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Flawed Valuations Threaten $1.7 Trillion Private Credit Boom
(Bloomberg) -- Colm Kelleher whipped up a storm at the end of last year when the UBS Group AG chairman warned of a dangerous bubble in private credit. As investors dive headfirst into this booming asset class, the more urgent question for regulators is how anybody could even know for sure what it’s really worth.
The meteoric rise of private credit funds has been powered by a simple pitch to the insurers and pensions who manage people’s money over decades: Invest in our loans and avoid the price gyrations of rival types of corporate finance. The loans will trade so rarely — in many cases, never — that their value will stay steady, letting backers enjoy bountiful and stress-free returns. This irresistible proposal has transformed a Wall Street backwater into a $1.7 trillion market.
Now, though, cracks in that edifice are starting to appear.
Central bankers’ rapid-fire rate hikes over the past two years have strained the finances of corporate borrowers, making it hard for many of them to keep up with interest payments. Suddenly, a prime virtue of private credit — letting these funds decide themselves what their loans are worth rather than exposing them to public markets — is looking like one of its greatest potential flaws.
Data compiled by Bloomberg and fixed-income specialist Solve, as well as conversations with dozens of market participants, highlight how some private-fund managers have barely budged on where they “mark” certain loans even as rivals who own the same debt have slashed its value.
In one loan to Magenta Buyer, the issuing vehicle of a cybersecurity company, the highest mark from a private lender at the end of September was 79 cents, showing how much it would expect to recoup for each dollar lent. The lowest mark was 46 cents, deep in distressed territory. HDT, an aerospace supplier, was valued on the same date between 85 cents and 49 cents.
This lack of clarity on what an asset’s worth is a regular complaint in private markets, and that’s spooking regulators. While nobody cared too much when central bank interest rates were close to zero, today financial watchdogs are fretting that the absence of consensus may be hiding more loans in trouble.
Code of Silence?
Private credit was embraced at first for shifting risky company loans away from systemically important Wall Street banks and into specialist firms, but the ardor’s cooling in some quarters. Regulators are doubly nervous because of the economy’s febrile state. These funds charge interest pegged to base rates, which has handed them bumper profits — and made their borrowers vulnerable.
Values are especially cloudy outside the US, because of poor transparency. And it’s the same for loans made by funds that don’t publish quarterly updates or where there’s a single lender with no one to judge them against.
The Securities and Exchange Commission has nevertheless begun to pay closer attention, rushing in rules to force private-fund advisers to allow external audits as an “important check” on asset values.
Some market participants wonder, however, whether the fog around pricing suits investors just fine. Several fund managers, who requested anonymity when speaking for fear of endangering client relationships, say rather than wanting more disclosure, many backers share the desire to keep marks steady — prompting concerns about a code of silence between lenders and the insurers, sovereign wealth funds and pensions who’ve piled into the asset class.
One executive at a top European insurer says investors could face a nasty reckoning at the end of a loan’s term, when they can’t avoid booking any value shortfall. A fund manager who worked at one of the world’s biggest pension schemes, and who also wanted to remain anonymous, says valuations of private loan investments were tied to his team’s bonuses, and outside evaluators were given inconsistent access to information.
Red Flags
The thinly traded nature of this market may make it nigh-on impossible for most outsiders to get a clear picture of what these assets are worth, but red flags are easier to spot. Take the recent spike in so-called “payment in kind” (or PIK) deals, where a company chooses to defer interest payments to its direct lender and promises to make up for it in its final loan settlement.
This option of kicking the can down the road is often used by lower-rated borrowers and while it doesn’t necessarily signal distress, it does cause anxiety about what it might be obscuring. “People underestimate how dangerous PIK products are,” says Benoit Soler, a senior portfolio manager at Keren Finance in Paris, pointing out the sometimes enormous cost of deferring interest: “It can embed a huge forward risk for the company.”
And yet the value of loans even after these deals is strikingly generous. According to Solve, about three-quarters of PIK loans were valued at more than 95 cents on the dollar at the end of September. “This raises questions about how portfolio companies struggling with interest servicing are valued so high,” says Eugene Grinberg, the fintech’s cofounder.
An equally perplexing sign is the number of private funds who own publicly traded loans, and still value them much more highly than where the same loan is quoted in the public market.
Private Fans
For private credit’s many champions, the criticism’s overblown. Fund managers argue that they don’t need to be as brutal on marking down prices because direct loans usually involve only one or a handful of lenders, giving them much more control during tough times. In their eyes, the beauty of this asset class is that they don’t have to jump every time there’s a bump in the road.
Some investors point as well to the shortcomings of the leveraged-loan market, private credit’s biggest rival as a source of corporate finance, where Wall Street banks gather large syndicates of mainstream lenders to fund companies.
Direct lenders also use far less borrowed money than bank rivals, giving regulators some comfort that any market blowup could be contained. They typically lock in cash they get from investors for much longer periods than banks, and they don’t tap customer deposits to pay for their risky lending. They tend to have better creditor protections, too.
In the US, direct lenders often set up as publicly listed “business development companies,” requiring them to update their investors every quarter. BDCs do give better visibility on their loan prices but their fund managers are paid according to the portfolio’s worth so there’s an incentive to mark debt high.
Investors Face $30 Billion Cost Hit as US Markets Move to T+1
Settling trades in one day instead of two — under a system dubbed T+1 — will strain the business of loaning and recalling shares used for short selling, require financing to ensure deadlines can be met and, along the way, risk telegraphing pending stock sales to people betting prices will fall, the researchers found.
The resulting impact could amount to about $24 billion in securities lending costs, their report estimated. Investors in foreign-exchange markets could also face $6.2 billion in added costs.
“The shorter settlement cycle pushes centralized costs, which the banks and the clearinghouses are now managing, onto institutional investors,” Larry Tabb, head of market structure research at Bloomberg Intelligence, said in an interview. “It’s also leaking a lot of information to folks who borrowed securities as well as increasing operational pressure just to execute a trade.”
US regulators aim to speed up settlement times in late May to lower the risk that buyers or sellers might default on transactions before they’re completed. While investors will get their assets faster, and sellers can redeploy their cash sooner, the transition is widely acknowledged to pose big operational challenges for the industry.
‘Information Leakage’
The largest cost may come from quickly recalling shares that have been loaned to bearish investors — who may glean that sales are afoot. “Information leakage” alone may cost investors $17 billion annually, Bloomberg Intelligence estimated.
“Recalling securities before they’re sold increases leakage by not only informing custodians that investors are preparing to sell, but also giving notice to the borrowers, who are already short,”
Cutting the days between trading and settlement could also lead to more failed trades, which would leave investors on the hook for $4.1 billion, the researchers found. They estimate that 10% more borrowings could fail under T+1, “increasing both fail-funding costs and overall borrowing rates as urgency increases.”
US banks, brokerages and investors will have to review all of their post-trade technologies and procedures to ensure they’re ready for the new pace of stock trading. The changes also pose a challenge to investors outside the US who need to buy dollars as part of their equities trades.
The shortened settlement cycle will require a change in behavior from all market participants who are forced to adapt to the tighter window. The time will be even less for European and Asian market participants operating in different time zones.
The FX market, which still settles in two days, also faces increased costs associated with the move to T+1, as traders are given a shorter window to convert foreign currency to dollars in order to buy stock on US venues.
This week’s fun finds
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An interactive piece where CNN answers the question that was on many people’s minds this February 29: Why do we add an extra day?
