Downsides to private credit?
Just wondering if anyone has any contrarian views on the secular move towards private credit, given the amounts of capital chasing this strategy + backdrop of higher rates + necessity to earn higher yield to make up for underfunded liabilities.
Bulk of the growth in private credit came in the last decade of relentless bull market - where private equity purchase multiples have only gone up, interest rates have only gone down, and there has always been dry powder waiting on the sidelines to rescue broken capital structures. In other words, this quantum of private debt has never been tested through a real default cycle of 5-7% vs. 1-3% we’ve had for a long time.
With higher rates, substitute yield assets such as HY bonds, syndicated loans, structured credit, REITs, etc will look a lot more attractive relative illiquid assets where you have to tie up capital for 5-7 years.
Also, the illiquidity premium has been competed away already to nonexistent levels. You can pretty much expect the same yield for 8x levered unitranche vs. blended strip yield of 4x bank loan/6x thru junior debt (i.e. 2nd lien or HY bond). This is a natural progression as new supply of capital comes into the system to meet incremental demand until the point of efficient equilibrium.
There are some benefits to LPs in the form of “smoothed out volatility” relative to owning traded debt which gets marked every day. Same way PE has become popular relative to public equity not because of superior returns but because of smoothed out return curve (80% of PE funds have not beaten S&P in the last decade while taking way more risk).
Private capital market is on the precipice of a capital glut (if not already) that will erase the “alpha” opportunity that existed in the last 3 decades. Next decade PE returns will converge with ordinary Russell 2000 type numbers and PC will converge with B/CCC rated HY returns. There is no free lunch and this is the story of every capital market that ever existed whether it’s junk bonds in the ‘80s, distressed debt and L/S equity in the 2010’s, real estate in the 2000’s. Excess returns get competed away because capital is a commodity. When that happens, will there be a point in locking up capital for a decade at a time?
Time to invent the next financial weapon of mass destruction
SB’d
This is an excellent comment that could really get this conversation going, and I wanted to push on one of your points more.
In general, private credit lenders highlight a couple unique aspects of their asset class vs public, 1) less volatility with marks, 2) stronger covenants 3) deeper diligence on a company. Given the above, what prevents this asset class from 'smoothing out the volatility' in a crash, as you state in your post? We've seen in this bull market how private firms across the board have been relatively creative with how similar assets are marked. And while covenants don't matter once you get to the level of breaching a covenant (in that, they tend to be renegotiated at lower levels to keep the company operating), the ability to coerce a company into filing or restructuring the B/S to receive additional mezz-like paper does (on the surface) make private credit seemingly more attractive through a downturn (so long as those companies don't end up falling to the wayside). Of course, these are still much smaller companies compared to the average public issuer, but there's been plenty of examples in the public markets where lenders have gotten hosed due to aggressive leverage/bad docs or secular shifts against certain industries (retail, energy etc).
The other point I wanted to touch on was the concept of fees, and this is really @ any private credit employee in this forum. Given that we are starting to see 8-10x levered unitranche deals in the public market (for sectors like software that have incredible interest...) and returns beginning to compress, has anyone noticed fees for these vehicles start to compress as well?
Agree with your points but I'd comment on the following: 1) Docs are being negotiated more vs. regular deals but, like you said, they don't really matter. Also, given the race to PC, due diligence work is heavily diluted with people's deal enthusiasm outweighing willingness to ask hard questions and reject on actual credit concerns - this feeds into the docs point too, with sponsor term sheets being readily accepted.
"... (80% of PE funds have not beaten S&P in the last decade while taking way more risk)."
Not doubting this and actually agree in spirit but I'd be curious to get the source on that 80%.
Not sure if this is the exact source OP is referring to, but here's pension data showing how PE returns are typically lower with the added leverage risk
From an employee perspective:
If you’re doing mostly sponsor financings you can feel like a second class citizen. They jam you with a tight deadline and crazy leverage/pricing demands. The market is so hot and the deployment pressure is so high that you inevitably cave due to the “relationship”. You work til 1am putting together an 80 page deck for your IC, just to find out some clown firm beat you on pricing by 50 bps so you lose the deal. Once you get promoted, unless you land the unicorn seat of being on the IC, you’re a glorified sales person
This is something i've personally been curious about, re: career track in PC. Are there roles like in corporate banking where you can opt into relationship vs credit focus or does everyone become sales-people in the end? The nature of seeking direct financing would indicate this isn't the case but I'd love to hear your POV.
we are all glorified sales/admin at some level
do you work in Private or public markets?
I don't see why $1.3T CLO market charging 40bps to house loans in a mostly non-MTM portfolio (at least for loans above ~80) and the $1.2T private credit market charging 1.5 & 10-20% above a hurdle don't converge. Love to hear why it wouldn't over next 5-10 years. Don't tell me because private credit analysts are so unique / smart.
Otherwise I think being an analyst in a private credit fund kind of sucks vs. multi-strat credit fund that actively turns over its book (where there is some variety in work / more interesting, way higher comp ceiling but downside is fewer spots and higher volatility / you may get fired).
Can you describe what you mean w/r/t portfolios of loans above 80 being mostly non-MTM? In this market, if you did have loans trading down that much, i would imagine that in itself would give a CLO manager a lot of anxiety with the fear of it trading down further and becoming a restructuring concern. W/r/t to 1.5 and 10%-20%, the ability to find special situations opportunities probably helps justify that fee (Vs CLO's that dont use those vehicles to engage in those) but you're right not every PC lender is doing special situations.
Take a look at a typical CLO indenture; there is concept of Discount Obligation which allows a manager to mark loans purchased above 80% to par wrt to all collateralization tests
https://www.sec.gov/Archives/edgar/data/1379785/000137978519000025/exhb…
Following
Anyone bullish about the future of PC? Would love to hear the other side of the fence.
Some of it can be interesting and has greater alpha if you are differentiated - i.e. mostly doing deals outside of the sponsor universe, doing more complex deals. The reason is that these are the deals not shown to the entire market and therefore not competitive, but these are hard to come by and don’t fit the model of some of the larger platforms that mostly care about AUM and not returns. If you are at a much smaller platform, employee owned and with partners that aim to make money through carry rather than AUM mgt fees - mostly because they have a great track record of delivering good returns and don’t want to be your next 5% guy.
Some rare shops that are in that bucket still exist but they won’t be the ones that come into mind directly when you thinnk about private credit
What are some of the smaller platforms with good returns and are willing to participate in more complex private credit deals? Also, do banks facilitate these hairy deals?
If there is anyone reading this who works in the space, I would love to hear your perspective on how something like this gets underwritten. This thing is likely not very profitable (if at all). How does the investment committee conversation go?
https://www.prnewswire.com/news-releases/bowery-farming-secures-150-mil…
Like every other VC - "we are 15% LTV on series C post money and once they raise Series D at 2 billion valuation, we will be 8% LTV. Let's get this done at 5%. Next."
One of the downsides is the fact that just one or two principal losses out of 15 deals can cause a real issue on returns.
In PE you may lose your ass on a few investments but can more than make up for those with some major wins. In PC, that’s not possible as your returns are lower.
Also in some industries, the sharpe ratio sucks for credit investing. You don’t get paid enough for the extra risk you are taking. If you’ve heard the terms debt Like returns for equity risk, that falls into this category.
But PC is more secure than straight equity, obviously, and I believe you can negotiate warrants.
obviously, but out of 20 investments you likely have a bust esp in Mezz style credit, and the point stands. It’s very hard to dig out of a hole. And if it’s a senior lending style fund, returns even lower and the issue can be more pronounced. Most people here have never seen a down credit cycle, oh they do exist, believe me.
You're basically a bank. Giving loans. And you have to suck up to sponsor hardos. Plus, I don't find it to be a very transferable skill set
I hear you but MF PC And Mezz a bit different.
Agree on Mez. Not that many mez funds really I don't think.
You're doing the same analysis (just as, if not more, thorough) and I'm sure there's more of a legal angle to consider.
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