The private credit boom

0:06Pushkin. Since the 2008 financial crisis, there have been a lot of bank regulations. So finance activities moved from the banks to things that are not banks. One particularly fast-growing part of the non-bank sector is private credit, which you may have heard a lot about. And indeed, one of the biggest players in private credit, Blackstone, just today hit a big milestone,$1 trillion in assets under management. It's got a lot of people asking, what's private credit again? Today on the show, we'll tell you. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu here in New York, joined by master of the shadows, Alexandra Skaggs.

0:51That is going on my business card. Master of the shadows and Alphaville reporter. Yes. So Alex, okay. Private credit, I think this is a thing that's a little hard to talk about just because people may not have an intuition for it. But I think it's worth underlining the growth, right? Like when something grows a lot in finance, people get excited, people get worried. And I mean, in 10 years, private credit has gone from something like$600 billion, which, you know, maybe midsize part of the financial system to 1.5 trillion. So it's more than doubled in 10 years. It's just astonishing. Yeah, it's been really wild to see how much it's grown.

1:27And I think a big part of that is bank regulations, like you mentioned. One of the most interesting things to me about private credit is really who uses it. So like if you're a super small business, if you have like a startup coffee shop, you're like going to your uncle or like family, you know, somebody with a lot of money. If you are Apple, you go to JP Morgan. But there's a lot of space in between those two markets. And the companies that are sort of in this kind of mix tend to be a little bit smaller, maybe like a few hundred employees. One example of that kind of company is Melissa and Doug, which make kids toys, which I didn't know what it was until like a couple of years ago.

2:07And I saw they were taking out loans. And another one is a Kentucky company called Big Ass Fans. What do they sell? It's a mystery. Nobody knows. No, they're wonderful. It's a really funny name for a company. And it's like those kinds of companies either get bought out by private equity or they want to grow because every parent in the country needs a puzzle or a push toy for their kid from Melissa and Doug. Not that I would know. Or a big S fan. Yeah, or a big S fan. That's also very valid. So as private credit has doubled in the past 10 years, it's gone from we're serving this less served middle chunk of the market to we're competing with the JP Morgans of the world for this bigger business, right?

2:53Yeah, yeah. So I think there was just a big private credit loan to Bombardier, which I mean, they make like giant like subway cars and I think airplanes. So having private credit be financing that kind of business, I think is really wild and really shows sort of how much it's grown. Yeah. And I think we should explain like maybe the connection between private equity and private credit here. And so, you know, I mentioned in the top Blackstone, right? They're primarily a private equity player, but they've also become one of the biggest players in private credit. If I'm not mistaken, their private equity business does dwarf their private credit business in terms of assets under management.

3:31But these markets have become, I think, very symbiotic. Private credit is tending to lend to companies that are owned by private equity. Yeah, it's a really fascinating tension, I think. Yeah. So Blackstone's private credit fund has about$50 billion under management, which is a lot of money. But compared to the total size of Blackstone, as we say,$1 trillion, it's not giant. But it's funny because, you know, private equity's business model is basically, okay, let's take on a ton of debt, take this company private and like see how it goes. Yeah, leveraged buyout. Yes. And now all of a sudden you've got these private equity players who are lending to other companies that are doing leveraged buyouts.

4:13I think it's worth asking here, like, what does private credit offer that like the big bank loans can't, right? And, you know, part of it's in the name, it's private. Which is to say, you got a handful of lenders. You can call all of them on an afternoon if you needed to. If you're the borrower and you're having issues at your company, you can ring up the people that lend to you. You kind of know who they are. The bank lending system for these companies involves chopping up the debt and selling it on to a million people. And it becomes quite complicated. And who do you talk to? And your debt's trading up and down in public markets.

4:49It's quite messy. With a private loan, you call the people who you were pitching to originally, and you kind of know who they are and like, you know, you can get a meeting with them. Yes. So the interesting thing when it is like a smaller group of lenders and these kind of one on one relationships, really, and it is still really like a relationship business a lot of the time, it gives people more room to cut each other breaks. The interesting thing is, though, that a lot of times the counterparty is private equity. So you can also have a little bit of room to like not cut each other breaks. Yeah, yeah.

5:25And I think that the flexibility is really important because in a lot of cases, I would say, the lender and the borrower had the same interests, right? The borrowers, they're going through some hard times. Like maybe they had a few quarters of lackluster sales. The lender doesn't want them to default because that's like the catastrophe scenario from the lender's perspective. Like they'd much rather give them the room they need if they have some conviction that the business can be turned around, you know, over a certain number of quarters to just give them the time to figure it out so that they can continue getting paid on their debt.

5:54But in public markets, because it's so dispersed, because there are so many lenders, because there's a public ticker of where the debt's trading at, that becomes a lot harder to do just in practice. Yeah. I will say, though, the other example to the lender doesn't want the borrower to default, the borrower doesn't want to default. The borrower might not want to default, and it might also want to pay its owner giant dividends. So I think there are two sides to that coin. This is another part of it too. It's like the contract writing. In public debt markets, during the low interest rates era, borrowers had a lot of leverage.

6:32Lenders needed to get the money out there. So borrowers had the ability to say, you're going to give us some generous contract terms. It's going to be hard for you to place restrictions on, for example, issuing dividends to our owners, to our shareholders. You're not going to have a lot of recourse if we default or if our financials start looking bad. And private credit, that's less true. They've been able to maintain tighter contracts from the lender's perspective and worse contracts from the borrower's perspective. And you talk to the private credit folks, as we've been doing at the Unhedged Newsletter, and a lot of them will talk about, our contracts are tippity top.

7:05No, it's true. And I do think if you're chopping up a loan and giving it to a ton of people, or if you're buying a loan that's been chopped up and redistributed, I mean, you don't have time necessarily to look through the entire contract and be like, oh, there's a loophole I might not have noticed. There are a lot of lawyers that get paid a lot to do this. But I would say that the underwriter lawyers or the sponsor lawyers are often more focused on those potential loopholes. Yeah. No shade against the other lawyers. OK. We've laid out what private credit is, but I think we should talk about should we worry about how much it's grown, right?

7:45And again, to reiterate, when a thing grows a lot in finance, people worry. It's just a natural instinct. I think there are some reasons you could imagine to be extra worried about private credit. It's private. It's in the shadows. You don't know exactly what the contracts are, what the relationships are. And there could be interlinkages. You know, during 2008, there were warning signs, but no one really knew the exact extent to which lenders were connected to borrowers and what quality the collateral was and all this other stuff, right? And I think, you know, we live in the shadow of the last crisis, no pun intended.

8:17And when you have something with the word credit in it, that's grown a lot and it's not entirely transparent, you start to get nervous about a credit event. Yeah, absolutely. I think that things that are worrying here is that like basically it's very disperse, at least when it's at the banks, like regulators can see it. But here regulators can kind of see it, but kind of not. And there's just a lot. It's not as concentrated in those like central intermediaries. Of course, having it concentrated in the central intermediaries was sort of what caused the crisis in the first place in 2008 and 2009.

8:52But I do think that the sort of dispersed nature of that market and potentially questions about banks' exposure to private equity firms are the things that raise concern about that market. And also, I just think the newness of it, right? Yeah. This is a sector of finance that, at least at its current scale, has not been tested by a major crisis, a major event. You could say COVID, but let's be real. COVID was not a financial crisis. The government declared there shall not be one. And so there was not one, right? And it had all the tools to do it. And obviously, this wasn't as big in 2008. I think that's another root of the fear is if we have a recession, if we have some other type of financial issue in the system, what happens with this untested sector?

9:39And that's not just private credit. It's also private equity, right? Which is another segment of finance that's untested. We don't know the interlinkages. We don't know how this fares when people are really starting to sweat and there's like real stress in the system. I guess the other side of that argument, which, you know, is that this actually isn't that big of a deal or isn't that scary because it is a big deal. It's like a giant market. But the argument that it isn't that scary is mainly about who is holding the bag. Right. Because in this case, you know, it's end investors, it's pension funds who are supposed to be very sophisticated and have, you know, really good risk management in place.

10:15And I think that, But during the financial crisis, 08, 09, the banks were holding the bag and that sort of took everything in the economy and just brought it to a screeching halt. Yes. Whereas here, if Kelper's has a loss on 2 % of its fund, the consequences, I think, might be less severe. Yes. This is a really good point. And I mean, if you asked me, Alex, where do I come down on does it add risk on net to the system? Does it subtract risk? I'd probably say subtract with like a great degree of humility and lack of confidence. But if I had to make a guess, I'd say subtract for exactly this reason that the end investors in private credit, your pension funds, your endowments, your sovereign wealth funds, those are the people that are kind of ultimately on the hook if things go south.

11:04And yeah, maybe there's some contagion, but like the ultimate, ultimate, ultimate core end investor are people with some money to lose, which I don't think was as true in 2008 where depositors and to some extent homeowners were the end investor. And these are not people with money to lose, right? And there's also another difference, which is when you're talking about banks, like banks are the heart of the financial system. And they're also significantly more leveraged than a private credit fund is. They're leveraged one to 10. $1 is turned into 10 or$11, right? And with private credit, we're talking more like$1 turned into$2 or$3.

11:40And those differences in leverage, the illiquidity of it, the fact that you're not trading day by day on some of these loans. And the fact that investors with money to lose are sort of holding the bag at the end of the day, that makes me a little bit more sanguine about this than 2008. But again, just the fact we don't know, just the fact it's untested makes me very hesitant in that conclusion. Yeah. And you could maybe make the argument that the leverage is shifting from the banks to companies. Yeah. Because these are highly levered companies that are getting these loans. So I think that the risk is definitely being dispersed.

12:16And I do think that the bag holders are eventually big institutional investors or wealth managers or basically people who can afford it. It'll be interesting to see if rising rates do start to bite, because remember, this is a floating... So they lend at floating rates, which means that borrowing costs go up when interest rates go up, that could start to pinch companies a lot sooner than maybe it would have if they had taken, like issued a bond. Right. You know? Rising rates slowed the economy. So the company's revenue is falling at the same time its interest costs are rising. So they get bit on both ends and you're kind of, you're out of luck.

12:52Exactly. And you know, and remember, private credit and pension funds aren't the ones that employ people, companies are. This is a very good point. Listeners, are you worried about private credit? Let me know. Ethan.Wu at FT.com. We'll be back in a minute with Long Short.

13:36again. So that just felt clunky. And I thought Katie had a very nice way of putting it. Yeah, I like that. Anyway, Alex, I am long the dude that ran across the 38th parallel to North Korea. That's so awesome. What did this dude do? We don't really know. I mean, supposedly he was in some criminal hot water in South Korea, US soldier. And he was in some trouble in South Korea. He was on a tour near the 38th parallel. and he just, apparently he was like laughing as he was doing it according to the eyewitnesses. So he's like cackling running across the 38th parallel. I mean, if you're gonna run across the 38th parallel, you should at least have fun.

14:14Does he have like a white flag that he was waving? I feel like that would be a good strategy. It's peace to the Korean peninsula, yeah. All right, Alex, are you short something? Yes, I am short the Economics Job Market Rumors Forum. Ooh. Yeah, so this is a really fun one. And it's basically a message board that's really poorly moderated, no rules, all technically anonymous. And that means that economists and actual like academics get on here and say things that they are too scared to say in polite company under their real names. We can call it like a 4chan for economists. And part of the reason it's gotten so like toxic, I guess is the word you could use, is that everyone's anonymous and people have been like very confident in their anonymity.

15:02And then there's this wonderful paper out, I think today, and a wonderful presentation with it that basically shows that the actual protection of the IP addresses of the people posting on this forum was like really, really bad. So you can very easily identify the IP addresses of all the people commenting. And there was actually one of the commenters said, oh, I'll give a million dollars to anyone who can find out my IP address. And the presentation has that. And then the IP address of the guy underneath it. It's beautiful. An early version leaked, so I don't know if that version is going to get into the actual official presentation.

15:44But this has leaked early on the internet. And understandably, all of academia, specifically economics professors, are freaking out. My favorite part of that was the people on there that were associated with a Harvard IP had a lot more to say about MIT than the people with an MIT IP had to say about Harvard. They did. That's incredible. It really is incredible. listeners we'll see you back here on Tuesday for another episode of unhedged catch you then

16:13unhedged is produced by jake harper and edited by brian erstat our executive producer is jacob goldstein we had additional help from tofer forhez cheryl brumley is the ft's global head of audio special thanks to laura clark alistair mackie john schnarz eric sandler and jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free, and a 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.