Experienced direct lenders invest in resilient sectors, leaving banks with the riskiest LBO assets

“But Mrs Diaz,” we protested, “they were the ones throwing food. We were just eating our lunch!”

“That may be,” she answered, “but why would I want those hooligans in my classroom?”

A similarly absurd narrative exists for the First Brands and Tricolor bankruptcies: two private businesses, one in auto parts, the other sub-prime auto loans. No private equity sponsors. Financings for one in the bank market, the other in ABS. No direct lenders. Allegations of fraud and double-pledging of assets. And yet it seems private credit is being asked to report to detention.

Yet what is there for the sector to worry about? Capital markets have turned frothy, barely six months after tariff roll-outs sparked inflation and economic uncertainties. September’s 3.0% CPI was encouraging, Fed rates are on their way down, equity indices are near record highs, and liquid credit spreads are at their tights.

As often happens in late-cycle bull markets, risk managers extrapolate these trends, with attention on loosening structures and compressing returns, and predict danger. It also seems, for the first time in a while, more adventurous lenders are finding a higher number of challenges in their portfolios.

These problems manifest themselves in rising default rates and non-accruals, and more toggling by borrowers to PIK options. These phenomena are most visible in publicly traded BDCs, but market watchers assume what exists in those vehicles must also be present in non-traded BDCs, as well as other private funds.

Missing from these forecasts is a proper understanding of how private markets differ from public. The bank model for leveraged loans has always been a risk distribution one. Private credit instead exists to hold risk assets. This key difference has resulted in more effective alignment with owners of middle market companies and their lenders, providing resources and time to allow portfolio problems to be addressed.

In the case of First Brands, it appears early warning signs had surfaced. Based on private trade-payment data, Moody’s probability of default index had flashed red back in November 2024. Risks for both businesses concerning governance, liquidity and accounting had been raised, leading many lenders to pass on the financings. Having a private equity partner assess these risks would doubtless have helped lenders either gain confidence in the underwriting or radically alter the terms of the syndication.

Experienced direct lenders have learned over time that the most resilient sectors through business (and other) cycles are business services (vs manufacturing), corporate (vs consumer), defensive (vs cyclical). Because the top credit managers have successfully taken the best LBO financings private, banks are left with industries such as (to name recent examples) frozen food, restaurants, oil and gas, and... well, auto parts.

Our friend Sonali Basak and her iCapital colleagues published an excellent piece highlighting takeaways from First Brands and Tricolor. Despite critical concerns about systemic risk and BDCs, there’s no evidence of a broader contagion. Of the roughly USD 500bn in overall BDCs, only USD 237m or 0.05% had primary exposure to First Brands.

Make no mistake, banks see private credit’s remarkable success in disintermediating them from private equity sponsors for LBO financings as an existential threat, leaving them with a reduced choice of assets. Expect blame shifting to continue — even if the house they say cockroaches are infesting is their own.