Today’s private credit – tomorrow’s public liability?

Overview

Leithner & Company neither owns private credit nor plans to do so. We’ve conducted no due diligence in this space; we therefore know little about the major players, whether in Australia or overseas, and nothing of the contents and quality of their portfolios. Over the past 30 years, however, we’ve thoroughly studied the history of financial manias; as a result, we’ve learnt a thing or three about their causes and consequences.

We suspect that today’s private credit craze might be – or before long could become – merely the latest in a long series of such episodes over the past several centuries. Few ended well.

What Is Private Credit?

The phrase “private credit” refers to loans which (1) haven’t been issued by banks and (2) aren’t traded in public markets. Lenders in this market are typically asset managers who act as intermediaries between end-investors and borrowers. End-investors include pension funds, insurance companies and, increasingly, retail investors via private credit managed funds and ETFs. They lend to intermediaries – or, in some cases, directly to borrowers. 

“Private credit,” the Reserve Bank of Australia stated recently (“Growth in Global Private Credit,” 17 October 2024), “provides an alternative source of finance …, particularly for firms with unique financing needs or irregular cash flows that are too risky for banks or too small for public markets.”

For retail investors, this raises Red Flag #1: if banks – which, after all, specialise in the assessment of creditworthiness – won’t lend to these risky borrowers, then why, through an “investment” (“speculation” might be the more apposite term) in a private credit fund, should you?

Has Private Credit Become a Mania?

“As private credit is sourced from non-banks,” the RBA adds, “it can be difficult to measure.” Clearly, however, it’s grown rapidly. Globally, according to a study released by the International Monetary Fund in 2023, over the past decade private credit under management has quadrupled to US$2.1 trillion. That’s a compound annual growth rate (CAGR) of almost 15% per year. 

In April, The Financial Times, citing JPMorgan as its source, estimated that the size of the world’s private credit market is closer to $3.1 trillion. That’s a CAGR of more than 19% per year. In the U.S., the IMF estimated earlier this year, private credit is as big as the sub-investment grade (“junk”) bond market.

Although it’s difficult to measure, private credit has certainly grown rapidly, is now huge – and, if it continues to grow at its current pace, in ca. five years will be twice the size of the junk bond market. For these and other reasons, I suspect it’s becoming – or has already become – a mania.

Approximately 70% of the world’s current stock of private credit (70% of $2.1-3.1 trillion = $1.5-2.2 trillion) has been raised in the U.S., and about one-quarter ($0.5-0.8 trillion) in Europe; the rest of the world (the RBA estimates that $40 billion has been raised in Australia), is a relative backwater ($100-150 billion).

“Globally,” notes the RBA, “the growth in private credit has raised concerns related to a lack of visibility over leverage and interlinkages (with private equity firms), with regulators taking steps to strengthen oversight of the market.”

Hence Red Flag #2: just as the credit default swaps which underpinned many CDOs before the GFC were growing rapidly, highly opaque and virtually unregulated, so is today’s private credit. In principle, are such markets suitable for retail investors?

Why Invest in Private Credit?

According to the RBA, “private credit has an attractive risk-return trade-off for some investors. It pays a relatively high interest rate – generating higher returns than other similar assets such as leveraged loans – and to date has exhibited low volatility relative to publicly traded assets, like corporate bonds.” 

Red Flag #3: that’s exactly the same rationale touted by advocates of junk bonds in the 1980s-1990s and Collateralised Debt Obligations (CDOs) before the GFC.

Buy a diversified portfolio of “high yield” bonds, the advocates of junk debt assured investors in the 1980s, and you’ll receive higher payments of interest without incurring higher default risk. Higher reward without higher risk! Subsequent reality was very much otherwise: during that decade and into the 1990s, larger numbers of these bonds defaulted – and their owners suffered grievously.

Moreover, many small American banks (“savings & loans”) had purchased large quantities of these bonds. Their default pushed many of these banks into insolvency; by 1999, the resultant “S&L Crisis” cost American taxpayers more than $150 billion (that’s more than $225 billion in current dollars).

Approximately 15 years later, investment banks played the same game: never mind CDOs’ mind-boggling complexity, they assured investors before the GFC: their yields exceed other AAA-rated securities – and, trust Moody’s and Standard & Poor’s, top-rated securities virtually never default!

To put it mildly, CDOs grossly underperformed expectations; their investors and many others suffered accordingly.

Are Private Credit’s Advocates Underestimating Its Risks? Five More Red Flags

The RBA reckons that “the value of private credit assets appears more stable than (the value of) some comparable asset classes.” That’s “partly because (private credit’s) valuations are typically less frequent and more subjective (than those of allegedly comparable assets). While private credit funds must generally adhere to accepted accounting principles, these principles do not mandate specific techniques for asset valuation. Stale valuations may pose a risk to financial stability whereby a macroeconomic shock leads to a broad reassessment of asset valuations across the sector.”

It’s also true that “default rates in private credit have been relatively low and less frequent in recent times relative to ... syndicated loan or high-yield bond markets.” Yet “the (private credit) sector has greater capacity than other forms of lending to postpone losses and defaults …This has made it more resilient thus far in the cycle but could increase the sector’s vulnerability to large shocks.”

The RBA thus raises a crucial point: “the (private credit) sector has also not endured a recession so there is little precedent to understand its resilience to a large downturn. Where there have been defaults, private credit typically has a higher loss ... This may reflect a higher incidence of lower or poorer quality collateral ...”

Why? Borrowers of private credit are typically medium-sized and highly-leveraged businesses. “Globally,” observes the RBA, “most of these businesses have been acquired by private equity firms, which tend to increase debt levels to enhance investor returns. Borrowers ... often have irregular cashflows or limited collateral, thus necessitating (private credit).”

Moreover, “there are strong links between private credit and private equity markets. Most private credit borrowers are partly controlled by a private equity firm ... (Indeed), around three-quarters of private credit assets are managed by funds whose umbrella firm is also active in private equity. Private equity firms are often involved in strategic decisions about the borrowing firm’s management, operations and capital structure.”

This, the RBA concludes, “can help reduce the frequency of defaults, but can also introduce conflicts of interest, given that managers may have multiple connections through portfolio firms and investors.”

Hence Red Flags #4-8: private credit offers infrequent and subjective valuations, unknown vulnerability to shocks/ability to endure downturns or recessions, and a hornet’s nest of potential conflicts of interest. What’s not to dislike?

But My Adviser Is Urging Me to “Invest” in Private Credit!

“Financial advisers,” Jasson Zweig wrote very recently (“You’re Invited to Wall Street’s Private Party. Say You’re Busy,” The Wall Street Journal, 20 December 2024), “might tell you that you need to buy alternative assets because public stocks and bonds are overpriced and doomed to provide years of poor returns.”

“What they won’t tell you,” he helpfully adds, “is that they need to sell you alternative assets, because otherwise their own firms will be doomed to years of poor returns.”

Over the past few decades, Wall Street’s traditional cut as the middleman has withered. Many managed funds used to levy management and other fees of at least 1% of assets; these days, many ETFs charge just 0.1% and even less. Similarly, commissions on the purchases and sales of stocks, which were once 1% and more, have gone the way of the Tasmanian tiger.

On the other hand, according to Zweig, the expenses of alternative funds including private credit, which are often 2% annually, can range up to 6% or more. And commissions on sales, often 2% to 5%, can sometimes even exceed 10%.

That’s obscene, but there’s more: no matter how private assets are packaged, they retain significant drawbacks. Private-equity and private-credit funds use heaps of borrowed money and focus upon smaller companies. Investors in these funds are therefore – perhaps unintentionally and even unwittingly – adding a highly-leveraged and thereby high-risk vehicle to their portfolios. They’re likely not diversifying their risks. Quite the contrary: they’re increasing and concentrating them.

Over the past couple of years, Zweig (who writes “The Intelligent Investor” column in The Wall Street Journal, and in November released a new edition of Benjamin Graham’s classic book) has reported “a series of quirks, mysteries, bad deals and outright rip-offs among alternative assets.” If you’re considering private debt, do yourself a huge favour and study them carefully. Zweig has uncovered:

• investments offering “guaranteed” yields of 15% or more which never appear or quickly evaporate (federal and state authorities in the U.S. are investigating many of them);
• “interval funds” charging lavish fees but allow investors to withdraw money only a few times a year;
• illiquid portfolios trading for 75% or less of their reported value;
• funds purporting to offer high returns at impossibly low risk;
• companies which don’t even exist but nonetheless claim that they’ve sold more than $344 billion of imaginary shares;
• brokers hawking illiquid stocks and debt in companies they control – without disclosing their conflicts of interest.

A crucial question thus arises: do the rising numbers of advisers and brokers who recommend alternative assets such as private credit know what they’re doing? According to Zweig, “when it comes to the opacity and complexity of (these) assets, some financial advisers know what they’re doing. (But) others might not even know what they don’t know.”

He cites a recent survey of more than 500 American advisers who’ve recommended alternative assets to their clients. It asked them what they regarded as these assets’ top challenges. The greatest number of respondents (48%) named “high levels of administration and paperwork.” Only 36% cited the lack of liquidity; a mere 26% said fees and expenses were too high; only 10% doubted they could get access to superior managers; and a trifling 4% said alternatives are “too risky.”

“These advisers,” Zweig reckons, “didn’t merely drink the Kool-Aid; they’re drunk.” On that basis, should you accept a recommendation to “invest” in alternative assets including private credit? “Unless your adviser has extraordinary expertise,” he concludes, “I’d suggest (a curt) response: ‘No thanks.’”

We’ve Seen This Movie Before: It Usually Ends Badly

There’s a direct parallel between today’s private credit and the private mortgages of the 1980s and 1990s. “Private mortgages,” wrote Paul Clitheroe (“Looks good, maybe a little too good ...” The Sydney Morning Herald, 25 July 1998), “have become a popular investment choice. Experts estimate that up to $20 billion (that’s equivalent to $41 billion in 2024) is invested in this area.” “Most solicitors involved in mortgage lending,” he added, “act in a competent and ethical fashion and have a considerable amount of experience in this area.” 

Let’s assume that the same point applies to most of today’s private credit funds. That’s hardly an endorsement.

As Clitheroe observed (“Is that investment a diamond or a dog?” The Sydney Morning Herald, 17 July 1998), “at a level below the more blatant schemes is a range of investment disasters that are far more subtle, attract far more people and hence are significantly more dangerous to the broad community of investors. Estate Mortgage, which collapsed in 1990, was a classic example.”

It advertised heavily in mainstream media, and prominent journalists and financial advisors supported it. “In fact,” Clitheroe recalled, “the only thing that should have alarmed rather than seduced the tens of thousands of investors who poured in more than $500 million was the fact that returns to investors were so high.”

Why? Estate Mortgage claimed that it was more efficient (for example, that it approved loans more quickly) than its competitors. Therefore, it alleged, property developers of the highest quality turned to it rather than the banks, allowing it to charge them more for loans. Moreover, “financial advisers who wanted to look at the quality of (its) loans were provided with carefully-vetted properties that satisfied even closer investigation. All this caused many who should not have been caught to get caught.”

“The trouble,” according to Clitheroe, “was ... given Estate Mortgage was paying investors around 20%, with a little over 2% annual management fee, its borrowers must have been paying at least 22% for the money. (As the property market weakened), Estate Mortgage collapsed like a pack of cards.”

During the late-1990s, Clitheroe recounted, conservative law firms arranged private mortgages which paid annualised returns of approximately 7% to investors. This, he reckoned, made sense: “the law firm is likely to be charging an administration fee of around 1% per annum, meaning the borrower needs to pay a rate of (interest of) around 8%.” But “given that variable rates on home loans are between 6.6% and 6.9%, you may be wondering why a borrower would pay 8% to a law firm for a loan when they could pay under 7% to a bank.”

The answer, he said, “is pretty simple ... A law firm generally lends money on the basis of security rather than (like a bank) worrying about the borrower’s income, whether they will lose their job, etc.”

Clitheroe could “see some logic in lawyers’ arguments that their clients are willing to pay a slightly higher rate for the convenience, low establishment fees and privacy of dealing with their law firm. But where I start to get really hot under the collar is when (I examine) the large number of private mortgage advertisements ... If these were offering investors 7% per annum, the risk-return equation works. But they aren’t. They talk about ‘first mortgage security,’ ‘no fees or charges,’ ‘no costs,’ ‘monthly interest’ and ‘guaranteed returns’ ... The problem is that the promised returns make no sense.”

“Let’s think about this. We are being offered a secure loan, at no cost to us, that offers 12% or more. This is a real return of 11%. Given we pay no fees, someone must be. It certainly won’t be the law firm, so it must be the borrower, meaning that for us to get 12% they must be paying at least 13% per annum. What sort of people pay 13% for a loan? ... (They) will either have insubstantial security, poor cash flow or ... just don’t have the asset base to satisfy the banks.”

“My suspicion,” said Clitheroe, “is that a large number are in the final category.”

Conclusions

Private credit contains a significant number of danger or warning signs (“red flags”). Some specialists can likely circumvent them most of the time, but those who overestimate their expertise almost certainly won’t. I suspect that most of today’s advocates of private credit are overconfident – and therefore that most of these funds will underperform and disappoint their investors. 

Jason Zweig corroborates my hunch. He’s found that “while some managers of alternative assets (including private credit) deliver superior returns, most don’t – and getting access to the few outperformers is all but impossible for most investors.” As it’s long been, so it remains today: insiders get the cream; outsiders get the crap.

“Investors” (speculators is probably the more apt term) whose private credit funds merely underperform will be relatively lucky; the less unfortunate will suffer significant destruction of capital – and the luckiest of all will steer well clear. “The pack of cards comes tumbling down,” Clitheroe observed, “when the (private) market starts to decline, and the (investment) which looked so good in a strong market starts to look like an absolute dog in a weak one.”

That’s an slur on man’s best friend. Nonetheless, his advice about private mortgages a quarter-century ago remains timeless – and applies to private credit today:

“If you are attracted to the ... returns offered by the ... private mortgage market, ... do your research carefully and consider the implications of a (market downturn) ... The area of private mortgages is (grossly) under-regulated and things will change.”

Zweig’s conclusion specifically addresses private credit; it’s also current and forthright. It refers to the U.S., but I suspect it also applies to Australia: “hold on to your wallet … Wall Street is gearing up for a sales push that could enrich the middlemen and impoverish you … Private or alternative assets … (usually entail) higher fees, greater risk, more conflicts of interest and a harder time selling. In the right hands, these assets (can) work wonders. In the wrong hands, they wreak havoc.”

Zweig’s advice: “this coming year, … your financial adviser may inundate you with pitches to buy private assets. You should evaluate them with more scepticism than ever.”

Click LIKE so that Livewire knows that you want more of this type of content. Click FOLLOW for notification when my next wire appears.