The squeeze on private credit

From hero to zero. That’s the vibe shift around private credit this month. The timing and catalyst for this reappraisal were a bit of a surprise. They usually are. But a reality check was inevitable and justified. This “asset class” has been over-marketed in a big way.

The backstory

The arc of private credit has been idiosyncratic in some ways. The explosive growth in assets under management in private credit over the last decade and a half has its roots in the Global Financial Crisis. Banks were largely pushed out of this form of risky lending by subsequent regulatory reforms, and asset managers eagerly filled the void. That quiet restructuring of credit markets was a one off.

But from the perch of an asset allocator, much of what unfolded thereafter seems entirely conventional. An initial shortage of credit led to strong returns for lenders/investors with low observable risk. This in turn attracted more inflows from investors. The inflows grew the asset class, decreased the cost of capital for borrowers (typically private equity backed firms), and kick-started a virtuous cycle for both borrowers and lenders.

But given time, investors always throw too much money at a good thing. As capital available to lend went from billions to trillions, private credit shifted to a borrower’s market. Lenders began funding riskier companies and reducing covenants (protections for lenders). In more egregious cases, they skimped on due diligence just to get the money out the door.

In credit markets, the quality of underwriting doesn’t really matter a lot of the time. But at least once in a credit cycle it matters a heck of a lot.

We appear to have arrived at that moment.

Stay calm and form an orderly line…

At least five large semi-liquid private credit funds have recently “gated” because investor redemption requests have exceeded these funds’ ability to raise cash. While gating is not necessarily a bad thing – it does imply something unpleasant is taking place.

Today, the problems seem to come both from within and without. From within, an uptick in non-accruals, PIK usage and a surprising string of bankruptcies (some tinged with potential fraud). From without, a major reassessment of the future of the software sector. Investors are wondering if AI is going to kill off SaaS. By most estimates loans to software companies make up 20-30% of the private credit market. Ouch.

Opportunity amidst dislocation?

At times like this, it’s natural to seek the proverbial babies thrown out with the bathwater. It seems unlikely, for example, that the software industry will cease to exist because people can now “vibe-code.” But corrections of the type we’re seeing in private credit usually take a while to play out. People tend to underestimate just how “reflexive” markets can be.

The negative turn in sentiment towards private credit can itself turn the virtuous cycle of the past decade into a downward spiral. Illiquidity and opacity tend to make things worse. But if conditions deteriorate, don’t expect private fund managers to rush to adjust the NAVs on their funds. They’ll stick their head in the sand as long as possible. Putting money into a limited partnership with a seasoned portfolio of private credit right now requires a kind of naïve credulity.

If you want to see what investors think private credit is really worth today, you need to look at listed (exchange traded) BDCs. Many of these investment vehicles are now 30-50% off their all-time highs and trade more than 20% below their latest net asset value (NAV). Whether this pricing is “fair” is a matter of debate. It’s true that publicly listed BDCs often overshoot fair value in both directions.

Sifting through public (exchange traded) BDCs requires some real due diligence. Portfolio quality varies dramatically amongst BDCs. Almost all of them carry high levels of leverage, and disclosure is imperfect. In short, it’s not a sector for the faint of heart. Falling knives abound. Still, for anyone seeking a “margin of safety” in private credit, the public equity market is now the better place to start looking.