Private Credit's Shifting Identity
It has slowly begun undermining most of its original value propositions
Private credit offers diversification to public markets, and the flexibility built into its terms can be good for borrowers and lenders alike. As the market boomed in 2022 and 2023, it started to face the hard question: What about the macro risk here?
It had four answers for us:
Scarce use of leverage.
There is limited leverage in these structures. This reduces the risk of fire sales, illiquidity, and other insolvency outcomes. (Private credit also asked the banks why they had never thought of that.)
Matched funding.
Private credit investment funds have term funding. They lock up long-term funding for several years, and thus avoid the redemption risk associated with maturity transformation. (They again asked why banks hadn’t tried this.)
No volatile marking to market.
These are private assets, with no tradable prices. This allows private credit managers and their investors to report more stable prices based on “fundamental” values.
No retail allowed.
Private credit need not be feared because the ecosystem would only be opened to sophisticated, institutional investors that understood and could bear the risks.
As the market has matured, let’s check in on of these characterizations. None has been wholly compromised, but each is slipping.
Leverage.
While data is scarce, leverage is increasing in private credit by all accounts. Private credit is increasingly making use of net-asset-value (NAV) financing, subscription financing, collateralized fund obligations, seller financing, and more. These various structures have different designs/uses, but they all allow private credit funds to do more financing on less client funding. That is, they raise leverage.
Redeemability.
From an investor’s perspective, locked-up funding is a drawback. New private credit fund structures have thus arisen to move towards solving that problem. “Evergreen funds” and “interval funds,” while not offering unlimited redemption on demand, are growing experiments in providing investors more opportunities to redeem a portion of their funds. They thus run some risk of maturity-transformation-related losses and/or needing to impose gates (the latter of which we’ve already seen in analogous structures).
Secondary trading.
Many firms—e.g., JPMorgan, Golub, Apollo—are building out loan trading desks for private credit loans. This will add liquidity and, by extension, more regular market-based marking of assets and any pursuant volatility. Several asset managers are pursuing private credit ETFs, with State Street and Apollo together filing for one last month.1
Retail onboarding.
The ETFs are an example of the many attempts to bring retail investors into the private credit fold. As private credit’s distributions to investors have slowed (which is also part of the reason for the increased use of leverage), it has found more limited interest/ability from institutional investors to provide fresh funds. While countless investors are likely still under-allocated to private credit, the low-hanging fruit increasingly looks to have been harvested. As such, the retail demand is next market for private credit to turn to. Early examples abound.
Per Bloomberg, emphasis added: “But private credit funds are finding it harder to raise capital from the largest investors as still-high interest rates weigh on financial assets. With quarterly inflows from the biggest investors near multi-year lows, according to data provider Preqin Ltd., small investors are becoming an increasingly important feeding ground for private credit firms.”
Per the Wall Street Journal last week: “Now many institutional investors are full up on alternatives, and money managers are building products aimed at individual investors instead.”
It’s now a well-trodden joke to note that as the crypto markets grew, they relearned every lesson that traditional finance had learned decades and centuries ago—with the ultimate lesson coming with the “runs” and failures in 2022. As private credit hits its own growing pains, it seems to be increasingly understanding why we have to structure banks the way we do.
Other recent notes on private credit:
Their ETF will mix public and private assets. Bloomberg reported that, to assure liquidity for the illiquid assets, Apollo would contractually agree “to ‘provide intraday, executable firm bids’ on the investments. And it would offer to buy them back from the fund at State Street’s discretion, subject to an as-yet unspecified daily limit.”