Staying ‘in the light’ if credit markets ‘go dark’

A concern amongst some market participants is the growth in private credit market resulting in large parts of the broader credit market ‘going dark’. The extent to which such an outcome is realized and its ultimate impact on credit markets can only be assessed in the fullness of time. That said there are steps that investors in private credit markets can take when selecting private credit managers/strategies to protect against some of the risks that may arise from credit markets ‘going dark’.

What is Meant by Credit Markets ‘Going Dark’?¹

Markets ‘going dark’ refers to the phenomena where the flow of information to the broader investment community declines materially or stops altogether. To better understand the dynamics behind this phenomena it is worth taking a step back and highlighting that as financial markets evolved the credit markets shifted from one where lending was driven by bank relationship lending to one driven more by syndicated lending. This evolution in markets saw lending shift from a single bank being the key service point for a single borrower to a group of lenders working together to provide funds for a single borrower. The transition from relationship banking to syndicated loans (often termed ‘quasi-public’ debt) brought about what may be referred to as the ‘democratization’ of credit markets which in turn impacted on how credit markets functioned. The increasing role of bank syndication, and the associated ‘democratization’ of credit markets, meant that rather than information being limited to the single relationship bank it was now more widely disseminated across the financial system.

This shift towards a quasi public market also had an impact on lender behaviour. With the debt of large companies traded actively— either in the loan market or the bond market—early signals were increasingly provided for when companies were in trouble and investors/regulators were given greater visibility into challenged companies or industries. With a more liquid market there also arose an increase in wholly passive investors as firm and market information was reflected continuously in trading prices providing signals when companies are in trouble. Syndicated lending accordingly succeeded in shifting lender behaviour by substituting liquidity and diversification as the primary means of reducing lender risk for the close borrower monitoring and tight covenants that had characterized relationship lending. Further, as syndicated loans could be traded in a liquid market, lenders could focus less on minimizing credit risk and more on simply ensuring that whatever credit risk a borrower presented was appropriately priced.

This dynamic towards broader dissemination of borrower information has reversed with the expansion of private credit markets. With more firms, and even entire industries, seeking capital from private credit funds there is the increased risk that only certain asset managers will have visibility into information regarding businesses and industries that previously would have been widely shared. Effectively the rapid growth in private credit implies a return to what some view as the ‘bad old days’ when credit was controlled by the banks and governed largely by relationships between a single lender and borrower. Making the situation potentially worse with private credit being the single lender is that, unlike banks which have reporting requirements to provide information to regulators etc, reporting requirements are far less onerous for private credit managers; i.e. moving increasingly to a world in which the broader dissemination of information about firms, investors, and transactions diminishes. The result is that for both non-private and private credit lenders larger parts of the business sector may ‘go dark’ as the availability of information to the broader lending community becomes more limited or is cut off entirely.

Should credit markets ‘go dark’ there are a series of risks that observers note. That said investors can take steps to manage those risks by undertaking the appropriate steps to understand private credit managers and strategies.

Risk 1 : Removal of a Moral Compass

As less public information is available from companies sourcing private credit then knowledge and public scrutiny of what a company is doing may diminish. The lack of information available for more broad based public scrutiny may encourage private credit managers to be less concerned with how returns are generated. Accordingly, higher returns may be generated at the expense of non-investor stakeholders or imposition of negative externalities at greater rates than public companies of a comparable business and size.

Investor Take-away :

Investors in private credit funds need to assume a greater role in becoming the gatekeepers and ensuring that a private credit manager has in place robust Environmental, Social and Governance (‘ESG’) assessment and monitoring processes. Importantly investors need to adopt a clearer ESG focus more closely assessing the Intention, Process and Outcome of a private credit managers investment process to ensure that companies are managed in accordance with accepted responsibilities towards external stakeholders.

Risk 2 : Group Think Adversely Impacting Corporate Outcomes

There is an increased risk that firms owned and financed exclusively by private credit funds will perform worse over the long term as the sole voice in corporate boardrooms becomes that of near-identical private credit managers.

Investor Take-away :

Such a risk is present especially in private credit markets which may be dominated by a few very large players. That said this risk can be mitigated by having biases (a) away from private credit managers competing in the same space as the large dominant players and (b) towards constructing portfolios with a larger number of smaller more specialist managers rather than just hiring a couple of large broadly based generalists.

Risk 3 : Increased Private Lender Focus on ‘Attractive Parts’ of the Economy

Exclusive ownership of companies by private credit funds can ultimately shape the entire economy as such funds will have a bias to finance certain types of firms and on certain terms. The result is a heightened risk that such favoured firms/industries will find it easier to attract funds compared to the rest of the economy thereby distorting business/economic development.

Investor Take-away :

There are two major risks associated with this dynamic. Firstly, lending to ‘favoured’ industries may become crowded potentially depressing returns earned as private credit managers chase deals. Secondly, ‘out of favour’ companies/industries may face heightened ‘headwinds’ increasing the refinancing or exit risk for private credit managers.

To manage this risk investors could not only seek credit managers operating within more specialized sectors where competition may be more limited but also increasingly focus on the exit strategy for managers. It is accordingly increasingly risky to just assume refinancing as an exit strategy. For example where lending is occurring to ‘out of favour’ companies/industries investors may have a bias towards strategies which focus on amortisation/asset realisations as the manager’s ‘planned’ exit strategy.

Risk 4 : Company May ‘Go Dark’

With the rise of private credit corporate debt is increasingly held in purely private hands. This impact has been magnified as the size of private credit managers has grown rapidly meaning that ever larger firms are turning to private credit markets. As a result, the entire chain of ownership and investment from the company to the ultimate investor is private. The consequences of this is that a very large segment of the economy may ‘go dark’ entirely even for private credit investors not directly involved in lending to those segments.

Investor Take-away :

To deal with this risk investors need to select those private credit managers that will have ongoing access to information flow so that though the market may ‘go dark’ they do not. This implies two approaches to dealing with such a dynamic depending on whether the investor is wanting to avoid the risk that the overall credit market ‘goes dark’ or the risk that a particular subset of the credit market ‘goes dark’. With respect to the overall credit market ‘going dark’ investors should bias towards the very large players operating in the private credit markets. Such large players will have such a breadth of relationships that their ability to access data regarding corporations and industries reduces the risk that the overall market ‘goes dark’. When dealing with sub sectors the focus of investors should be on niche credit lenders that can access and have more detailed knowledge regarding a particular sub set of the market. Either way this risk highlights the importance of utilizing private credit managers (a) with clear skill sets and capabilities which can be brought to the table (b) possessing network/relationships to be able to bring the flow of information together to maintain transparency to the market.

Risk 5 : Proliferation of ‘Zombie’ Companies

This is the risk that private credit lenders may have incentives to avoid recognizing losses when borrowers run into trouble. Such a bias could lead to the proliferation of “zombie firms” which may encounter bankruptcy at a relatively late phase in their financial distress thereby limiting workout options and/or potentially depressing the internal rates of return realized from loans.

Investor Take-away :

Managing such a risk comes down to ensuring that a private credit manager has the requisite processes and capabilities/resources to ‘appropriately’ manage the credit exposures in a portfolio. There are accordingly two aspects to managing this risk. The first is ensuring that the credit manager has the appropriate processes and capabilities/resources in place. Private credit managers should be reviewed to ensure that they have clear processes around (a) assessing whether loans are tracking to plan, (b) recognition of valuation impairments in a timely manner and (c) the requisite internal workout capabilities.

The second aspect is assessing the credit managers ‘willingness’ to proactively engage with managing the problem credits to ensure that returns are maximised. To assess ‘willingness’ it is important to look at the actual track record of the credit manager to better understand how they behave when credits have ‘issues’. Though conditions may result in a private credit manager needing to delay realization of a problem loan to maximise returns, investors should be wary if this appears to be the manager’s ‘typical’ behaviour. Feeding into this is having a bias toward private credit managers that are the lead or dominant/sole lender so that they are in the best position to dictate terms and outcomes should credit face issues; i.e. bias towards private credit managers that have more direct control over the outcome.

As the private credit markets grow there is an increasing risk that parts of the credit markets may ‘go dark’. Rather than fear such developments investors need to take the requisite steps to ensure that they have the processes in place to manage such risks to achieve the best outcomes possible. By undertaking the appropriate assessment of managers and market opportunities investors can maximise the potential that they can stay ‘in the light’ even if credit markets ‘go dark’.

1. For more detail see ‘The Credit Markets Go Dark’ : J.A. Ellias & E. de Fontenay (August 2024)