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Originally Posted by benb
One big thing our FA does for us is facilitate investing in private markets. That has only been something we qualified for in the last few years, but I don't know how on earth I would navigate that without professional assistance, and the returns on that have been very worth it.
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I'd be cautious how about how much you want to allocate to private credit. It's the fastest growing market from that was a niche market to almost $2 trillion. These are loans to small to medium sized businesses mainly and many from leveraged buyouts - it is an unregulated market since the lenders are non-banks. Past history on credit bubbles (Latin Am in 1980s, commercial real estate in 1990s, residential mortgages in 2007, oil & gas loans 2016) don't have great endings.
1) Private credit lenders are touting their performance, which is based on a very limited history. Most use traditional bank loan data for their modeling but those assumptions about default and loss given default (LGD) are changing for the worse.
-2) Many of these firms don’t perform their default/loss history like the rating agencies (Moody’s, S&P, Fitch) in that they don’t count loan modifications & extensions (to avoid payment defaults) as defaults; the rating agencies do but are limited to their rated universe. Also, some firms don’t discount their loan recoveries at the Distressed rate (14% and up) and use the loan’s coupon rate; by not using the distressed rate, they are not accounting for the uncertainty of cash flows in a distressed situation and moreover, it doesn’t reflect the price if they tried to sell the loan to an outside buyer, who would use the distressed rate for a distressed loan/security. Furthermore, Moodys’ found that about 50% of all modified loans usually result in another default or bankruptcy - essentially kicking the can down the road which again results in a higher LGD.
3) The historical loan loss data is based on covenant-heavy loans but the market has moved toward almost all covenant-lite loans. Covenants is a key loss mitigant that enables lenders to force borrowers to make changes to avoid a payment default. With the prevalence of covenant-lite loans, borrowers will burn through their resources until the situation becomes very dire and lenders can only watch the deterioration. Therefore, the LGD will be worse than the historical figure of 28% and probably be closer to 50% or more; in recessions, LGDs are usually worse than the long-term historical average.
4) Much of the loan volume is rated B3/B-, only one step away from distress rating. A wave of downgrades could be significant, particularly the collateralized loan obligation (CLO) market in which there are tests for the amount of CCC rated credit in the collateral pool. Managers can replace these loans during the reinvestment period, but a large flux of CLOs issued 2-3 years ago will be ending their reinvestment period and the collateral pools will become static. If the CCC buckets violate the tests, it could trigger the cashflow diversion to the AAA tranches which would cause downgrades and losses in the lower rated tranches of the CLO.
5) Besides the weak ratings, loan volume has primarily come from private equity leveraged buyouts as high interest rates have dampened regular financing. Much of these deals have add-backs to their profit measures (EBITDA) to shore up the leverage ratio tests (debt to EBITDA). S&P completed its fifth analysis on EBITDA add-backs and found that over 80% of the borrower don’t achieve that level of EBITDA in the following year - so the add-backs don’t seem to be one-off expenses.
All of this may not cause the next credit cycle but creates a vulnerability. In the 1990s, it was an oil shock that caused the risk-off wave. With the current political and geo-political situation, a major event could easily trigger the cycle. My one fear is that the US’s strong support of Israel could foment another terrorist attack like 9/11. There is also the possibility of China invading Taiwan or North Korea causing an incident.
Since the loan market is extending leverage throughout the US economy to the small- and medium-firm markets (known as Middle Market lending and Direct Lending), this could cause a deep recession if it collapses heavily since over half of the US employment is through small and medium-sized firms; this is unique in the developed world as most economies are dominated by large firms (e.g. Germany with Siemens, VW, Bosch, etc). Most small firms liquidate rather than reorganize and as you mentioned, private equity firms will make decisions on allocating resources to save firms.
The private market has gotten so competitive that yields are falling and now the non-banks are competing with the commercial banks for the large buyout deals, which in turn results in more yield compression and weaker credit terms.
Good article from Institutional Investor:
High Yield was Oxy. Private Credit is Fentanyl.
Note my background was investment risk for major insurers.