A Rolling Loan Gathers No Loss
Pay Me My God Damn Money
I like getting invited to private credit fund manager Christmas parties. I've always found it fascinating that sometimes the borrowers would turn up to the same party which always made me wonder, you're sitting here as the lender and you've invited the borrower? What the hell happens when things get going and you need to enforce? Here is this bloke who you've lent money to and is drinking your drank and eating your food. And you're telling me that as a fiduciary, you're going to ask for your money back? Or are you going to push things down a bit? Note 1
(On the back of me writing this, regrettably I don't think I'm going to get invited to any Christmas parties any longer.)
Coffin Corner
A term for pilots, if you're too slow and don't have enough altitude, you're in coffin corner. No room to move. Can't speed up or slow down without stalling. Razor thin margins. The Fed is in coffin corner right now.
US PPI came in screaming hot (3.4%) before the oil spike flows through. Oil is now persistently circa US$950. There is absolutely no chance of a Fed cut and if they raise, it produces a slow liquidity drain across the US private credit environment.
See how quiet the Fed was last week? Nothing. Zilch.
Since 2008, the Fed has stepped in to correct every credit dislocation. But the US credit market is shifting from public to private in nature, a slow motion liquidity squeeze with no firm channel for the Fed to express its views on a large and growing part of credit markets.
(On another note, the most eye opening thing someone said to me is that spreads aren't narrow because of complacency but rather that a sovereign risk premium is being applied to US Treasuries. It's happening! Corporates are getting a stronger bid than sovereigns)
Oil
Oil makes this worse.
US crude (WTI) sits at approx US$95 which sounds dramatic but the long-run real oil price chart tells you we've been here before in the mid-00s through to 2014 we saw persistently elevated real oil prices and the world kept functioning.
But the Fed (and literally every other CB) is already behind the curve on inflation, and persistently high energy costs feed directly into literally everything.
One scenario worth thinking through: the US limits fuel exports and uses cheap domestic energy to keep their own inflation in check. Not beyond em!
The Fed is trapped between creating a larger run on private credit and taming inflation. The long end of the curve is going up and everything must be repriced.
But even if the US manages its own energy costs, that doesn't help us.
Australian Private Credit Has Different Problems
The US BDC market is going through the same pains we experienced in 2022, retail investors told they could park money in "safe" holdings generating 10% yields. Now everyone is heading for the door at the same time. No liquidity.
I used to call our fixed interest LIT market the "toilet paper index." Ultimate sign of retail panic. That dynamic is becoming prevalent in credit markets again.
Our listed market has been ahead of the curve on this pain, but the issues that matter for Australia are not the same as the US conversation.
US private credit is losing its mind over SaaS lending at roughly 20% of portfolios. The Australian problem is different and bigger. Real estate lending is over-represented which from my experience and conversations, approx 40-50% of Australian private credit portfolios are allocated to real estate.
Rising rates, rising input costs, squeeze on development margins. Reduced credit availability means the consumer backs away. Have you seen auction clearance rates?
If residential homes are pre-sold at values that assumed a different rate environment, completion and settlement risk rises. The gap between what a developer underwrote and what it actually costs to deliver widens dramatically. Underwritten LVRs change fairly rapidly.
Although the AFR will gladly write about US BDC stuff, the reality is little actual Australian money is allocated there. We have different risks sitting inside our portfolios right now.
What This Means
We don't have the same SaaS lending issues, but it is only a matter of time before our market echoes whatever is happening in the US in terms of sentiment. Advisers and CIOs are going to panic. Especially within the Fixed Income LIT space. Note 2
Sentiment is contagious even when the underlying exposures are fundamentally different.
We've seen this before, listed credit vehicles traded at material discounts to NAV in the Aus LIT market in '22. Underlying portfolios performed materially better than the listed price implied. Panic created the discount and the opportunists stepped in.
The work today is building conviction around NAV marks before any potential selloff, not after. If listed PC vehicles get hammered from here, you need to already know whether the underlying books justify the discount. That's the homework. Do it now.
Footnotes
This is normal in private markets; it is all about deal making rather than worrying about capital structure etc.
You need to acknowledge that despite private non-bank lending becoming bigger, and it absolutely will continue to do so, the growth of the space is absurd and it creates issues in finding appropriate borrowers. You need good managers who have strong relationships with their borrowers to be able to allocate capital to deals that have lined up. Not ideal raising capital if you need to then shove it into mediocre deals.
And this also flips the other way, if a deal is not quite performing (say technical defaults etc), this requires careful portfolio management. You cannot burn bridges as our industry is entirely too small, borrowers and lenders talk and if you enforce then you'll be known as the bad guy to be borrowing money from.
Also, if you're a decent borrower, you'd be playing allocations across lenders. That way it is very easy for a borrower with a loan that has gone sideways to talk to the lender (the private credit manager in this case) and offer them exclusive rights for some slam dunk deal or some short-term facility with excellent economics.
Messy, but this is the reality of private markets, and you'll never hear about this stuff because it is all behind the doors.
You know we went through this in the (post) depression era of the 20s and 30s. Chandler Act (1938) set out rules around absolute priority (and enforcing the concept of modern capital structure) rather than relative priority (where junior and equity tranches maintained stakes to keep businesses going) which ultimately promotes insider dealing that screws outside investors.
Agency problem yadda yadda, when the managers and lenders can screw external investors. 90 years later (exactly 3 generations!) we're doomed to recreate the same errors of our past.
I'm a sucker for financial history but this is a different essay that I'll write one day, more for me as I don't think people are all that interested, but maybe this private credit stuff makes the topic more interesting.
On closed-ended and semi-liquid funds the situation isn't as dire, there is a natural rolloff to loans that should lead to redemptions being met.
Also worth remembering the BREIT experience. When Blackstone faced redemption requests, they could sell underlying real estate assets and ended up selling assets for above book value. The gating mechanism worked. Redemption requests were met with a lag, but they were met.
You can't readily sell loans at par in a rising rate cycle or if spreads are widening, but gating mechanisms exist for a reason and loans rolling off mitigate longer-term issues.
The question for allocators is whether the unlisted space is correct or whether the listed market is pricing in distress that hasn't materialised in fundamentals.