Uncomfortable moments in private credit

[Music] Pushkin! Here at Unhedge, your friendly markets podcast for normal people, we excel at one important thing, giving you extra stuff to worry about. Today, drumroll, private credit. Seriously, if we weren't all focused on the straight of hormones, we would be laser focused on the constant trickle of grim headlines about this pocket of finance. It was the next big thing once, a revolution linking up companies with the money that they need to succeed. Now, finance people are worried that it's obscuring a multitude of sins, lots of funny lending going belly up. Today on the show, is this the next financial crisis in the making or a storm in a teacup? How bad could it get? This is Unhedge, the markets and finance podcast from the natural times. I'm Pushkin. I'm Katie Martin, a market's columnist in the bunker of FT Towers in London. And I'm joined by a dynamic duo in New York City, Robert Armstrong from the ever excellent Unhedge newsletter. I'm biased because I write for it, but whatever. Rob, say hello. Now, Katie, first of all, hello. Second of all, you said this was a podcast for normal people. Do you have any actual evidence that normal people listen to this podcast in any sense of the word normal? I do. I do. I do. Okay. Good. Normal people say hello, unhedge at FT dot com. Tell Rob you are normal. Anyway, we are also welcoming back to the podcast, the FT's Antoine Gara, who covers private markets for us in the big Apple Antoine. Thank you so much for coming on. We know you're busy. Yeah, thanks for having me. Second greatest Antoine of all time after Antoine Walker, the great Celtics power forward. Can't confirm her tonight. Okay. So listen, guys, we do not want to shout fire in a crowded cinema here. We're not trying to stir up panic. We are saying that in among the Iran news, there's lots of alarming headlines coming through about private credit. They're all over our website FT dot com. As a Goldman Sachs executive said this week, the bank's private capital clients are glad of the distraction from the Iran war. He may have put it slightly clumsily, but he is not wrong. Who's a major PR failure? The same the quiet part out loud. That's the problem. So Antoine, listen, I know for a fact that normal people listen to this podcast. And some of them might not know what private credit is, but they are embarrassed to ask. So tell us, explain it to us like we are five. What is private credit? How big is it? Private credit, the industry will tell you it's lending money to mid-sized companies. So you think, you know, Germany's middle-stand or, you know, the industrial base of America. But what it really is is lending money to private equity firms to buy mid-sized companies. And it's boomed into a true trillion dollar industry, you know, especially since the 2008 financial crisis when banks really stopped making those loans. So the ecosystem is, you're a company, you want to get hold of some money. You can go to a bank to get that money, just get like a standard loan. Or if you're really big, you can issue a bond that lots and lots of different types of investors can buy. But the bit that's grown up in between, particularly in the States, but also to a growing extent in Europe, is this private credit thing, where companies borrow money effectively from companies that are not your kind of standard banks or whatever, they are in this private credit, private equity ecosystem. Antoine is making his, Katie is making a hash of it face. A little bit more realistic is I'm a private equity firm and I want to buy a company. And I can go to JP Morgan and see how much leverage they want to give me and what it costs. And then after the crisis, I could go to dozens of so-called private credit firms, blue owl, Aries, Blackstone, Apollo. And I could see what kind of loan they want to give me, whether I could get more leverage, whether there would be less covenants or more covenants, and whether I could sort of have the structure I want. And so it's really about the alternatives of what banks were offering versus what these new lenders in a sort of unregulated manner were offering because they're outside of the banking system. The important bit as well is that if you're an investor and you buy these funds where all of these loans live in a kind of tradable fashion, you can't just get in and out every day. You might be able to get 5% of your money out if you want it, or 7% of your money out if you want it. But there are restrictions on how long you're supposed to stay in these things. You're not supposed to just jump in and out of them every day. So that has just created some tension, right? Yeah, absolutely. And the restrictions are there for good reason because these private loans are hard to trade. You only have a limit amount of other buyers who need to find out how the companies are doing. So the idea that you would be able to trade them overnight if you wanted to give people money back overnight would be a really scary thing, which is why they have put in this limited ability to pull money. We should probably clarify for our listeners about that 5% number. So there's this standard thing with these semi-liquid or semi-private funds where 5% of the fund can go out every quarter. It's not that I come from my money back and I can only get 5%. If I'm the first one in line wanting money back, maybe I can get all my money back. It's 5% of the funds value that can go out every quarter. And after you hit that 5% limit, the door comes down. So that's absolutely right. Yeah, so you could get 100% back in good times. But then in the bad times, that's when it goes into sort of this pro-rata concept where everyone's getting in line and they're getting filled with just a little amused-boosh of liquidity. I think that may be the first time on this show we've used the term amused-boosh. I'm trying to come up with creative finance terminology. He's jealous of your taco rob. That's kind of where this all is. Anyway, listen. The other really important thing to bear in mind about private markets, private credit, private equity is clues in the name. They are private. If you are a company, right, and you go out and you issue a bond into public markets to be bought by every pension fund under the sun, that's a public exercise. Everyone can see that you've done it and it's kind of on a very easily accessible database somewhere. Similarly, if you are a company and you get loans from a bank, banks have to report to regulators very often about what is in the box, who have they let money to, under what terms, where are their risks, where might they be concentrated. In private credit, we don't necessarily have the same level of visibility about who has borrowed what and on what terms. That sounds a little bit murky. It's a bit of a murky amused-boosh, no? Yeah, it is a little murky, although the funds do show you what they own. That's actually part of what's scaring people right now, because they're reporting haircuts to their loans and sort of rising things called non-accrual, where people start stopping paying interest. You can see enough in these funds that you can sort of start to get a little bit scared, and that's a lot of what the headlines are these days. Let's talk about those headlines for a second. We're here and these gates are coming down on quite a number of funds. Let me tell you about just a few FT stories. Just this week, one of them, the Chair of Partners Group, one of Europe's largest private capital groups, has warned that private credit default rates could double in the next few years. Bad. Next one, Morgan Stanley and private credit lender Cliffwater have restricted withdrawals from private credit funds. Also bad. Next one, by Sujeet Indap and some guy called Antoine. Private credit lenders such as Blue Owl are obscuring weaknesses in their portfolio and a sharp correction in debt markets is approaching soon, says one US Distressed Debt Investment Fund. One more for you. JP Morgan Chase has clamped down on its lending to private credit groups with bankers looking to cut risks as concerns mount over the credit quality of companies in their stables. This is just a lot of bad headlines to have in a short space of time. Antoine, you've written some of these stories. Why are they suddenly all coming thick and fast? Sure. Yeah, this feels like the financial equivalent of explaining how world where one started. We just sort of, we don't really have like the exact start or when it all really began to unravel, but it's exactly right as you put it. Who is the Archduke in this metaphor by the way? He's fine with the Archduke. Sure. Why not? Yeah. I wish I had brushed up on my history first. No, it personally. So you have it right though. So there were these defaults in the summer. There was even a big argument is this private credit or not because a lot of the defaults were from loans that had been actually originated by banks like JP Morgan and Jeffries. So the private credit industry was saying, you know, screaming actually, this isn't private credit, but it gave people in finance the general sense that okay, we've just come out of this environment where money was really cheap and maybe a lot of people made a lot of bad loans and we're starting to see that. So there was a vibe shift, whether it was private credit or not, seems like it's kind of besides the point. And then what's really, really changed the whole ball game this year is AI. And everyone saw how powerful some of these AI algorithms were. And they said, "Oh my God, this is going to disrupt a lot of industries, especially software, especially some of these sort of professional and business services industries." And then once they did that, they said, "Well, who owns these companies?" And it turns out it's private equity firms using money borrowed from private credit funds. And so that's really what's caused the big, big scare where now people are really pulling their money. They're saying, "I don't know what these companies are going to be worth in five years if Anthropic can redo financial data or HR software in a matter of minutes." I would like to editorialize for a second here. For me, what Antoine just described illustrates why selling this product private credit as a retail investor product was just a dumb idea. It was just putting a square peg into a round hole because there's no such thing as giving people a little liquidity. That's not how it works. If you give people a little liquidity, they want more. If 5% of the people come to the door or 5% of the money comes to the door and says, "We want our money back," and then they don't have enough to give it back. It was 6% comes to the door and says, "And they say, 'No, we're putting down the gate.' You know what message that sends? Everybody try to get your money out now because they're telling people, "No." The only caveat here is that you can get fabulously rich selling those funds. How do you mean? If you're running a semi-liquid retail focused, or if I'm a financial advisor and I'm putting my clients into them, I get a pretty hefty fee versus putting them into a boring old JP Morgan bond. But if retail investors demand liquidity, they should be put into products that are liquid. You shouldn't pretend that the illiquid product is a liquid product. We separate from the question Antoine just raised of whether the loans behind these products are money good or not. This liquidity setup, we pretend to retail investors that this is like a mutual fund in some way. This is bad and will always be bad. Here ends the sermon by Robert Armstrong's square. The sermon by Reverend Robert Armstrong. Robert, while writing the sense that yes, these retail investors, and they're not proper mom and pop investors, they're generally very wealthy individuals. They've signed a piece of paper that says, "Yes, I understand that I can't necessarily have all my money back whenever I want it." But fact is, they really get their nickers in a twist when they're told, "No." It feels unfair. Do you feel like there's a certain amount of frustration in private markets around some misconceptions that might be building up? Do they sometimes even admit to you that we've got a bit of a problem to deal with? The frustration is off the charts. You can listen to their conference calls where they're saying, "Effectively, my stock is tanking, but my portfolio is doing great. All the companies are growing. I never made a software loan contrary to what you think." Everyone is very much frustrated and people are somewhat defensive about what's happening right now. It's a mixture of, they have some reason to be frustrated, but investors also, if you're in a liquid structure, you do have to think about the future because you can't get your money out today. If you have a concern about something like AI and what it's going to do to business, especially highly leveraged businesses, you're well within your rights to say, "I just don't want to stick around to find out." That's also what's happening. If the bosses are so confident and they think their stock is being picked on unfairly, there is something they can do. It's called buying the stock. Open up your wallet, buddy. There have been some, especially KKR executives have been buying their stock backhand over fist. At Blackstone, interestingly, their credit fund have a lot of redemptions and they chose to meet well beyond the 5% cap. The way they really met that was there was this big hat that went around Blackstone, especially the upper management and people put in their own money to buy out the investors who want to redeem. I guess that's a good thing. I like that. I like that. They're money on the line. If what you're saying is true, step up and put your skin in the game and that sends a powerful message. That's capitalism friends. The industry really does believe that defaults are not about to skyrocket and even a lot of software companies. The performance is still pretty strong. They do believe very strongly in the fundamentals of the companies. That is true. One of the things that people were talking about, even end of last summer, early autumn when some of these big name failures started to come through that were related to the private credit sector, people were saying, look, history doesn't repeat but it rhymes and this feels a lot like, it's very reminiscent of that period, I think we've spoken about this on the pod before, that period in 2007 and the run-ups of the crisis in 2008 where there were just little rinky dink subprime mortgage lenders who kept falling over and we didn't quite know why and we thought, well, I've never heard of these guys before and I'm not sure I care. This is an idiosyncratic thing and this is an esoteric failure and let's not worry about it until one day there was this kind of collective thing where we all looked at each other and were like, well, I think we have a problem here. I'm not saying this is the same. I'm saying that it's very reminiscent of that period. I think the thing that distinguishes this from that, I hope, touch wood if there is any wood in this studio, is that even if private credit just completely dissolves itself in acid, that should be a kind of controlled explosion, right? It shouldn't leak through to the greater financial system and to and how confident are you around that narrative? Very confident. People are right to say, okay, I'm reading the same kind of headline I saw in 2007. Where the risk is held is fundamentally different. In 2007, all of this risky stuff was owned by banks which themselves were at the time very, very risky because they only had about a dollar of money in reserve for every $30 they had lent out, meaning if you lost $5, you're out of business because all of your money in reserve is gone. All that money moved out of the banking system into private markets. It was part of the regulatory response. Now it all sits in structures that instead of being 30 to 1 leverage over a capital, it's more like 1 to 1, 2 to 1, maybe 3 to 1 in some instances. There's just these bigger shock absorbers if you're going to lose money. All three of the people on this podcast know that you don't really know how much debt is in a financial system until the bad things start to happen. You think you're at 1 to 1, then the underlying company starts to get in trouble and it tends to happen that leverage is like in the coffee cup, you have this other kind of loan. It's under the table, it's everywhere. I buy the, this is a less levered system argument, 100%, but I'm just saying one never really knows, does one. No. I think there are good questions now because there was a lot of "financial" innovation the last 10 years or so. These structures have been innovated and then the loans themselves were somewhat innovative. There were a lot of addbacks and there was a lot of ways in which you could increase the leverage. So yeah, so the marketing that everything is well constructed, I think that everyone should have a little bit of skepticism of, is that actually true or has there been a little bit of edgy behaviour in the different pockets? You're so right Antoine, innovation is the scariest word in finance. But I think we've given our listeners enough to worry about here without panicking them. If that's the tone that we've hit, then good success. But we're going to be back in just one second with Long Short. Okay, listeners, it is time for Long Short, that part of the show where we go long, I think we love "or short" a thing we hate. Rob, what you saying? I'm long the US 10-year bond. Let me just say that we've had a pretty weird couple of years. We've had wars, various kinds of panics and there's AI and there's immigration and everything else. And what does the 10-year US bond do? Nothing. Four and a quarter percent yield. Flat is a pancake for like three years now. I have a feeling you've been long this thing before and it is weaker. since then and I'm going to mark you to market when I get back to my desk. But Antoine, what are you saying? I'm long the jets. They haven't made the playoffs during the private credit boom and so maybe it's their time now. It's never a good idea to be lost. This is an American ball sport of some description I assume. What do you got for us? I am long Ukraine. This morning I went to the London Stock Exchange to attend the launch of a new ETF, which is an investment product which is the Ukraine Reconstruction ETF. I love this. I think there is a big investment theme that's coming in the next few years around getting Ukraine back on its feet. I've been banging the strife for a while and maybe I'm finally right. So Slava, Ukraine, that's what I say. Listeners, we are going to be back in your ears on Tuesday, barring further geopolitical disasters. So listen up then. Unhedge is produced by Jake Harper and edited by Brian Urstad. Our executive producer is Jacob Goldstein. We had additional help and tofe for four heads. Cheryl Bromley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackie, Greta Cohn and Natalie Sadler. FT Premium subscribers can get the Unhedge newsletter for free and a 30 day free trial is available to everyone else. Just go to FT.com/unhedge-offer. I'm Katie Martin. Thanks for listening. [Music]