Is Private Credit 'So 2022'?
Is Private Credit 'So 2022'?
Thanks for the mems and the memes
Despite what some private credit executives would have you believe, there are limits to how much bank activity can move to private credit (in private credit’s current form). You can’t recreate a 10x (or more) leveraged system funded by deposits in a world of 1x leverage and long-term funding. (That’s not to say banks can’t dump all their credit risk outside the banking system, but the ultimate funding will need to come from the banking system.)
It’s thus worth examining the private credit boom in the context of its timing. The rapid increase in rates in 2022 saddled banks with “hung debt”—loan deals intended to be syndicated that lost substantial value after being written. Some $80 billion in hung debt in the year following the start of the Fed’s rate-hike cycle meant that a combination of nursing losses and avoiding selling at a loss left banks’ leveraged lending balance sheets occupied. For instance, in the first quarter of 2023, private credit underwrote 94% of buyouts by quantity and 70% by dollar amount.
As the Bank for International Settlements wrote in its 2024 Annual Economic Report (emphasis added),
The restrained lending by banks during the recent tightening cycle and the temporary drop in syndicated leveraged loan issuance created the opportunity for private credit funds to make further inroads into areas traditionally dominated by banks.
While the famously hung Twitter loan continues to plague banks, bank balance sheets are otherwise clearing up. Bank-syndicated leveraged loans (LLs) are trading at a 22-month high in the US. While private credit direct lending (DL) picked up the banks’ slack in 2022 and covered their refinancings in 2023, private credit deals are now increasingly being refinanced by the banks:
As the banks became competitive again and high rates persisted, private credit began facing an erosion of “illiquidity premiums” and increasing defaults. As a result, private credit is also having to do more loan modifications, such as payment-in-kind transactions and “extending and pretending.” This is impacting the ability to return funds to investors and to put money into new loans. Available private credit funding is increasingly going to “secondaries”—funds that buy up stakes from other investors at a discount—or are being rolled into “continuation vehicles,” in which investment managers create a new fund to hold onto the assets of a retiring fund and try to get most of the investors to stay on.
While private credit is clearly not “so back,” that’s also not to suggest that it’s “so over.” Investors have increasingly accepted that it is a diversifier for a public markets portfolio—particularly insurers. And insurers are increasingly part of, or partnered with, private credit firms. For instance, Apollo CEO Marc Rowan recently said it can raise more than enough annuity funds (at least in this higher rates world)—through its life insurance and retirement savings “Athene” unit—than it needs for the private credit deals it can find.
Private credit is here to stay, but we may have already seen the passage of its golden age.
Comments also welcome via email (steven.kelly@yale.edu) and Twitter (@StevenKelly49). View Without Warning in browser here.
I am concerned about Athene. The life insurance industry in its history has had direct lending and has sometimes been quite good at it. The problems come in one of two forms: a) when new investments come in that the risk-based capital rules haven't anticipated, and more risk gets taken than should be. b) When the ordinary process gets turned on its head, moving from writing policies and then investing the proceeds, to making investments and writing policies to fund them.
The second point may seem like a distinction without a difference, but it is a change in mindset where the companies using the second model always take more risk than those using the first model. They blow up more frequently. After a few blow up using new assets, that is when the first point comes into plain view, and you can finally start calculating what the correct risk weightings should be.
Now, going back past the beginning of my career (actuary, financial analyst, quant, businessman), there once was a rule that all new assets that didn't fit the risk categories (non-admitted assets), could only be invested in as a deduction from surplus. You can invest in them, but it lowers your surplus by the cost of the non-admitted asset. I think that still exists in some limited form, but with new asset categories the adventurous try to shoehorn new assets into a category that it doesn't really fit.
Thanks for a good post.