Uncomfortable moments in private credit

0:08Rob Armstrong: Here at Unhedged, 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 Strait of Hormuz, 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?

0:50Rob Armstrong: or a storm in a teacup? How bad could it get? This is Unhedged, the markets and finance podcast from the Financial Times. I'm Pushkin. I'm Katie Martin, a markets 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 Unhedged newsletter. I'm biased because I write for it, but whatever. Rob, say hello. Now, Katie, first of all, hello.

1:18Katie Martin: 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? You do? I do. Okay, good.

1:31Rob Armstrong: Normal people say hello on hedged at FT.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.

1:46Katie Martin: Yeah, thanks for having me. Second greatest Antoine of all time after Antoine Walker, the great Celtics power forward.

1:52Antoine Gara: Can't confirm or deny.

1:56Rob Armstrong: 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.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.

2:24Katie Martin: It was a major PR failure. The saying the quiet part out loud is the problem.

2:29Rob Armstrong: So Antoine, listen, I know for a fact that normal people listen to this podcast. So 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?

2:43Antoine Gara: Private credit, the industry will tell you it's lending money to midsize companies. So you think, you know, Germany's Middlestand or, you know, the industrial base of America. But what it really is, is lending money to private equity firms to buy midsize 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.

3:11Rob Armstrong: 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.

3:42Katie Martin: Antoine is making his Katie is making a hash of it face.

3:46Antoine Gara: 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.

4:30Rob Armstrong: The important bit as well is that if you if you're an investor and you buy these funds where all of these 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 five percent of your money out if you want it or seven percent 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?

4:58Antoine Gara: Yeah, absolutely. And the restrictions are there for good reason, because these private loans are hard to trade. You know, you only have a limited 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.

5:23Katie Martin: 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 for 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 fund's value that can go out every quarter. And after you hit that 5 % limit, the door comes down.

5:55Antoine Gara: 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, you know, amuse-bouche of liquidity.

6:14Katie Martin: I think that may be the first time on this show we've used the term amuse-bouche.

6:19Antoine Gara: I'm trying to come up with creative finance terminology.

6:23Rob Armstrong: 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 lent money to, under what terms, where are their risks, where might they be concentrated.

7:02Rob Armstrong: In private credit, we don't necessarily have the same level of visibility about who has borrowed what on and on what terms. So Antoine, that sounds a little bit, a bit murky. It's a bit of a murky amuse-bouche, no?

7:16Antoine Gara: Yeah, it is a little murky, although the funds do show you what they own. And that's actually part of what's scaring people right now, because they're reporting, you know, haircuts to their loans and sort of rising things called non-accrual, where people start, you know, stop paying interest and so on. And so 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.

7:44Katie Martin: Let's talk about those headlines for a second. Yeah. I mean, we're here and these gates are coming down on quite a number of funds.

7:51Rob Armstrong: But 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 Sujit 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.

8:30Rob Armstrong: One more for you. JPMorgan 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.

8:53Antoine Gara: Yeah, this feels like the financial equivalent of explaining how World War I started. You know, we just sort of we don't really have like the exact start or, you know, 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, I do. Sure. Why not? Yeah. I wish I had brushed up on my history first. Know it cursely. But so the 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 Jefferies.

9:35Antoine Gara: So the private credit industry was saying, 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 ballgame 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 sort of some of these sort of professional and business services industries.

10:21Antoine Gara: 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.

10:51Katie Martin: 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, right? That's not how it works, right? 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, 6 % comes to the door and they say, no, we're putting down the gate.

11:35Katie Martin: You know what message that sends, everybody try to get your money out now because they're telling people no.

11:41Antoine Gara: The only caveat here is that you can get fabulously rich selling those funds. How do you mean?

11:48Katie Martin: Oh, you mean if you're running a semi-liquid retail focused...

11:53Antoine Gara: Yeah. 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.

12:04Katie Martin: Yeah. But if retail investors demand liquidity, they should be put into products that are liquid, right? You shouldn't pretend that the illiquid product is a liquid product. Totally separate from the question that Antoine just raised of whether the loans behind these products are money good or not. this liquidity setup where like 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 esq

12:40Rob Armstrong: the sermon by the by reverend robert armstrong i mean yeah rob you are right in the sense that like yes these retail investors and they're not like proper mom and pop investors they're generally very wealthy individuals. But 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 knickers in a twist when they're told no, and it feels unfair. Now, do you feel like there's a certain amount of frustration in private markets around some misconceptions that might be building up? Or do they sometimes even, you know, admit to you that, yeah, no, we've got a bit of a problem to deal with?

13:16Antoine Gara: I mean, the frustration is off the charts. You can listen to their conference calls where they're saying, you know, effectively, my stock is tanking, but my portfolio is doing great. All the companies are growing. I never made a software loan, you know, contrary to what you think. Like, so everyone is very much frustrated and people are somewhat defensive about what's happening right now. And it's a mixture of they have some reason to be frustrated, but investors also, if you're in an illiquid structure, you do have to kind of think about the future because you can't get your money out today. So 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.

14:10Antoine Gara: And that's also what's happening.

14:11Katie Martin: And if the bosses are so confident and they think their stock is being picked on unfairly, there's something they can do. It's called buying the stock. Open up your wallet, buddy.

14:22Antoine Gara: There have been some, especially KKR. KKR executives have been buying their stock back hand over fist. And then at Blackstone, interestingly, they had their credit fund have a lot of redemptions and they chose to meet well beyond the 5 % cap. And the way they really met that was there was this big hat that went around Blackstone, especially the sort of upper management. And people put in their own money to sort of buy out the investors who want to redeem. So I guess that's a good thing.

14:56Katie Martin: I like that. Yeah, I like that. That's people who are running these products putting their money on the line. Like 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.

15:10Antoine Gara: And the industry really does believe that defaults are not like about to skyrocket. And even a lot of software companies, the performance is still pretty strong. So they do believe very strongly in the fundamentals of the companies. So that is true.

15:27Rob Armstrong: So one of the things that people were talking about, even like end of last summer, early autumn, when some of these, you know, big name failures started to come through that were related to the private credit sector. people were saying look you know 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 in the run-ups the crisis in 2008 where there were just like little rinky dink subprime mortgage lenders who just like 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 and oh this is an idiosyncratic thing and oh 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 sort of looked at each other and were like well i think we have a problem here i'm not saying this is the same i am saying that it's that it's very reminiscent of that period but i think the thing that distinguishes this from that i hope touch wood if there is any wood in this in this studio is that even if private credit just completely dissolves itself in acid, that should be a kind of controlled explosion, right?

16:37Rob Armstrong: It shouldn't leak through to the greater financial system. Antoine, how confident are you around that narrative?

16:45Antoine Gara: Fairly confident. I think that's right. The way I sort of look at it is people are right to say, okay, I'm reading the same kind of headline I saw in 2007. But 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 sort of 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. So now all that money moved out of the banking system into private markets. It was part of the regulatory response.

17:32Antoine Gara: And so now it all sits in structures that instead of being 30 to one leverage over sort of capital, it's more like one to one, two to one, maybe three to one in some instances. And so there's just these bigger shock absorbers if you're going to lose money.

17:50Katie Martin: 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 one-to-one, 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. So I buy the this is a less levered system argument 100 percent. But I'm just saying one never really knows, does one? No.

18:26Antoine Gara: And I think they're good questions now because there was a lot of quote unquote financial innovation the last 10 years or so. So these structures, these structures have been innovated. And then the loans themselves were somewhat innovative. There were a lot of add backs and there was a lot of ways in which you could sort of increase the leverage. So yeah, so the sort of the marketing that everything is sort of well constructed, I think that everyone should have a little bit of skepticism of really, is that actually true? Or has there been a little bit of edgy behavior in the different pockets?

19:04Rob Armstrong: You're so right, Antoine. Innovation is the scariest word in finance. 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.

19:26Rob Armstrong: Okay, listeners, it is time for Long Short, that part of the show where we go long a thing we love or short a thing we hate. Rob, what are you saying?

19:34Katie Martin: I'm long the U.S. 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 U.S. bond do? Nothing. Four and a quarter percent yield, flat as a pancake, for like three years now.

19:57Rob Armstrong: 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?

20:06Antoine Gara: I'm long the jets. They haven't made the playoffs during the private credit boom. And so maybe it's their time now.

20:13Katie Martin: It's never a good idea to be long the jets.

20:15Rob Armstrong: This is an American ball sport of some description, I assume.

20:17Katie Martin: Katie, what do you got for us?

20:19Rob Armstrong: 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 this drum for a while and maybe I'm finally right. So Slava Ukraini, 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. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein.

21:00Rob Armstrong: We had additional help from Topher Forehead. Cheryl Brumley is the FT's Global Head of Audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free and a 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.