June 5, 2024 | Readers and friends in media have been asking for a while about this crazy little thing called “private credit,” the latest stratégie du jour from the largest Buy Side managers. The “credit trade,” as it’s also known, is actually quite old and is basically known as direct lending.
Investors large and small are being pitched on private credit even as the US enters the most serious debt default cycle since 2008. The rising number of M&A transactions involving chapter 11 cases, says White & Case, suggest restructuring is the new growth sector for private investors. Is catching the falling knife of private credit a good idea for retail investors?
Direct lending is conducted by hedge funds, dealers, business development corps (BDCs), REITs and other specialized vehicles that pursue credits banks won’t finance. The private credit sector, by definition, excludes the toxic world of consumer lending and servicing entirely. But direct lending does include some consumer credits like business purpose loans, owner-occupied commercial real estate (CRE), and various manner of bridge financing.
Direct lenders are the pawnbrokers of the 21st Century for subprime commercial borrowers, usually firms financed via leveraged buyouts. If you are an old school direct lender, you underwrite and fund loans for hard cash, and then either retain or sell loans to various end investors. But today the world of private credit includes layers of leverage atop private equity. The crowd of large institutional investors in credit is similar to the happy group that ran into CRE in 2020. The CRE chart below is from FRED.
Direct or “hard money” lending, in its purest form, is one of the oldest forms of credit and usually does not involve leverage. Private credit shops lend to borrowers that for a variety of reasons, usually related to credit or reputation, cannot raise money from banks or even HY bond investors. In private credit, think of banks and investors as the victims in the ever repeating story, with direct lenders/credit managers as the perpetrators and universal banks as the enablers.
The most successful direct lenders have relationships with insurers, pensions and large funds such as PIMCO and Black Rock (BLK), who buy their loans. Yet now private credit is becoming just another retail speculative strategy alongside crypto currencies and AI stocks.
Q: Given that loss severities on relatively prime bank credit exposures are approaching 100% of the principal amount of the loan in CRE and corporate debt, is investing in private credit really suitable for retail investors? The chart below comes from the most recent IRA Bank Book for Q2 2024.
Source: FDIC/WGA LLC
Banks are the biggest players in credit because they have the size and the funding, but they tend to avoid subprime borrowers. Banks often make mistakes rather than get paid for fixing the mistakes of others. Some banks will provide “secured” leverage to funds, BDCs and REITS that engage in subprime direct lending. Private credit managers make new loans and also get paid for fixing other peoples’ mistakes.
Retail investment firms like Wellington, Franklin Templeton, Lord, Abbett & Co and Blackstone (BX) offer credit-oriented retail funds that invest in better assets, but below investment grade credit is where the real money is made. No less than Swiss private banker Lombard Odie, for example, is marketing a retail private credit strategy with a $250,000 minimum and a mere 18-month lockup period. What could possibly go wrong? Many retail offerings promise retail investors quarterly liquidity and “rolls forever.”
BDCs and REITs compete with large banks and direct lenders in the credit trade, but have even less comparative advantage in terms of funding vs commercial banks. While the world of hard money lending usually is done in cash, today we see large commercial loans extended by nonbanks using leverage and equity provided by funds as the source of cash. Remember, private equity investors are expecting double digit returns. But sometimes the direct lender must become a debt collector and ultimately the new owner.
Some of you may recall when hedge fund Elliott Capital Management seized a ship belonging to the Argentine navy in 2012. The big time credit trade is about being a repo man globally and with enough money in the bank to go to war. The idea with the private credit trade is to lend against large distressed assets at high-yield rates and then pursue repayment through various legal means – hopefully without breaking the peace. In classic direct or “hard money” lending, you are usually ready to own the asset at or around the appraised price.
An affiliate of Ares Management (ARES) known as AREEIF Lender LLC., for example, just foreclosed on a 188-unit apartment building Russland Capital developed at 1411 South Michigan Avenue, in Chicago, The Real Deal reports. The lender filed an $80 million foreclosure lawsuit on the property in January. The equity of the owner is wiped out and Ares now will pursue a recovery.
Data providers such as Bloomberg now track hundreds of private credits managed by a range of different firms, including credit managers and specialized banks. These deals often have private equity firms involved as capital providers and private lenders providing the senior leverage. When the issuers becomes distressed, the private equity may be wiped out and the lenders may end up owning the company.
“Goldman Sachs (GS) was an early leader in private credit,” notes Eric Platt at Bloomberg. “Credit is an area of asset management that is increasingly in vogue as insurers, sovereign wealth funds and pensions up their commitments to the asset class.” But the near-banks like GS, Morgan Stanley (MS), SoftBank unit Fortress, Apollo (APO), Barclays (BCS), Nomura (NOM), all play in below-prime corporate credit but have no funding advantage vs a bank. And investors want at least 20% equity returns on private credit strategies.
Institutional interest in credit has spawned a new cohort of leaders within the alternative asset investment industry, with the likes of Ares Management, HPS Investment Partners, Churchill Asset Management, Clearlake, Blue Owl and Sixth Street among some of the noted players. Veteran credit shops such as Golub Capital (GBDC) and The Carlyle Group (CG) round out the list. And there are now a growing number of firms offering turnkey credit strategies for large global investors who suddenly decide to get directly involved in big time direct lending and debt collection.
The common thread with all of the nonbank players in credit is using investor funds to finance the assets and, if needed, take the hit when an event-of-default leads to a loss. Models such as APO’s use of insurer Athene (ATH), Bayview’s investments in residential mortgage servicing assets and insurers, and the Ares credit portfolio in CRE, offer examples of how sophisticated global investors seek double digit returns. With the collapse of CRE valuations several years ago, however, the calculus of getting repaid in the worlds of corporate credit and commercial real estate has changed dramatically.
There are a number of nonbanks that make gobs of money in consumer credit, but they are mostly licensed lenders/servicers and operate in a world of regulatory risk that large investors cannot tolerate. Doing private credit as a fund means you avoid consumer assets and focus on big commercial loans and CRE assets. You are competing with professionals globally and thus must be a lot smarter and very lucky since your leverage costs 3-4x what it costs a bank.
When the credit trade bottoms out and causes systemic problems, it will be among the near-banks that play in subprime corporate and CRE credit. The trouble may begin in commercial credit, but consumer exposures are also a concern for some of the firms involved in private credit such as GS and APO, which are heavily involved in lending on Ginnie Mae exposures.
We can divide consumer vs commercial credit exposures in many respects, but when the economy deteriorates and asset prices for homes and CRE fall, then the two sectors will coincide. Tracking consumer credit is a relatively easy task. With commercial private credit exposures, however, we don’t and won’t really know about a default by a corporate issuer or on a building unless the event is so significant that it hits the headlines. But the investors in private credit strategies will know.
After all, private credit is private.
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