Colm Kelleher caused a storm late last year when the chairman of UBS Group AG warned of a dangerous bubble in private credit. As investors dive headfirst into this fast-growing asset class, a more pressing question for regulators is how to make sure everyone knows the true value of their assets.
The meteoric rise of private credit funds has been driven by a simple pitch to the insurance companies and pensions that have been managing people's money for decades. The idea was, “Invest in our loans and avoid the price fluctuations of competing corporate loans.'' Because loans are rarely traded, and often not at all, their value remains stable and backers enjoy rich, stress-free returns. This enticing offer turned Wall Street's backwater into his $1.7 trillion market.
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But now the building is starting to show cracks.
Central bankers' rapid rate hikes over the past two years have strained the finances of corporate borrowers, making it difficult for many companies to keep up with interest payments. Suddenly, one of the greatest virtues of private credit, the ability of funds to determine the value of loans themselves rather than exposing them to the public market, looked like one of its greatest potential flaws.
Data compiled by Bloomberg and fixed income firm Solve, as well as conversations with dozens of market participants, show that some private It highlights how little movement fund managers have over where they “mark” specific loans. value.
In one loan to Magenta Buyer, an issuer for a cybersecurity company, the highest amount received from a private lender was 79 cents at the end of September, indicating how much the company expects to recover on every dollar lent. The lowest price was 46 cents and we were in trouble. His HDT, a supplier to the aerospace industry, was valued at 85 cents to 49 cents on the same day.
The lack of clarity about asset values is a regular complaint in private markets and a problem for regulators. When central bank interest rates were near zero, no one cared much, but now financial watchdogs are worried that the lack of consensus is making even more loans difficult. There is.
“In the private market, no one knows the true valuation, so information tends to slowly leak into prices,” said Peter Hecht, managing director at AQR Capital Management, a U.S. investment firm. “That dampens volatility and gives a false sense of low risk.”
All private lending funds and companies mentioned in this article either declined to comment or did not respond to requests for comment.
Code of silence?
Private credit was initially embraced to move risky corporate loans from systemically important Wall Street banks to specialized firms, but enthusiasm has cooled in some quarters. The frenzied state of the economy has made regulators doubly nervous. These funds charged interest rates fixed to the base rate, making them huge profits and making borrowers vulnerable.
“As interest rates rise, so do the risks for borrowers,” Lee Folger, director of financial stability, strategy and risk at the Bank of England, said in a recent speech. “Valuation delays and opacity can increase the likelihood of sudden risk reassessment and correlated sharp declines in value, especially if further shocks materialize.”
Values are particularly cloudy due to less transparency outside the US. The same applies to loans made by funds that do not publish quarterly updates or funds that do not have a single loan examiner.
Tyler Gerash, president of the Healthy Markets Association, an industry group of pension funds and other asset managers, says policymakers are being caught napping. “This is just a regulatory failure,” said Gerash, who helped draft some of the post-financial crisis Dodd-Frank Wall Street reforms. “Investors would have more confidence if private funds were subject to the same fair value rules as mutual funds.”
Nevertheless, the Securities and Exchange Commission has begun to take greater care, hastily enacting rules forcing private fund advisers to allow external audits as a “critical check” on asset values.
But some market participants question whether the pricing fog is appropriate for investors. Fund managers, who requested anonymity for fear of jeopardizing client relationships, said many backers share a desire to stabilize the mark rather than press for more disclosure. It said it raised concerns about a code of silence between lenders and insurers, sovereign wealth funds and financial institutions. Pensions stacked in asset classes.
An executive at a major European insurance company said investors would be forced to book a shortfall at the end of the loan term and could face severe liquidation. A fund manager who worked for one of the world's largest pension schemes, and asked to remain anonymous, said the valuation of private loan investments is tied to team bonuses, giving external valuers inconsistent access to information. He says he was
red flag
The sparse nature of trading in this market may make it nearly impossible for most outsiders to get a clear idea of the value of these assets, but the red flags are easy to spot. Consider the recent surge in so-called “payment in kind” (PIK) transactions. In this deal, a company promises to defer interest payments to direct lenders and make them up at the final loan settlement.
This kick-the-can option is often used by lower-rated borrowers, and while it doesn't necessarily indicate distress, it does raise concerns about what's being obscured. “People underestimate how risky PIK products are,” said Benoît Sorel, senior portfolio manager at Keren Finance in Paris, adding that interest deferrals can sometimes come at huge costs. “There is a possibility that this could embed huge future risks for the company,” he said.
But even after these deals, the loan amounts are surprisingly generous. About three-quarters of PIK loans were worth more than 95 cents on the dollar at the end of September, according to Solve. “This begs the question of how a portfolio company that is struggling to meet its interest payments can be valued so highly,” says Eugene Greenberg, the fintech's co-founder.
An equally puzzling sign is the number of private funds that own publicly traded loans and still value them much higher than if the same loans were quoted on the public market.
In a recent example, The Carlyle Group's direct lending arm helped provide a “second lien” junior loan to U.S. lawn treatment company True Green, with the debt valued at 95 cents on the dollar in a late 2016 filing. is marked. September. The bond was publicly traded and was valued at about 70 cents by mutual funds at the time. In a speech on “non-bank” lenders, BoE's Mr Foulger said most private credit portfolios “still outperform their public market peers”.
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And it is not only the comparison with the public price that sometimes shows a discrepancy. As in the case of Magenta Buyer and HDT, there are eye-catching cases where different private credit companies view the same debt in very different ways. Thrasio is an e-commerce company whose loan valuations are almost as diverse as the product brands it sells on Amazon, from insect traps and pillows to cocktail shakers and radio-controlled monster trucks.
The company has struggled recently, and lenders are divided about its prospects. Bain Capital and Oaktree Capital Management priced the loans at 65 cents and 79 cents, respectively, at the end of September. The two BlackRock funds didn't even come to an agreement. One appraised the loan at 71 cents, the other at 75 cents. Monroe Capital was the most optimistic, setting debt at 84 cents. Goldman Sachs Group Inc.'s wealth management division had 59 cents.
It appears that Wall Street banks made a shrewd decision. Thrasio filed for Chapter 11 on Wednesday as part of a debt restructuring agreement, with one of its public loans valued at well below 50 cents, according to market participants. Oaktree lowered the price to 60 cents in December.
“Dispersion increases when companies are in distress or when many funds are marking the same assets,” said Ethan Kay, an analyst at Bloomberg Intelligence. “When businesses are under stress or distress, there is increased uncertainty about what their future cash flows will look like.”
Analyzing PitchBook data from the end of September, Kay found that in one in 10 cases where two or more funds hold the same debt, the price difference is at least 3%. If, as is often the case in this industry, three out of four funds own the same loan, the difference becomes even more pronounced.
Companies in distress reveal particularly surprising values. Credit service provider Progrexion filed for bankruptcy in June after losing a lengthy lawsuit against the U.S. Consumer Financial Protection Bureau. Bankruptcy court filings estimate that creditors at the front of the line will get back 89% of their funds. Later that month, the company's New York-based lender, Prospect Capital, set its senior debt at 100 cents.
In data compiled by Solve on the biggest gaps between how lenders value their loans and those of other parties, Prospect's name appears more often than most other companies. BI research shows that small businesses are generally more willing to evaluate loan amounts.
Florian Hofer, director of private debt at alternative investment firm Golding Capital Partners, said: “There are significant differences in how managers approach valuations, and there is a lack of transparency and comparability between them. “I'm doing it,” he says.
private fan
For many defenders of private credit, this criticism goes too far. Fund managers argue there is no need to slash prices because direct lending usually involves one or a few lenders and is much easier to control in tough times. In their eyes, the advantage of this asset class is that they don't have to jump every time there's a bump in the road.
Some investors believe that leveraged loans are private credit's biggest rival as a source of corporate financing, with Wall Street banks assembling large syndicates of mainstream financial institutions to finance companies. It also points out the shortcomings of the market.
“There are a number of technical factors that could impact the broader syndicated loan market, including downgrades that could prompt a sell-off or investors exiting certain sectors,” said Karen Simeone, managing director at private market investment firm Harvest Partners. . “You don't get this kind of thing with private credit, so I think it's natural that these valuations fluctuate less.”
Direct lenders also have far less money to borrow than their rivals, giving regulators some comfort that a market rally will be contained. They typically keep the cash they receive from investors for much longer than banks and do not use customer deposits to pay for risky loans. Creditor protection also tends to be better.
Third-party advisers such as Houlihan Lokey and Lincoln International are increasing ratings and monitoring of loan marks, but they are not a panacea as the funds are paid out of the fund. “We don't always have unfettered access to credit,” says Timothy Kang, co-head of Houlihan's private credit assessment practice. “Some managers have access to more information than others.”
In the United States, direct lenders are often set up as publicly traded “business development companies” and are required to provide quarterly updates to investors. Although BDCs provide greater visibility into loan prices, fund managers are compensated based on the value of their portfolios, so there is an incentive to value the debt at a premium.
Wells Fargo's Finian O'Shea said: “Part of the problem stems from Portfolio Mark's decision-makers, such as third-party valuation companies and BDC boards, who stand to lose a lot if they don't work together. “It will become.” Securities, BDC analyst.
For AQR's Hecht, the real fear is not the more wild case of value disparity, but that the very purpose of private credit is to lend to risky businesses, which is not reflected in overall asset values. Yes, it is the same as the UBS chairman's lament.
“What I'm concerned about is a normal credit risk environment where almost every asset is marked 100,” he says. “Most of the time, people look at these asset valuations and think there's no risk.”
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