The Private Credit Playbook Part 2
The Private Credit Playbook Part 2
Why the IMF is Concerned
Private Credit Background
Three weeks ago, I summarised the bulls’ view of the private credit sector and this week I return to the subject with a more nuanced view, with data taken from a recent commentary by the IMF.
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Growth of Private Credit
Source: IMF from Bank of America Global Research; Bloomberg Finance L.P.; PitchBook LCD; Preqin; S&P Capital IQ; and IMF staff calculations. Includes private credit funds, business development companies, and middle-market collateralized debt obligations, from 2000 to June 2023.
Private credit assets increased to approximately $2.1 trillion (tn) globally in combined assets and undeployed capital commitments in 2023 and have grown exponentially over the past two decades, as per the chart above.
Geographical Market Split
Source; IMF from Bank of America Global Research; Bloomberg Finance L.P.; PitchBook LCD; Preqin; S&P Capital IQ; and IMF staff calculations.
As of June 2023, private credit managers located in the US had AUM of $1.6tn (including commitments). This has grown at 20% pa for the last five years – a normally unsustainable rate for a credit market. Private credit now accounts for 7% of total credit to nonfinancial corporations in North America, comparable with the shares of broadly syndicated loans and high-yield corporate bonds.
Relative Size of US Private and Public Credit Markets
Source: IMF from Bank of America Global Research; Bloomberg Finance L.P.; PitchBook LCD; Preqin; S&P Capital IQ; and IMF staff calculations. Bank credit includes both securities, and loans and leases for US commercial banks.
The growth is part driven by the demand from borrowers, mainly private equity sponsored companies, with private equity AUM growing also. Managers whose umbrella firm is also active in private equity hold more than three-quarters of private credit assets. Surprisingly, in about 70% of private credit deals, the borrowing company is sponsored by a private equity firm. Part of the growth, to be fair, is also the supply of capital to a high return asset class:
Private Credit Returns have been Attractive
Source: IMF from Bank of America Global Research; Bloomberg Finance L.P.; PitchBook LCD; Preqin; S&P Capital IQ; and IMF staff calculations. Until June 2023
The interest rates on private credit loans are higher than the yields on market-based debt instruments, which raises questions as to why borrowers don’t simply go to public markets. One reason is size – it’s more difficult for a smaller borrower to access public markets. But the increments in the chart are significant.
Interest Rates on Private Credit vs Public Markets
Source: IMF from Bloomberg Finance L.P.; Preqin; S&P Capital IQ; and IMF staff calculations. Bond yields are based on the aggregate Barclays Bloomberg US corporate bond indices. Leveraged loan yields originate from the LSTA US Leveraged Loan Index. Private credit loan interest rates are based on BDC filings and reflect the median among a sample of loans. The bond and leveraged loan yields reflect the marginal cost of funding, whereas private credit loan interest rates reflect the BDC portfolio. The reference date is year-end 2023.
Characteristics of Private Credit Borrowers
Size is a really important reason - private credit borrowers are smaller than the typical leveraged loan or bond issuer, and they are more highly leveraged relative to their earnings. The IMF says there is evidence to suggest that weaker firms with low or negative earnings and high leverage are less likely to secure bank loans and are more inclined to borrow from nonbank sources.
Leverage – Private Credit Borrowers vs Public Markets
Source: IMF from Bloomberg Finance L.P.; Preqin; S&P Capital IQ; and IMF staff calculations. Private credit firm fundamentals are based on a sample of private credit transactions from Preqin that have matching data in Capital IQ Pro. This matched sample may therefore be subject to a selection bias given that most private firms do not publicly release financial statements. BDCs = business development companies; EBITDA = earnings before interest, tax, depreciation, and amortization; HY = high yield; IG = investment grade.
Private Credit Deals by Sector – Last 3 Years
Source: BTBS from IMF Data from Bloomberg Finance L.P.; Preqin; S&P Capital IQ; and IMF staff calculations.
The chart highlights that private credit borrowers tend to be riskier than their traded counterparts. Looking at private credit borrowers by sector, there is a greater weight of technology and health care sectors than in public markets, which likely reflects the greater exposure to these sectors by private equity.
North America Buyout by Value by Sector 2020-2023
Private credit borrowers predominantly use floating rate loans. In contrast, only about 29% of high-yield corporate bond issuers’ total debt is variable rate. Which means that higher interest rates should affect private credit borrowers much more quickly. The gap is illustrated in the chart:
Cost of Private Credit vs Dependence on Variable Rate Debt
Source: IMF from BDC 10-K and 10-Q filings; S&P Capital IQ; and IMF staff calculations. Cost of debt is calculated as interest expense divided by total debt. Medians are taken for each bucket of variable rate debt reliance, whereby this reliance is expressed as the ratio of variable rate debt over total debt. The cost of debt within each bucket varies based on credit fundamentals. Private credit rates are based on a sample of BDC portfolios.
Default and Other Risks
The IMF report says “As private credit assets under management grow rapidly, and competition with investment banks on larger deals intensifies, supply-and-demand dynamics may shift, thereby lowering underwriting standards, raising the chance of credit losses in the asset class…The private credit sector may also eventually experience....weakening covenants as assets under management rise rapidly and the pressure to deploy capital increases.”
They highlight a number of risks:
Potential for Losses
In a downturn, private credit could see large, unexpected losses. Private credit looks inherently risky, given it’s typically floating rate money and caters to relatively small borrowers with high leverage.
Such credit losses could create significant capital losses for certain investors. Some insurance and pension companies have significantly expanded their investments in private credit and other illiquid investments. A number of private equity firms have bought insurance companies. If they were investing in the firms’ own private credit funds, I would not be surprised to see a significant unwind. The IMF highlights this as a potential risk to financial stability, as they see those entities as having particularly high exposure to private credit markets. In general, my observation is that concentration seems normal for certain types of investors in private markets.
Multiple Layers of Leverage
The IMF report highlights that the potential for multiple layers of leverage creates interconnectedness concerns. Leverage deployed by private credit funds is typically limited, but funds that use only modest leverage may still face significant capital calls in a downturn.
They flag that private credit investors, funds, and borrowers deploy leverage extensively, forming a complex multilayered structure. Investors such as insurance firms and pension funds may use leverage and are also subject to margin and collateral calls during periods of high market volatility.
Private credit investment vehicles may employ leverage directly within a fund or through other vehicles and leverage can be increased through more complex strategies such as collateralized fund obligations. In addition, private credit borrowers extensively deploy leverage - most firms borrowing from private credit funds are backed by private equity sponsors, leading to higher debt for the firms or leverage ratios deemed excessive by banks.
These multiple layers of leverage throughout the value chain could magnify losses and trigger spillovers to other markets during a downside scenario of forced deleveraging. “In such scenarios, vulnerabilities among borrowers may lead to large, unexpected losses for funds and end investors.”
Even funds that deploy modest amounts of leverage may still face significant capital calls. That could also force an entire network reduce exposure at the same time and that could trigger spillovers to other markets and the broad economy. I think this could be a particular risk if firms are investing in their own funds.
Valuations Uncertainty
The IMF argues that private credit loans tend to suffer from stale valuations because of the absence of secondary markets, limited comparable transactions, and irregular appraisals.
Private credit prices move less than in high-yield and leveraged-loan markets, even though private credit borrowers are riskier. Their analysis suggests that the reaction of BDC loans to credit shocks is much smaller than that of B-rated leveraged loans, despite the lower credit quality of BDCs’ loan portfolios. The smaller valuation adjustment is reflected in an additional discount applied to the market prices of BDC shares. This discount widens during stress periods.
The IMF report highlights that that if there is uncertainty about valuations, that could lead to a loss of confidence in the asset class. To me this is a serious risk.
The FT recently reported on the valuation of Pluralsight debt by several different funds:
Pluralsight Debt Valuation
The FT reported:
“Marks are not scientific,” one Pluralsight lender said. “Everyone’s view of valuation can be different based on a host of assumptions they have, and until you have to liquidate a position that mark is a function of . . . all the analytics you used.
Loans to Pluralsight were extended in 2021 when Vista Equity Partners bought the business for $3.5bn. They reported
“It was a novel loan, based not on Pluralsight’s cash flows or earnings, but how fast its revenue was growing.”
I have heard of covenant-lite, but this seems astonishing.
The FT analysed how the seven lenders to Pluralsight who report their marks publicly disclosed a broad range of valuations for the debt. The range widened as the company ran into trouble over the past year.
Ares and Blue Owl marked the debt down to 84.9 cents and 83.5 cents on the dollar, respectively, at the end of March, 2024. Golub had valued the loan just below par, at 97 cents on the dollar. The other four lenders, Benefit Street Partners, BlackRock, Goldman Sachs and Oaktree, marked within that range.
(I wrote this before I headed to Japan in August and wasn’t surprised to read while I was away that the debt holders assumed control of Pluralsight.)
We have only started to see cracks emerging here and the opacity of private credit is a real issue, as it’s extremely difficult for anyone on the outside to understand the degree of risk. I would not be surprised if some of the IMF’s warnings are being repeated in a wider forum, before too long.
The IMF expressed concern that credit fund managers may be incentivised to delay the realisation of losses as they raise new funds and collect performance fees based on their existing track records. Clearly, there are large incentives to hide losses from investors. I don’t want to accuse the industry of being dishonest, but at least public companies have to have their accounts audited. I am unsure what degree of external scrutiny is being applied in private markets.
Liquidity Issues
The IMF is also concerned about potential increasing retail participation in private credit markets. Although they are currently low, liquidity risks could rise with the growth of retail funds.
Potential liquidity pressures could also arise from credit and liquidity facilities offered to portfolio companies. Private credit funds often combine loans with revolving facilities. There is a risk that, like the “dash for cash” in 2020, firms simultaneously and unexpectedly withdraw their credit balances, suddenly increasing private credit funds’ need for cash. Private credit funds might also transfer the liquidity stress to end investors through their committed capital.
Private Credit Liquidity
Stresses may already be appearing here, as payment-in-kind interest payments have jumped for BDC portfolios:
BDC Interest and PIK Share
Source: IMF from BDC 10-K and 10-Q filings; S&P Capital IQ; and IMF staff calculations
Mitigating Factors
Despite the riskier nature of private credit borrowers, their credit losses have not historically exceeded losses in high-yield bonds and are comparable to leveraged loans.
Riskier Loans have not Led to Larger Losses…Yet
Source: IMF from Cliffwater; Fitch Ratings; Preqin; and IMF staff calculations. In 1, bank loans refers to US banks’ commercial and industrial business loans. Average annual credit losses are computed for a 10-year window between 2013 and 2022. In 2, “other years” refers to the 2007–22 period, with the exception of 2009 and 2020.
Headline default rates for private credit indices tend to be quite high, but include covenant defaults, which often lead to renegotiated terms rather than a true payment default. Sponsorship by private equity firms mitigates private credit risks because private equity sponsors want to preserve their investments and will inject additional capital into portfolio firms if they believe that stress will be transient.
Evidence from the leveraged-loan market illustrates that firms sponsored by private equity have lower default rates during periods of stress than other firms (right hand chart above). This strategy may lessen defaults in a short-lived downturn. To help boost recovery rates in case of liquidation, most private credit loans are secured, which again mitigates credit losses.
Conclusion
The mere fact that the IMF is writing about private credit in their Global Financial Stability Report tells you they are worried. If rates fall and markets continue to go up, (as has been the case since I wrote this) pressures will recede. But when I see hyper growth in the activity of lending at high rates to highly leveraged smaller companies, I think that’s an area which it’s important to monitor.
Add in concentration risks, opacity and the incentives of the fund managers and you have a potentially explosive cocktail, especially if rates don’t fall, but stockmarkets do. Now that might not be a central case, but it’s certainly a possible scenario, and one where I would want my portfolio to have some protection. Mine does, but I would not be surprised if many don’t.
As ever, when I explore a new area, I would welcome feedback from industry participants – please email me with your contrary opinions.