DI25002 Growth in Private Credit V01 180825

 

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Private credit has become a favoured asset class for many investors looking to ferret out better returns at what appears moderate risk. But it’s also an activity increasingly putting regulators on edge as they scan the horizon for potential financial crises of the future.

Private credit is a blancmange of an investment category — an amorphous, opaque and hard-to-define bucket where the numbers are uncertain, though everyone agrees they are growing at breakneck pace.

Yet the clue is in the word: private. In essence private credit simply describes the new generation of unlisted investment funds that stump up loans to back leveraged company buyouts and other ventures by private equity funds.

It grew out of the banking crisis as conventional banks withdrew from the sector because of more onerous capital rules. That left a void rapidly filled by investment funds that raise money from institutional investors such as pension funds and sovereign wealth funds.

Before 2008 private credit was virtually non-existent. Today it is an industry valued at between $1.3 trillion and $3 trillion, depending on definitions. It is overwhelmingly an American phenomenon but Britain is the main jurisdiction outside the US, perhaps accounting for 10 per cent of the global pie.

The biggest providers are often the very same firms that have provided the equity for the boom in buyouts in recent years: names such as Blackstone, Apollo and KKR, though there are more specialist debt-focused houses too, such as Ares.

Home-grown players include the London-based ICG, better known by many as Intermediate Capital Group, alongside M&G, Permira and Bridgepoint.

Legal & General is also pushing deeper into the market, both through its 40 per cent stake in Pemberton and an alliance recently struck with Blackstone.

Of an estimated $250 billion of private credit extended across Europe, Britain accounts for about two-thirds, according to one estimate.

Investors have flocked to the asset class, which has typically produced total returns of 8-10 per cent a year.

Their capital is locked up for seven to nine years and put into funds which then make leveraged loans typically to 50 different buyout deals, spread across sectors and geographies.

Borrowers aren’t always so enthused.

The interest they pay can be 1.5 percentage points higher than in a conventional syndicated loan, but the syndicated loan market occasionally shuts completely, leaving them little option, while the private credit suppliers can be much more flexible and accommodating of covenant breaches.

Raoul Hughes, chief executive of Bridgepoint, says private credit is a boon to borrowers, because of the tolerance for higher leverage, but also because of the speed of decision-making. “You’re interacting with a single lender,” Hughes says. That was important when renegotiating fees or covenants, with the terms of a syndicate of banks always downgraded to the least amenable bank, leading to what he calls the “lowest common denominator” effect. Bridgepoint, based in London, is better known as a private equity house but has doubled its private credit book from €7 billion to €14 billion in the past four years.

It’s the leverage, which in some cases is growing, that sometimes concerns policymakers. The Bank of England warned last month that the private finance ecosystem of funds, their portfolio companies, and interactions with banks made it particularly exposed to macroeconomic uncertainty and tighter financing conditions.

The Bank’s governor, Andrew Bailey, in his capacity as chairman of the Financial Stability Board, a global watchdog, told members to “take steps to address the financial stability risks created by non-bank financial institution leverage”.

The industry itself accepts there has been a lapse in standards in some cases.

Some more conservative lenders limit lending to no more than four to six times profits on the basis of earnings before interest, taxes, depreciation and amortisation, but others have been going further, to as much as ten times.

Peter Lockhead, co-head of private finance at ICG, said: “There has been a slow relaxation of standards over documentation in the last couple of years and on leverage levels over the past six months.” He points to areas such as payment-in-kind (PIK) notes, which allow borrowers to roll up interest payments into a larger principal, and the way some lenders are prepared to offer larger chunks of junior debt lower down the repayment hierarchy.

Well-drafted documents are crucial to ensure lenders don’t slip down the creditor pecking order. “If you don’t pay attention you can get yourself in a lot of trouble,” says Lockhead who last year completed a $17 billion fundraising for ICG’s principal fund SDP.

“PIKs are like a Pacman that eats away at the equity,” John Graham, president and chief executive of CPP Investments, one of the world’s largest private equity investors, warned last year.

Too much debt can topple buyouts as happened at Toys R Us and Chrysler, though sometimes the damage only becomes apparent after the private equity house has exited the investment, as with Saga, the insurer and cruises group. The supermarket groups Asda and Morrisons are both grappling with heavy debt burdens after being bought by private equity. 

The sheer volume of funds available for deals may have the effect of pushing standards down further as private credit firms stretch to win deals. There is $450 billion looking for a home, according to Preqin, the research group.

Providers are successfully pushing into areas still dominated by the banks. This month a $26 billion debt package from Pimco for Meta Platforms’ gigantic data centre project in Louisiana was hailed as a coup for the sector.

Many argue that central banks are unnecessarily alarmed. Private credit funds may be safer because they provide semi-permanent capital, unlike banks which are dependent on their short-term deposits staying steady.

According to Ludovic Phalippou, professor of financial economics at Saïd Business School, University of Oxford, “Private credit funds do not create runnable liabilities, don’t rely on central bank backstops, and they don’t transmit shocks through overnight funding markets.” He told a House Lords committee last month: “They are, in fact, a very natural type of lender — pools of committed capital making long-term loans. Structurally, this is far more stable than deposit-based banking.”

Not everyone thinks the banks are quite so insulated. The Boston Fed, a regional arm of the US Federal Reserve, warned in May that the US’s $1 trillion private credit market was largely funded through bank loans and could “indirectly expose banks to the traditionally higher risks associated with private credit”.

Banks still provide bridging loans to facilitate leveraged buyouts; they can provide capital to private credit funds; and sometimes provide ancillary or other forms of credit. Lloyds has a partnership with Oaktree Capital, Barclays with AGL Credit Management, while HSBC and Standard Chartered operate their own private credit platforms. The distinction between private credit and bank-led credit is getting blurred.

Even if banks are relatively immune, regulators still worry about the other group of companies they regulate: insurers. Under Solvency II rules, insurers can use up to ten times leverage to invest in private credit. The crackdown on banks lending to buyouts may simply have shifted the bulge to a different part of the system.

Lockhead at ICG says credit quality is paramount for success. There will be some defaults, he says, but: “You have to get it right 98-99 per cent of the time.

When we do a deal, no one goes for a drink. When we’ve got repaid, that’s when we go for a drink.”

There is an element of pass-the-parcel in this. Private equity investors, unable to exit their investments through flotations, are increasingly turning to continuation funds or selling to other private equity investors in secondary deals. There is no “price discovery” or confirmation of an asset’s value through a public listing. The same uncertainty therefore feeds through to the debt associated with the buyout, where lenders resort to “extend and pretend” behaviour to avoid making write-downs on debt.

Zombie companies sustained by zombie loans: that may ultimately be one of the less positive outcomes from the private credit boom. Not, as Phalippou puts it, the systemic shock feared by central bankers, but a misallocation of capital and a drag on productivity growth nevertheless.