided an obvious hedge against the volatility of public markets.
Fund investors are reminded of the negative side of the premium returns they receive due to the lack of liquidity of their investments. They cannot withdraw their money.
The value of assets varies from moment to moment, but is typically only recorded in quarterly snapshots. The sudden decline in the value of software companies shows how misleading this approach to valuations can be.
In any case, fund investors are now reminded of the downside of the premium returns they receive due to the illiquidity of their investments. They cannot withdraw their money.
Given the plight of these investors and the concerns that problems with private credit coverage have raised about the quality of unregulated credit generally, it may seem odd that the Trump administration is both pursuing deregulation plans to force U.S. banks to make riskier loans and allowing alternative assets to be included in individuals’ 401(k) retirement plans.
The opening up of 401(k) plans to Wall Street follows an executive order from Donald Trump last year that has been interpreted as a boon for firms supporting his re-election. These schemes hold more than $14 trillion in assets but are excluded from investing in alternative assets. They represent the honeypot for Wall Street’s asset managers.
With the war in the Middle East causing the biggest oil shock in history The financial system and credit intermediation standards that lead to higher inflation rates (potentially leading to higher interest rates) and lower economic growth may well be stress tested.
It may not be the best time to introduce households to an industry where the influx of repayments on private loans is already under significant stress and naked swimmers are surfacing at a disturbing rate.
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Stephen Bartholomeusz is one of Australia’s most respected business journalists. He was most recently co-founder and deputy editor of the Business Spectator website and associate editor and senior columnist at The Australian.Connect via email.
