Is private credit the next revolution - or a bubble waiting to burst?

Private credit may sound new, flashy, and like the next big thing in finance but it isn't. For decades, banks conducted most of the lending. There may not have been that many lenders but they controlled the terms, the covenants, and the fees - indeed, they had the final say on the stuff that matters. That all changed during the Global Financial Crisis when regulators started to clamp down on risky lending practices. 

The shift opened up a whole new market for non-bank lenders to take charge - and today, by some measures, it's a near-US$2 trillion industry. It's now so big that the IMF has a whole chapter of its latest Global Financial Stability report dedicated to it. But depending on what you read, you either think it's the next big thing - or the precursor to GFC 2.0.

Recently, at the MA Financial Alternatives Summit, two veteran investors went head-to-head on this pressing issue. The bull was Frank Danieli, Managing Director and Head of Credit Investments and Lending at MA Financial Group and the bear was Charlie Callan, Associate Director at BondAdviser. In the following, I summarise and analyse their clash.

The bull's case in summary:

• Private credit is no short-term fad - it's been outperforming for two decades
• Negotiation allows lenders and borrowers to craft a customised solution
• The rise of passive investing in public markets makes private markets a more attractive place to generate alpha
• The biggest tailwind for this asset class isn't going away anytime soon

The bear's case in summary:

• Private credit is showing signs of an asset bubble
• The downside risk in the asset class is misunderstood
• There is no transparency in the asset class
• The structural evolution argument is all "sizzle, not steak"

The bear's view: A bubble with no transparency and limited understanding of its risks

On the first point, private credit firms are "awash" with cash at the moment - something Callan describes as "a sign of mania". The size of the Australian private credit market itself has grown three times in just five years. As a further sign of the top, Callan calls out that there is now a new product on the street - synthetic payment in kind. The revelation caused Callan to react with "What? Why? It's just banking right?"

Secondly, protections against falls in asset values are becoming more scarce with 85% of US private credit deals said to be "covenant-lite" (loans with fewer restrictions on the borrower and fewer protections for lenders). For investors, it means that the base case has to work out near-perfectly. 

Fundamentals, in Callan's view, are also worsening and this is seen both in the decline in coverage rates (a measure of determining whether a borrowing firm can meet its loan obligations) as well as a rise in amend and extend clauses (a clause that gives the borrower the right to request that the maturity date of all or a portion of its facility be amended and extended, along with amendments to key terms). 

Finally, from a returns point of view, private assets do not trade in the same way that public assets do. When new information arises in public markets, public asset valuations (eg credit spreads, bond yields) react accordingly - but the same does not happen in private markets. Even as the market grows and demand grows in size, the value of those loans doesn't move.

"When more money comes into the market, you can't just go and buy a new loan. The manager has two choices - either sit in cash (which the manager is not incentivised to do) or buy a new loan. What happens is, as private credit grows in size, the outcomes for investors get worse because the incremental risk of the loans being taken significantly increases through time," Callan notes.

"It's not like public asset markets where the value goes up and it's great for existing investors and it's fair for new investors. In private markets, the market's growing and it's getting riskier," Callan adds.

The bull's view: The long term fundamentals don't lie

Danieli immediately went after Callan's first point that private credit returns are just a sign of short-term growth. 

"Private credit globally has outperformed traditional fixed income, whether that be corporate bonds, high yield bonds, or leverage loans between 1.6 times and 2.6 times better performance over two decades. And the same in Australia has been evident, although the asset class has been more emerging here," Danieli highlights. 

He goes on to add that depending on the traditional asset class you are comparing it to, private credit tends to outperform 70-90% of the time. 

His second argument is one that private credit bulls often speak to - customised loans work out better for both parties.

"Because you can design your bespoke terms and covenants, you have the ability to step in and control the situation when things don't go your way or when the world turns and that ability to step in has, in my view, contributed to lower volatility," Danieli says. 

Third, the rise of passive investing in public markets (both equities and fixed income) has created a surge in momentum investing - allowing people to make moves based on a general risk on or risk off feeling. While this is good in some scenarios, it also makes a fundamental investor's job to generate alpha more difficult. This is yet another reason why Danieli likes the opportunities available in private credit (in spite of its opacity). 

Lastly, the biggest tailwind for this asset remains intact. At the start of this piece, I mentioned that banks did most of the high-risk lending before 2008. As a consequence of the regulator clampdown and the ensuing changes in global finance, consolidation in the US banking sector has occurred - down 49% in the last 20 years alone. This, in MA Financial's view, opens up a new 'holy grail' for non-bank lenders - participating in "the things that banks used to do, but either cannot do so anymore or are now inefficient in doing" (their words, not mine).

The one thing they do agree on

Both Callan and Danieli agree that not all credit is equal. There are good loans and bad loans in both public and private markets. The role of active management in private markets is as important as ever to realise the benefits of alternatives — higher returns with lower volatility. As Callan put it - manager selection matters, especially those with scale and diversification in their portfolios. 

For more leading insights, visit MA Financial Group here.