Gerd-Jan van Wiggen: From private credit to public crisis
This column was originally written in Dutch. This is an English translation.
By Gerd-Jan van Wiggen, Partner at Probability & Partners
After years of strong returns and high expectations, we have seen turmoil emerge in the private credit markets in recent months. Since the bankruptcies of First Brands and Tricolor last year, there has been a significant increase in focus on the quality of private credit exposures. There is concern that standards for credit approval and monitoring are too low and that, as a result, private credit portfolios may contain many loans on which repayments are either non-existent or limited.
This concern has led to outflows from various private credit funds. Some parties, such as Blue Owl, have had to limit or freeze investor redemption requests because the underlying loans are illiquid and the options for repaying investors are limited. In addition, a number of major banks have recently started trading in CDSs on flagship private credit funds managed by Blackstone, Apollo Global and Ares Management.
Are we on the brink of a new systemic crisis?
Comparisons with the 2008 financial crisis are now frequently being made. At that time, there was over USD 1 trillion outstanding in sub-prime mortgages. Lax lending standards, limited transparency regarding the quality of underlying exposures and the extensive (re)packaging of these loans meant that it was unclear where the risks lay within the system and what their scale was until things actually went wrong.
If we draw parallels with private credit today, there are certainly similarities with the situation prior to 2008. There is currently over USD 2 trillion in outstanding private credit. Although this amount is of the same order of magnitude as sub-prime mortgages, the comparison is somewhat flawed. The exposures within private credit are spread across various sectors and counterparties, resulting in greater heterogeneity within this group. However, certain sectoral concentrations can certainly be problematic.
Following the financial crisis, standards for granting and monitoring loans, valuation methodologies, accounting and capital rules, and buffers have improved significantly for banks. The determination of defaults and the handling of forbearance measures are specified in detail in legislation and regulations. Partly as a result of this, banks have gained a better understanding of their exposures. The side effect of these tightening measures was that it became more difficult for parties to obtain bank financing.
Private credit has stepped into the gap that has arisen here. Investors in private credit are more likely to finance weaker parties and hope to offset the effects of this with a higher risk premium. However, this assessment can only be accurately made if all relevant information is available to the investor. This is where the problem lies. Defaults are harder to spot with, for example, payment-in-kind arrangements rather than actual cash payments. Decisions are often made based on aggregated information.
Finally, the question remains as to where private credit exposures end up. Capital rules make it relatively attractive for insurers to hold private credit exposures on their balance sheets. A number of parties have built up substantial private credit portfolios in recent years. In addition, a number of banks have indirect exposure to private credit funds, as they provide liquidity or have otherwise facilitated the creation of such funds. Some pension funds have invested to a limited extent in private credit funds to achieve extra returns and diversify risk.
Although there are therefore similar concerns and circumstances to those prior to the 2008 crisis, the ultimate question is whether problems in private credit could spread to the broader financial markets, such as public debt and the banks. Opinions on this are divided. The public debt market could be disrupted across various sectors if problems arise in private credit. Whether this will lead to a large-scale crisis remains to be seen. However, it is plausible that a period will arise in which investors’ appetite for investing in credit products wanes. This could slow down economic growth. Banks are in a substantially better position than in 2008 and can withstand greater stress. Interbank interdependence has also decreased, partly due to central clearing.
What should I, as an investor, be looking out for now?
As an investor, it ultimately comes down to whether you can understand what you are investing in. You should ask at least three simple questions: Increased vigilance certainly seems sensible at the moment. Ultimately, this environment offers opportunities for specific investors. As soon as private credit exposures actually become non-performing on a certain scale, opportunities arise for parties who can buy them up cheaply and restructure them. In this sense, the aftermath of the 2008 crisis has helped countless investors.
- Do I understand the structure? If it is not clear exactly how returns are generated within the proposed structure and where cash flow is going, this is at the very least a reason to dig deeper.
- What does the investor reporting tell me? Indicators can look impressive but mask a great deal. Try to ascertain how specific metrics are determined and what opportunities exist to embellish or manipulate them. And does the investor reporting provide sufficient insight into lending policy and its implementation, as well as into key processes?
- How concentrated am I in certain sectors? Some sectors are more sensitive to interest rate movements and specific economic developments. The rise of AI in recent months also shows how perceptions regarding this sensitivity can change rapidly.