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Every so often, I’ll check in to show items floating around Wall Street circles and blogs.
Longer term trends in the markets and economy.
Extra details on what seems underappreciated or overhyped.
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**Everything as of 7/10/2024
Interest and chatter on the health and structure of the growing private credit market has been flying around the Street lately so it’s time take a look at what the market is and why it’s suddenly a hot topic.
What is Private Credit?
Credit Lending is perhaps the second-oldest profession. Private Credit refers to non-bank lenders (think hedge funds, private equity funds, and even pension fund or insurance companies) providing customized loans of fixed duration to moderately sized companies with less than stellar credit ratings.
After the 2008 financial crisis, the Dodd-Frank Act tightened the rules on how much money banks could lend to customers and how creditworthy those customers must be to receive the loan.
This left many borderline subprime customers out in the cold. Small and medium-sized companies (think $10 Million to $1Billion in revenues—not your Mom and Pop Dry Cleaners) who used to rely on banks for direct financing or for issuing HY bonds had to find alternative sources of credit to make their capital investments or to just manage cashflow and keep operating.
Never missing an opportunity to cause a problem, private funds stepped in and began supplying these companies loans with privately negotiated terms, amounts and rates.
Why is it suddenly a big deal?
Two reasons —
Private credit tends to do well when more traditional lenders are struggling and vice versa.
As a September rate cut is now baked in, we’ll start to see a recovery of bank balance sheets after a miserable 3 years of sitting on losses. The recovery will allow the traditional lenders to resume lending activity and cut into private credit deal making.
The upcoming A.I. Capex Boom
The A.I. boom is unique for a technology play due to its large capital expenditure requirements to build datacenters and computer chips. While the MAG7 gets to tap into traditional bank lending, somebody else will need to loan the risky startups money for their projects.
The Risks of Private Credit
The main concern brewing if above events come true is a lack of transparency around who is issuing the loans, who is receiving the loans and how well the counterparties could handle a negative shock like a startup defaulting on the loan or if a major change in interest rate policy occurs.
In the open HY bond market, traders know preciously what the loan terms are, who currently owns the loan and how easily they can hedge/sell off their exposure if necessary. Not so, with private credit.
—Private Credit is illiquid
Each loan is unique and often not being solicited widely for trading. If a wave of defaults hit during an A.I. recession, we could see liquidity runs among private lenders who no longer receive their monthly loan payments to turn around and lend out nor can they sell the bad loans off to curb losses and raise funds. Unlike the banks, who could sit on their losses until things turned around, the private credit market is highly concentrated and relatively short term. This would create a concentrated panic should confidence fall in the players involved.
—Hidden Leverage Accrues
Corporate entities have lots of sneaky tactics to massage balance sheets and make themselves look more creditworthy than they really are for fresh financing. Think of the famous REPO 105 contracts which helped destroy Lehman Brothers. With no oversight, it’s unclear how accurate the perceived strength of private creditors or their customers actually holds up in stressful environment.
— Spillover into Counterparties
Lending practices and standards generally deteriorate overtime until credit losses cause lenders to break. Eventually, someone flies too close to the sun and allows for loan terms just too loose to work out.
My guess is at some point, we’ll see something along the lines of a LTCM scenario where one or two major players get caught with their pants down during an economic slowdown or loan default and needs to be rescued or quarantined to avoid spillover to other institutions.
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Thoughts? Questions? Comments?
Reach out! Maybe I’ll do a full post on the topic or as a Q&A
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