Private Credit’s ‘Back Leverage’ Is Another Pain Point for Funds

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1:39Bloomberg Audio Studios, podcasts, radio, news. You're listening to Bloomberg Business Week with Carol Masser and Tim Stenevek on Bloomberg Radio. Investors in Cliffwater's$33 billion flagship private credit fund look to redeem about 14 % of shares in the first quarter, leading the firm to cap its repurchases at 7%. It said this in a letter to investors that was seen by Bloomberg. And Carol, this is on a day where shares of asset managers are already taking a hit. Yeah, those alternative asset managers, we're talking about areas management, KKR, falling as JPMorgan Chase is said to be restricting some lending to private credit funds.

2:16The move adds to already weak sentiment. We've talked about this a lot surrounding alternative asset managers after weeks of stock sell-offs. And there's more, but Let's get into it with another look at the world of credit. It's one of those big questions and concerns that are out there in the trading environment. Chris Whalen is back with us. He's chairman of Whalen Global Advisors, co-founder of Institutional Risk Analytics, author of a bunch of books, including Inflated Money, Debt, and the American Dream, worked at the New York Fed in the 1980s, worked on Wall Street. You have seen a lot. We talked with you so much during the financial crisis.

2:50I always remind everybody that because you look at balance sheets of things and try to figure it out. Private credit. You were talking about something when you came in. First of all, private credit. The J.P. Morgan move, is that something that's worrisome, responsible? Jamie's the one, back in the fall, talked about more cockroaches when it came to the private market. Chris, how are you kind of adding all this stuff up? Well, J.P. Morgan is the biggest secured lender in the world. They are the big dog. So if they start to pull back, the other banks will do likewise. I think also they have a view of the marketplace.

3:26They deal with everyone that they want to deal with. So when they decide that they don't like the risk, that tells you something. Yeah. You know, basically the industry got very greedy. They decided to up their fees by inviting retail investors into private stuff. And private stuff is by definition illiquid. So when you have any kind of concerns that come into the market about credit, about quality of assets, the retail investors want to run for the door and also some of the institutional investors too. Shame on them because they know it's not liquid or like read, like understand what you're buying?

4:04It's not suitable to borrow a term from the FINRA rules. You cannot put people into things that are not suitable. And what the industry has done is protected themselves with contracts and non-disclosure agreements. So you can't really sue them. They're not really fully under the fraud provisions of U.S. law. So you as an investor have almost no recourse. And many of the bank loans that are being made to these things are also explicitly non-recourse. Look at the litigation between Western Alliance and Jeffries. Jeffries spawns a special purpose entity, and then they tell everybody they're not responsible for it.

4:43You remember Citi in 2008. They were forced to buy back special purpose vehicles that they had essentially the lawyers tell them, well, you're not responsible for it. If enough people show up and demand that you redeem them, then yes, you are responsible for them. I think this is going to ultimately force many of the sponsors of these deals to take back the vehicles. And that could be a source of significant losses. What about the alternative asset managers? I'm looking at Blue Owl, for example, down 64 % from highs last January. It's down another 5.5 % today. Blackstone down 42%, private equity play, down 42 % from September highs.

5:26Right. Apollo down 30 % from highs just in January. Right. Like, we're seeing this play out. All in the private credit world. Yeah. Yeah. It's unfortunate, but, you know, it's not systemic. Well, that's what I want to go. These are tiny firms. Is it? Okay. They're little. All non-banks are little. Apollo, Blackstone. All of them. The mortgage guys that I work with, they're all little. Okay. And the banks lend to them, so there is exposure to the banks. Right. But it's not going to end the world. You could literally pile all these things up and sell their assets tomorrow if you could. And it would cause losses and a lot of aggravation, but would it bring the economy to a halt?

6:06No. Why is the economy protected? just because of the size of those lenders? I don't want to call them lenders, but the size of the firms. Well, these are private assets. These are private mistakes. Yeah. So they'll have to get worked out privately. But private credit as a whole is almost several trillion dollars. It is enormous. And you could argue that the fundraising in private, say last year, was bigger than the public markets. So it's not that it's insignificant. I don't want to give you that impression. But it's different from when public markets crash because everyone sees that. See, the definition, if you remember Jerry Corrigan, the definition of a systemic event is when people are surprised.

6:46So nobody's surprised by this. Everybody knows what's happening. And you don't have a public bulletin board with prices for this stuff that you can see and you can report on here at Bloomberg. That's the difference. Which we talk about this, right? The lack of transparency, which is why everybody... You know there's a problem. You just don't know how big it is or how fast it's moving. So the story, one of the stories today, Chris, is Apollo preparing to start reporting the net asset values of its credit funds on a monthly basis. Aims for daily NAVs and third-party valuations every time. Good move?

7:19Well, it depends who's doing the valuation. Ah. Right? Who is? Who would be? They'll probably hire an external firm. There are many firms that do these sorts of private valuations. They model them, et cetera. But the only valuation that matters is when you sell the asset to somebody. Right. Right, the price willing somebody to pay, right? So that's why we have public markets. And I remember many times Mark Rowan, the head of Apollo, going on and on about how private markets were superior to public markets, including on Bloomberg. And he was wrong. He was wrong to even suggest that in public. He was misleading retail investors.

7:55Because of the lack of transparency and the lack of liquidity. But that's a story that we continue to hear, and I'm not calling on him specifically, but what we hear from the folks who want to sell this to retail is that, hey, we accredited investors have been able to access this stuff for years, and institutions have been able to access this stuff for years, and we want everybody to be able to access it so then they can have the upside there. I disagree. I think many times if you look at Harvard and some of the other big institutional investors that have bailed out of private, they would have done much better than just buy the S &P futures.

8:33and they wouldn't have had the headaches and the risk of worrying about liquidity. You know, again, there's a reason why in the 1930s we created laws to protect investors, why we created public exchanges. Right. And it was all because the gang on Wall Street led by Goldman Sachs, let's remember Shenandoah and Blue Ridge and Goldman Sachs Trading Company, were totally opaque. And they went on and on about how this was a superior way for people to invest We're replaying the movie here, guys. It's almost 100 years. And we're literally replaying the same movie that Galbraith wrote about in his book, The Great Crash 1929.

9:13It's right there. But, you know, we're humans. Humans forget. Humans chase the shiny object. And that's it. So here we are. A lot of folks chasing it. And I think about how many conversations we've had in the last years. You know, it's not the public markets. You know, we've seen less companies. I mean, we've started to see some IPO movement. but we've seen a pullback on that. Ultimately, Washington did this. Sarbanes-Oxley, the Basel Accord. You're right about this. Yeah. That's really what happened. Explain that, Chris. Well, essentially, after Enron and WorldCom, two huge frauds. My old friend, my father's friend, Chuck Gavisher, was an Anderson partner.

9:54He watched his firm go down in flames, and then he became the most significant accounting figure in Washington. He was head of the General Accounting Office, and he was the father of Sarbanes-Oxley. You never let a crisis go to waste, right? Yeah. So they put this tough legislation in place where you had to have attestation by corporate officers and penalties for auditors and the whole bit. And it made public companies almost too risky, in a sense. And you've seen over time, they've tried to put laws and regulations in place to allow small cap companies to go public with less regulation, etc., etc.

10:31But really, Washington did this. You know, Washington always tries to legislate reality. So here, you have, you know, 20 plus years later, the result, which is that more money has been going in the private markets than public. And ultimately, it's not suitable. So Chris, how do you think this ends? I mean, is it a smarter, in your view, a smarter private credit market, a smaller private credit market? Some say that what's important about this market is you don't necessarily have the big banks lending to middle market and so on and so forth. And that's what I've often heard. Is that fair? It's fair.

11:07But look, private equity is a game for big institutional investors who have a time horizon that's not constrained. If you're a retail investor, most times you have a constrained liquidity horizon as well as a time horizon. So you can't expect these people to sit there and hear that you're going to shut the gate and you're not going to give them redemptions for a year and not have them freak out. Obviously, that's what's going on here. But you also have accredited investors, small institutionals, even big pension funds, state of Oregon. They have had a number of private investments that haven't panned out.

11:46So they are constrained now and they've been borrowing money to make up the gap. So this is why it's very important to have that suitability rule in top of mind. And it's liquidity, what's your time horizon for the investment? If it doesn't fit, then don't sell it to them. But the street saw the fees. Everybody wants a 20 % hurdle, right? That's the way Wall Street is. They are entitled to 20%. And to go back to the GFC, we saw people chasing it because there was money to be made, even though people saw some of the risks. Chris Wellen, thank you. My pleasure. Always appreciate it. Chairman of Will and Global Advisors.

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