Some investors think private credit is a tempest in a teapot. Others think it is about to spark a new financial crisis. Depending on the time horizon, both sets of views about the esoteric sector may be right.
Signs of trouble in the obscure world of private lending, which had soared in popularity with companies looking for quick bespoke debt and investors seeking high returns, have been brewing since the middle of last year.
The pace at which investors are demanding money back from some of the private credit funds, known as business development companies (BDCs), has accelerated this year on worries about competition, falling returns and fears artificial intelligence will upend software businesses financed by them.
Blue Owl Capital was the latest BDC to report it received a historic level of redemption requests this week and was limiting withdrawals, which it is allowed to do.
Other big players such as Ares Management, Apollo Global, Blackstone, KKR and private credit arms of banks such as Morgan Stanley, J.P. Morgan, Goldman Sachs have also capped redemptions.
Most have signalled the redemptions showed the private credit industry was going through a period of recalibration, rather than a crisis.
Still, other signs of stress have emerged. BDCs are getting hit with higher rates on their bank borrowings even as the historically high double-digit returns they make on private lending shrink.
“You’re going to have credit cycles, you’re going to have losses, you’re going to have some markdowns. I mean, they’re not lending at 5% for a reason, right?” said John Giordano, managing director of New York-based Seaport Global Holdings.
Giordano doesn’t believe risks are systemic, pointing to how BDCs have low leverage, hold senior debt or are involved through equity holdings in the management of their companies. He also cited how well capitalised the banking sector is.
AI Risks
Private lending bloomed after the 2008 financial crisis, becoming the alternative to bank finance for private equity firms seeking to acquire medium-sized businesses via long-term loans with simpler covenants and high returns.
Data on exact exposures, valuations and losses at BDCs remains sequestered, given they are private deals, but they collectively hold more than half a trillion dollars of private assets. The private credit industry, the Alternative Investment Management Association estimates at $3.5 trillion, is big enough to be consequential for financial markets.
Share prices of some of the publicly listed BDCs have fallen sharply this year, trading at a roughly 20% discount to their net asset values. Shares of U.S. software services firms, the sector most closely linked to private credit, have also fallen by a fifth this year.
Rory Dowie, equity portfolio manager at Marlborough in London, said his firm has cut exposure to some of these asset managers and even shed holdings in Swiss private equity firm Partners Group, whose chair Steffen Meister said last month default rates in private credit could double over the next few years owing to AI-driven economic disruption.
Dowie says the symbiotic relationship in AI-financing between public and private markets could result in a snowball effect. “It’s hard to say what’s going to crack first… and it becomes a self-fulfilling prophecy whereby you could get a bigger, more systemic issue occurring.”
Javier Corominas, director of global macro strategy at Oxford Economics, said in a note this week the market is already in the early stages of a rolling crisis in private credit, based on estimates that 25%–35% of these portfolios are subject to AI disruption risk.
“We are still at the beginning of discovering the issues and it might not happen tomorrow, it might happen in three months or six months,” said London-based Alberto Gallo, chief investment officer at Andromeda Capital Management.
“You have this box where you have 100 companies, but you know that 10 of them are dead cats. Until you open the box, they are still alive. That’s basically what they have created.”
Insurers Left With The Bag?
Corominas said total bank lending to BDCs is modest and manageable, but the bigger worry is private credit holdings among U.S. life and annuity insurers. Those holdings have more than doubled over the past decade.
Private credit accounts for around 35% of total U.S. insurer investments, close to a quarter of UK insurer assets, he said.
More worryingly, insurers affiliated with private equity firms hold an estimated $1 trillion in assets acquired through those relationships, and the exposure to the private credit losses will fall disproportionately on U.S. pension funds and retail savers who have purchased life annuities from these insurers, he said.
“Should private credit losses erode insurer solvency, the resulting contagion would not resemble the bank-run dynamics of 2008, but would instead manifest as a slow, grinding erosion of retirement security — harder to detect in real time, and significantly more difficult to reverse,” Corominas wrote.
Andromeda’s Gallo said he wouldn’t dismiss the private credit woes as non-systemic risk simply by comparing it with the 2008 subprime crisis, which was driven by extended housing leverage through what was termed collateralised debt obligations.
“This is a different animal with different contagion channels,” he said, referring to how leverage is pumped up in later stages in private credit by insurers.
In the subprime crisis, contagion was through banks, and there was proper valuation of assets, but this time it is through insurance companies with no mark-to-market and more default risk, he said.
“Regulators always fight the last crisis, and here you have the opposite, the mirror image of the last crisis,” he said.
(Additional reporting by Saeed Azhar in New York; Editing by Anna Driver)
