Private Credit Narrative Violation
Everyone's panicking about private credit. It's a bubble, and headlines are screaming about a credit crisis. We get it, private credit is toxic. But I challenge the narrative, and I think its mostly nonsense.
Let's look at what actually blew up recently. First Brands defaulted. Tricolor went bust. A few banks suddenly decided to take write downs on fraud exposure. Everyone is pointing fingers at private credit.
Receipts
Tricolor - 100% fraud. So bad they didn't even bother restructuring the business because there was nothing legitimate to restructure. Lenders: JP Morgan, Barclays, Fifth Third Bancorp. All banks. Zero private credit.
Zion Bank and Western Alliance - These are banks. Used the current environment as time for confessional. Reviewed their books and found fraud exposure. The borrower is a fund manager (Cantor) buying distressed mortgages. The borrower wasn't actually buying distressed loans. They were lining their own pockets with the borrowed money. Once again, this was bank lending through syndication. Not private credit.
First Brands - A bit more interesting, 100% fraud by the way. $9 billion in balance sheet lending, $2 billion off-balance sheet. Majority of the lending structure was broadly syndicated loans. Some private credit mix, aggressively, I'm getting to around 40%.
So let me state this plainly: every recent credit event we've seen has been either (a) 100% fraud or (b) unrelated to private credit.
First Brands
This is an interesting one. From Zerohedge the debts outstanding against First Brands:
Let's break this down to exposure by lender types:
Don't know what Jeffries is at this stage to the opacity of the deal structure. If you call it 75% private credit (incredibly aggressive) then PC funds represented 40% borrowing. In terms of what retail investors were exposed to, the BDC market which is the equivalent of our Fixed Income LIT (MXT, QRI, etc) & managed fund market, it was exposed to approx. $237m representing approx. 0.05% of the industry. 15 funds out of 166 held First Brands.
What Failed?
So the credit things we've seen in the US market today are 2 things:
- Complete due to fraud
- Fraud that permeates both public and private credits
And let's take it one step further, if we look at the failure points, they were all fraudulent loans done via syndication. Private credit ideally ends up being managers who end up writing their own direct loans (ie not a syndication). And you're hoping the individuals underwriting these loans can pick up unscrupulous individuals you don't want to give your mum & dad's money to. Well sometimes that doesn't happen and we have our own First Brands event at home.
Hey Look Over Here
Then Jamie Dimon comes out warning about cockroaches in private credit. JP Morgan took a $170 million write down on fraud loans. But somehow the narrative became "private credit is dangerous." Let's be real, its excellent misdirection.
Are You Ok?
If you ignore the news cycle and just look at the actual data, here's what's happening from Apollo. Default rates are coming down.
Auto loan delinquencies are coming down.
And, credit card delinquencies are coming down.
The narrative says private credit is blowing up. The data says credit is actually normalizing. One of those has to be wrong.
Parallels
This isn't about what is right or wrong, I'm sure there is plenty of stuff wrong in private credit, but to say the recent events have anything to do with private credit is a lie. It was fraud.
Factoring and trade finance stuff scares me. Lending on receivables represents pure financial engineering with lots of room for dishonest behaviour. If you're not an apex predator in that space as a lender, you're going to get killed. We've seen this before and we will see it again. Greensill looked like supply chain finance but made huge bets on receivables. It blew up thanks to GFG, everyone talked about the risks of alternative finance. But Greensill wasn't alternative finance, it was banks (and insurance companies) trying to juice returns and other risky bits through a non-bank wrapper. Same stuff we're seeing now where banks get involved or make or originate the bad loans, then blame private credit when it goes sideways.
Where to From Here: A Framework for Approaching Private Credit
Fraud is not business as usual stuff and not representative of industry issues in my view. But the business as usual stuff is defaults. And defaults are perfectly normal! Banks have defaults on their books all the time!
Default rates are probably the thing you want to be looking at, but then one asks, how can you even tell what the default rates are in private credit markets?
My thesis here is private credit is refinancing big chunks of the speculative grade/high yield/below BBB market, so why don't we just look at historical default rates so you can get an idea of risks involved. This is S&P data on default rates and the above chart from Apollo is a continuation showing that spec default rates are coming down now.
Historical default rates have peaked around 9%, so lets take that and chuck another 5% on for good measure - a 15% default rate in private credit during a recessionary cycle? Speculative/High Yield defaults average around 4% and I'm not even counting the recovery rate here. If you're in a private credit fund earning 8-10% per annum and you get a period where you cop a 10% drawdown in a recession, guess what? Totally normal!
Look, I'm sure there's plenty of stuff wrong in private credit. But the truth doesn't lie in the front page of a newspaper. Private credit is a neat little wrapper for all things financed privately with no regard for risk, no 2 vehicles are built the same.
Basel regs have forced banks to abandon any of this kind of lending, so this part of the market needs to be funded no matter what, there is constant supply of those that require financing.
And the ultimate truth is probably somewhere in the middle, where defaults & recoveries are perfectly normal parts of credit markets.