Back in November, UBS chair Colm Kelleher predicted that the next financial crisis would happen in shadow banking — delightfully infuriating Apollo’s Marc Rowan, speaking at the same conference later that day.
You can see both sessions here. It was something Apollo’s chief executive clearly couldn’t let go, going off on one at a Goldman Sachs conference in early December after being questioned innocuously about regulation:
So, the Chairman of UBS was asked at the tail end of his presentation, what is the single biggest risk to financial markets? And Colm said, a blow-up in the shadow banking industry. And with that, he got off the stage.
I went on and someone said, Marc, what do you think of what Colm just said. And I said, well, let’s just go through the facts. Everything that is on a bank balance sheet is private credit. Let’s start with that.
Every dollar, every euro that moves off of a regulated bank balance sheet de-risks the system. And the room was like gasping. And I said, well, isn’t it, everything on a bank balance sheet is levered 10 to 12 times. When you move it to a mutual fund, it gets zero leverage. When you move it to an institutional client, it gets zero leverage. When you move it to a BDC [business development company], it gets 1.5 times leverage. And so on and so on and so on. So, every time you move something out of a banking system, you de-lever the system.
OK, so it’s hardly Carl Icahn vs Bill Ackman, or even Icahn vs Larry Fink, but who doesn’t love a bit of tetchy, passive-aggressive, intra-Wall Street argy-bargy?
The thing is, despite Alphaville’s copious writing on how demented the private credit boom is becoming, I’m inclined to agree with Rowan here (to a point). At least when it comes to the thesis that private credit is somehow morphing into a systemic risk.
One of the legacies of the 2008 financial crisis is the constant hunt for “the next subprime”. That’s natural, and there’s obviously been no shortage of idiocy in recent years, some of which is genuinely dangerous to the wider financial system and therefore the global economy.
And while it’s easy to laugh at shrill financial journalists like us hand-wringing about the latest Wall Street fad, a bit of excessive obsessing is actually valuable. It arguably helps keep things a little in check. And as Kelleher showed, it’s not just journalists either.
But investors losing boatloads of money is not the same as a financial crisis. In fact, trillions of dollars can evaporate, prominent investment funds be forced to gate and major financial institutions can go belly-up without a wider conflagration, as long as policymakers douse the flames rather than fan them. Viz 2022-23. Not everything is a “Lehman moment”.
Alphaville’s eyes were therefore drawn by a report published this week by Goldman Sachs’ credit analysts examining the systemic risks posed by private credit.
They note three potential channels through which it could cause wider ructions and are sceptical of them all. We’re going to quote at length here, given the importance of some of the nuances, italicising what we think are important points:
Channel #1: An abrupt rise in financial distress among private debt borrowers leading to wealth destruction and causing an economic downturn or amplifying its severity.
Given the floating rate nature of their liabilities, the prospect of Fed cuts in 2024 is a welcome development for the debt capacity of borrowers in the direct lending market. That said, the level of the base rate will likely remain elevated by the standards of the post-global financial crisis period; a backdrop that will continue to test the ability of borrowers to adapt to a higher cost of funding environment. Our baseline view has been that the risk of a spike in losses on corporate credit portfolios, including direct lending, is quite low. If anything, and as we discussed in our last Private Credit Monitor, we see several reasons why losses on direct loan portfolios will likely peak at lower levels vs. the broadly syndicated loan market.
Many observers are, however, skeptical that borrowers in private debt markets, which are for the most part small firms that have less financial flexibility than larger firms, will be able to adjust to a higher cost of funding environment without a large uptick in financial distress. We readily acknowledge that the young age of private debt markets as an asset class doesn’t allow us to infer any clues from previous cycles. That said, the broader leveraged finance markets (which include the broadly syndicated loan and HY bond markets) have been around for almost four decades and can offer some lessons. One key lesson is that spikes in defaults and losses rarely happen in a vacuum. As we showed in previous research, defaults are more coincident with recessions rather than predictive of them. This relationship suggests the existence of a common shock that typically affects both defaults and GDP growth rate as opposed to a causal link running from defaults to growth. The notion that corporate defaults can cause recessions has little empirical support when looking at the last four business cycles.
What if the usual cause-and-effect relationship between the state of the business cycle and defaults in public debt markets does not hold for the direct lending market? In other words, what if defaults and losses spike even as the economy is expanding? We don’t think such an outcome would qualify as a systemic event. The size of the direct lending market is too small ($530 billion of deployed capital) and financial leverage is low (both among GPs and LPs), two factors that greatly limit the risk of contagion from one institution to another.
Channel #2: Rising distress among asset managers fueling stress on risk intermediation and a potential fire sale of assets.
As we discussed in our most recent Private Credit Monitor, issuer concentration in direct loan portfolios is higher than in public debt market; a byproduct of the non-syndicated structure of the market as well as the absence of a tangible benchmark index (as is the case for HY bond funds). This lack of diversification makes it plausible that one or more direct lending funds could suffer significant losses. But here again, such an outcome doesn’t qualify as systemic, in our view. For one, there isn’t an expectation by end-investors nor regulatory bodies that the asset manager must absorb the losses.
Put another way, asset managers act as agents for the end investor as opposed to financial intermediaries. Because there is no obligation to share losses, the risk of contagion to other funds within the same institution or to other institutions is remote. Second, the risk that large losses on a few funds spark a wave of redemptions and a run-on private debt funds is also low. The root-cause of bank runs are maturity mismatches between assets and liabilities (i.e.: short-term deposits are used to fund longer maturity loans). This mismatch is non-existent in private debt funds which are generally targeted to “buy and hold” institutional investors.
While the past few years have seen increased participation of accredited individual investors in so called evergreen funds, these funds typically hold loans with shorter maturities, have higher cash balances and, perhaps most importantly, impose caps on redemptions.
Channel #3: Rising distress among end-investors driven by larger than expected liquidity mismatches.
While the bulk of the investor base in private debt markets is not highly leveraged, balance sheet liquidity mismatches are often viewed as a potential driver of systemic risk. The risk is that some LPs either underestimated their liquidity needs or shifted their asset allocation strategy years after committing capital to the asset class. The concern is that the redemption constraints imposed by private debt fund managers can pressure LPs balance sheets and fuel some contagion.
We think this risk is also low, considering a broad range of liquidity and capital solutions that are available to both GPs and LPs. In our view, secondary activity in the direct lending market will continue to grow, providing LPs with a valuable degree of freedom in managing shifts in balance sheet liquidity needs and asset allocation priorities. As has been the case in the private equity industry for over two decades now, new funds dedicated to secondary transactions that allow LPs to either reduce or exit their holdings will continue to grow.
While private debt markets differ from private equity markets in many aspects, the last two decades can offer some valuable clues for what the future could bring to the direct lending market. Two decades ago, outright private equity portfolio sales often involved distressed LPs and thus cleared at a significant discount to the NAV. But the last decade has seen impressive growth of the secondary market, with AUM increasing to over $500 billion as of the first quarter from $100 billion a decade earlier, according to data collected from Preqin. Rather than a solution of last resort for distressed sellers, the secondary market has become a key tool to manage multi-asset portfolios. The structure of the market has also become more balanced from a supply/demand standpoint, resulting in significant compression in NAV discounts. We think secondary direct lending will likely follow the footsteps of their private equity counterparts, as more participants enter the market.
In other words, private credit is too small and too little leveraged to cause major wider problems. When problems do arise, locked-up capital means that the pain is more contained. And if an investor does need to ditch a big private credit fund exposure, they can do so at a discount to another big institution.
Returning to Rowan’s broader point, some of this lending is genuinely less risky (NB for the financial system as a whole!) when it is done by a shadow bank.
Even JPMorgan’s Jamie Dimon — who has griped that shadow bank rivals are “dancing in the street” — has admitted that some lending should migrate out of institutions such as his. As he put it in his annual letter to shareholders last year:
It’s always best to adjust to new reality quickly. We really don’t like crying over spilled milk, although we sometimes do. The new reality is that some things — for example, holding certain types of credit — are more efficiently done by a nonbank.
However, before Alphaville gets accused of being private credit cheerleaders, we should stress that we still think the industry is clearly in the midst of a mad boom.
Too much money has been chucked in over a short period of time, just as we are going to see the full economic impact of one of the most aggressive interest rate hiking cycles in history. Dumb stuff has clearly been going on in the shadows, and some gormless investors are going to lose a lot of money, purely because of an infatuation with the artificial smoothness of private marks over public debt markets.
Many private credit firms are going to get an awful lot of hands-on experience with workouts over the next few years. Reputations will be blotted, and some shattered. As Kelleher later nuanced at the November conference: “It will be a fiduciary crisis.”
But will it be of systemic consequence? It might be tempting fate to say this, but it’s hard to see how.
Further reading:
— The private credit ‘golden moment’ (FTAV)