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Opinion Credit
Private credit squared does not have a good ring to it
by Duncan Sankey
Duncan Sankey
Portfolio director and head of credit research
Cheyne Capital
Private credit lenders don’t have to put up with exotic assets and complex structures — they can choose SRTs
Post-2008 regulation fostered private credit in the form of direct lending to the corporate middle market, which conferred benefits on borrowers and lenders. Investors captured a liquidity premium for extending loans to companies that had previously used the broadly syndicated loan market or other forms of bank financing. Companies and their sponsors got to work with small groups of committed investors, with whom they enjoyed an alignment of interest. Lending agreements could be tailored, and difficulties could be hashed out to mutual benefit without the lender-on-lender aggro that had manifested in public markets. At the macro level, private credit arguably helped stabilise the system by moving credit from leveraged financial institutions with a reliance on short-term deposits to unlevered investors.
However, the market reached USD 1.5tn at the beginning of this year — up 50% since 2020 — with the potential to grow to USD 2.8tn by 2028, according to Morgan Stanley. Cracks are showing.
Conflicts between sponsors and lenders
With an influx of money has come a concentration of managers, an erosion of creditor defences and a proliferation of increasingly esoteric applications. The events this summer at online IT training provider Pluralsight — where sponsors lawyered up on lenders and moved collateral as part of a cash injection (diluting security available to creditors) — dispelled the notion of collegiality between participants in private credit deals. Meanwhile, private credit managers now fund consumer, auto, and home equity and equipment loans. They even provide financing to one another. When Blue Owl bought USD 2bn of consumer loans from Upstart, Apollo provided financing to Blue Owl. Private credit squared does not have a good ring to it.
Banks now extend loans to private credit, somewhat marring the notion of systemic deleveraging, while the extension of private credit into retail through ETFs may augment volatility.
To date, default rates have remained manageable, in part because the recent wave of private credit refinanced many broadly syndicated loans. But private credit valuations are opaque. The Financial Times noted a 13.5 cent variation in the valuation of Pluralsight’s holdings as reported by US business development corporations (BDCs).
Moreover, the market is witnessing a potentially worrying growth in payment in kind (PIK) transactions. According to Moody’s, these account for a median of 7.4% of investment income at publicly traded BDCs, up from 5.8% at the beginning of 2023. While higher PIK-ing often signals incipient credit distress, in private credit it could also indicate interest in recurring revenue lending designed to finance companies in early growth phases that cannot pay cash interest. Then again…
If rapid growth and diversification into exotic asset classes, complex structures, opaque valuations, PIK-ing, etc, all sound a bit 2008, there are alternatives. Private credit is not a monolith nor, in some parts, is it a crowded trade.
Risk transfer transactions with banks are one option. These have been around in various forms for over two decades, and the combination of banks’ desire to meet capital needs without tapping expensive equity, along with growing regulatory acceptance of SRTs (especially by the Fed), augur well for sustainable growth. Meanwhile, returns still sit in the low-mid teens.
Capital efficiency delivers high quality assets
Roughly two-thirds of the underlying assets in SRTs are corporate credit or SME loans and, since banks are incentivised to include assets based on capital efficiency rather than economic risk, investors benefit from regulatory arbitrage, often accessing the highest-quality bank assets (secured, undrawn revolvers) for a compelling return.
In SRTs, banks typically retain a vertical slice of the reference portfolio, as well as the senior portion (ie, they have skin in the game). Part of the attraction of SRTs for them is that they retain a relationship with borrowers, and thereby the ability to market higher-return, non-credit products.
Managers should be in a position to perform line-by-line analysis of the underlying credits and/or a thorough review of the bank’s lending and workout processes, defusing concerns about disclosure. Banks’ ongoing need for capital relief discourages adverse selection, which is in any case frustrated by information firewalls: relationship managers do not typically know if loans will be placed in a pool, nor will workout specialists typically be informed whether a non-performing loan has been hedged. Finally, the structure — writing protection on the equity tranche of a loan portfolio through a credit-linked note (which does not get “bailed in” should the bank be rescued) — is tried and tested.
In the crowded world of private credit, SRTs still offer some space for opportunity.
