The war in the Gulf has, understandably, taken up most of the bandwidth of global investors and most of the front pages of the financial media over the past few weeks. Soaring energy prices, coupled with substantial falls in bond and equity markets, and a high degree of uncertainty all demand attention.
But if that war had not been raging, it is likely that developments in private credit markets would have grabbed more attention. Indeed, one Goldman executive – according to the Financial Times – essentially admitted as much last month.
A top Goldman Sachs executive has said that the bank’s clients in the private capital industry are “glad” that the Iran war is providing a “distraction” from questions over the sector’s exposure to software.
This column last wrote about private credit – an increasingly big deal for markets – 18 months ago.
Go back two or three decades and private credit was a small and rather niche segment of the financial ecosystem. If firms wanted to raise debt finance they generally either borrowed from a bank (either from a single institution or from a collection of entities via a syndicated loan) or raised the money on public markets through a bond issuance. But over the last 15 to 29 years private credit has boomed. The sector is now far from niche, indeed it is so large that the International Monetary Fund devoted an entire chapter of this year’s Global Financial Stability Report to it.
Private credit managers raise capital, typically from large institutional investors with long-term investment horizons (pension funds, insurance companies, sovereign wealth funds, and the like), which is managed in a closed-end fund, usually with a long lock-up period. That is used to lend directly to corporates with the typical borrower being of a kind deemed either too large or too risky for bank lending but too small to raise funds on the public markets.
The IMF’s numbers suggest that whilst private credit truly was a niche pursuit around the turn of the millennium it has taken off in the years since the 2007-2009 financial crisis and especially over the past five years, especially in North America.
That column was inspired by a Finance Experts Panel poll which strongly suggested that the growth of private credit markets had been driven by tougher post-financial crisis regulation on banks, but was uncertain on whether or not the new market reduced systemic risk in the financial system as a whole.
It now seems the idea that it has reduced those wider risks will be stress tested. In recent weeks, many large and high-profile private credit firms have enforced rules that limit the ability of investors to withdraw their cash. As the Economist opined this week:
Private credit promised high returns to investors and safety to financial regulators. Now investors are demanding their money back and regulators are worried about panic spreading across the financial system, just as it faces a shock from President Donald Trump’s war in the Middle East. The good news is that Wall Street is much further from the precipice than many fear. Yet all should be concerned by the ineptitude displayed by some of its fastest-growing firms and the costs their woes could impose on others.
Usually questions about the future – and especially questions about the valuation of assets – elicit a high degree of uncertainty. The results last week were surprisingly decisive.
Asked whether “the enforcement of restrictions on withdrawals from private credit funds predicts that the funds will substantially underperform indices of liquid high-yield corporate bonds over the next 18 months”, around 50% of respondents (weighed by confidence) either strongly agreed or agreed with 29% expressing uncertainty. And then asked whether “assets in the private credit funds that are restricting withdrawals are substantially overvalued relative to their true market value”, 57% of respondents – again weighted by confidence – either agreed or strongly agreed with 30% being uncertain.
That, as Finance panels about the future go, is a reasonably clear result.
Of course, the redemption limits are a feature, not a bug, of the system. As Jonathan Parker of MIT Sloan put it, “The funds have redemption limits because they are investing in projects that are costly to sell. Enforcing limits avoids these expected costs. If these limits were not generally enforced, the funds could not try to get higher returns through making illiquid investments”. Much of the excess return from private credit reflects an illiquidity premium, and while investors might like the premium in the good times they focus more on the illiquidity in the bad times.
As John Campbell of Harvard argued, though, “a high volume of withdrawal requests suggests that some investors believe that current marks are too high and will fall in the future. Withdrawals can also create downward price pressure on funds’ asset values as funds try to sell their assets”.
That sort of selling pressure is currently evident. Blue Owl, for example, has announced that investors have sought to withdraw 20% of the value of its flagship $36B fund and 40% of its smaller tech-focused vehicle. The firm has enforced its contractual 5% limit.
Many longer-running market worries are now coming together in the private credit sector – the recent fear that AI developments could wreak havoc on software valuations has been one immediate catalyst, given the relatively high weighting towards software in many loan books. Worries over the macroeconomic fallout from higher energy prices are another.
The formerly booming sector looks set for a tough year. The bigger, and still unknowable, question is how much pain here will spread back to the wider financial system and what impact tighter credit availability will have on the wider real economy.
