Episode 36 – Is a Crisis Brewing in Private Credit?

Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is titled, “Is There a Crisis Brewing in Private Credit?” Now there’ve been a lot of headlines about this, and so today, we’re gonna dive into this story and figure out what to make of it. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined by David Krakauer, our Vice President of Portfolio Management.

Thanks for having me, Josh.

So, David, some of our listeners will have private credit investments in their portfolios already, but for some, this is gonna be new. So start us out with the definition. What is meant by private credit? What is this asset class?

Private credit describes a wide range of privately originated loans. So these are loans generated outside of the banking system or the public bond market, and they’re loans to nonpublic or middle market companies.

And these loans are typically floating rate, so they don’t generally have a fixed interest rate.

They are higher yielding, and they are negotiated directly with the businesses and borrowers of the money.

And so if this is new to people, that’s not necessarily surprising. Right? Because this is a relatively new asset class. This wasn’t something that people were making part of their portfolio twenty years ago.

Correct. Correct. And and, really, private credit has grown substantially post the rate of financial recession.

So Two thousand seven, two thousand nine, that that crisis.

Yeah. When we go back to two thousand seven, two thousand eight, two thousand nine, really post the GFC, we saw banks step back from middle market lending when they really tight their books and their standards.

And so much of the coverage of private credit has really grown in the years post the great financial crisis. And as of right now, we really see an asset class that’s closing in on about two trillion dollars in market size. So very substantial asset class that has really taken the place traditionally of the lending market that banks used to play a very prominent role in. And they still do private loans to businesses, but their standards and their underwriting is much more constrained than what it has been in the past.

And so really last summer I mean, before that a little bit because it had grown so rapidly. But really last summer, we started hearing some concerns in the media, especially about this asset class.

And we can kinda break those into three buckets. Right? And so let’s start with this bucket that we’ve heard of concerns about the liquidity of these investments. And this really started with a report from Moody’s last summer. So take us through what people are concerned about when they talk about the liquidity situation of private credit investments.

Yeah. Just so just so everyone understands, liquidity, when we say that word liquidity, what we’re talking about is how quickly you can expect to sell something, sell an asset, and get your money.

And so

With stocks, I can go sell it on the market this afternoon.

Correct. You know, that doesn’t mean you’ll make money. You may sell at a loss, may sell at a gain. But at any time for publicly traded stocks, you could sell your stocks and get money pretty quickly. So public stocks are very liquid.

Private credit, as Moody’s pointed out last summer in their report, is not a liquid asset class. It is an illiquid asset class just like private equity, private real estate, private infrastructure.

These are assets where it can take a while to sell the asset and actually get money in return.

And so the report from Moody’s was simply highlighting that there was a lot more of retail money going into private credit. And we say when we say retail money or retail investors, what we mean are investors that don’t have high net worths. So the need for liquidity is usually greater.

And so Moody’s was pointing out that there seemed to be this mismatch occurring in private credit where we had a lot more money coming in from investors that generally prefer highly liquid assets, but we’re putting money into an illiquid asset class like private credit.

And this illiquidity is actually part of a is a feature of private credit. It’s not a mistake or something. Right? Like, it’s designed this way.

Correct. When it comes to private investments in general, private equity, private credit, private real estate, like I mentioned, there is something called an illiquidity premium.

And you can think about this in a similar fashion as when you go to your bank and you look at the savings rates or CD rates. You go to your bank and invest your money in an ill liquid account, which is your savings account, and you get an interest rate. Or you can tell your bank, I’m willing to lock up my money for a longer period of time and buy a CD, which is an, in theory, an illiquid asset, and they’ll give you a higher interest rate. That’s called an illiquidity premium. So the same thing occurs in equity or credit markets where if you’re going to lock up your money into an illiquid asset class like private credit, you’d expect a higher rate of return or a higher yield on your money.

And so that’s part of the appeal of this is part of the reason that we think this asset class might be expected to have higher returns. There’s an illiquidity premium.

Correct. Correct. And these deals are also highly customized. So there’s generally a premium that comes as well for having such custom loans underwritten specifically for the business, specifically on the terms that makes sense for that business.

But then last fall, we saw reports of a few troubled deals. So this wasn’t just, investors didn’t understand the liquidity of the investments. We actually saw a few troubled investments in this space. Tell us what happened last fall.

Yeah. So last fall, two firms that were backed by private credit loans collapsed. The subprime auto lender Tricolor, which actually faced fraud allegations, as well as a car parts supplier called First Brands. And so these deals got extra attention when JPMorgan’s CEO, Jamie Dimon, said on one of his earnings calls, my antenna goes up when things like this happen. I probably shouldn’t say this, but when you see one cockroach, there’s probably more than one. And so that that’s a quote from Jamie Dimon that happened when these two, deals actually fell through, which which really sparked a lot more attention to this space.

Suddenly, that cockroach headline was all over the place.

Exactly. And then and then about a month or two ago, another company called Blue Owl Capital, a private credit fund manager, they changed their redemption strategy and redemption terms on one of their funds. And so couple of these headlines really just happened one after another that sparked a lot of concern, really more so from the retail investors that potentially were not even properly matched from a liquidity perspective with this asset class?

Okay. So there’s been a couple of episodes where we’ve seen individual companies that were backed by private credit loans or we see it saw a private credit loan fund get in the news. But we see companies getting the news all this time in in public markets or in bond markets. That doesn’t necessarily signal anything about the overall asset class. Right?

What to to what extent are there concerns though about kind of the overall quality of loans in the private credit space?

Well, here here’s the interesting thing about what’s unfolded is that we did have some of these headline, events, like the the two deal specific, headlines I mentioned as well as a quote from Jamie Dimon. But then soon right after those headlines, we also started to realize that there’s been growing concerns around software as a service type businesses in general in the market because of disruption from artificial intelligence.

And so when we think about software as a service, that’s a very specific sub industry within the tech sector.

Yeah.

There’s actually a large portion of exposure to software in private markets investing in general.

And so right after these headlines occurred, then there was concern that maybe private credit lending in general that there was quality concerns because of a large amount of exposure to software businesses in general. So that caused even further concern around not just the structure, the liquidity, but also then more about the quality of loans in general. And what we have actually seen when we dig into private credit across the entire asset class is that there’s about a twenty percent weighting to software in the entire market. And so there is, you know, something to look at here just to see what the quality looks like in these loans. But when we actually look under the hood of these funds, we have not seen any distress selling, of any loans. And we have seen very, very few examples thus far of loans actually having performance concerns.

So there’s a distinction here that I think might be pretty important. Right? Like, on the one hand, you have loans that have been made to individual companies, and most of these loans look like they’re okay. Then on the other side of it, you have investors who have put their money into private credit funds, and they wanna get out of the private credit funds. But in some cases, because of the liquidity rules, they aren’t able to.

These are two different things. Right? Investment in the funds and then the question of the actual quality of the loans that are that are underlying them.

Correct. Correct. So, you know, some investors have sought to exit the private credit investments as as Moody’s, you know, warned could happen, last summer. But we should definitely distinguish between a sentiment driven desire to exit private credit funds from whether the underlying loans within those funds are actually performing poorly. And again, we have just not seen strong evidence to suggest poor performance or poor underwriting of these loans in general. And so at this stage, you know, there isn’t strong evidence to suggest that there’s distress in private credit. And a real prime example of this is that when Blue Owl was in the the news, last month, it sold one point four billion of its loan portfolio at ninety nine point seven percent of par value to its institutional investors.

And so what that means is that, yes, they did a large sale to beat liquidity and and to exit a lot of their portfolio, but they didn’t have to sell it at a discount. And so if you actually had quality concerns inside of an asset class or concerns about the credit worthiness of these loans, you would not expect to get ninety nine point seven percent of par value when you go to sell these assets. So, again, that’s just another example of one of these headline events where, you know, the media was really sounding the alarms. But when you actually look at the specifics, we’re not seeing distress.

That’s not a that’s not a distressed sale ninety nine point seven cents on the dollar. That’s that’s almost your entire dollar right there.

No. I’d be very happy to get that when we’re going to sell an asset.

At Mercer Advisors, how do we think about this asset class whether to to be invested in it right now? How to approach investing in this space?

Well, our our current view is that while there are concerns about the higher concentration of software companies in private markets in general, including private credit as an asset class, the underlying portfolios within private credit appear to be fine.

And so the biggest issue is the classic investor investment mismatch in this space. And so what we spend a lot of our time focused on is making sure that any clients where we are recommending private markets, private credit investments, that we are doing so within a financial planning context where they fully understand and they are fully able to take on that illiquidity. Because these funds and regardless of their structure, you cannot expect to get your money back any single day or any single month or any single quarter within these funds. These are illiquid investments that are really meant to span ten years plus in some cases in order to fulfill their whole life cycle return stream.

Like with a CD, the the way it works is you have to wait until the CD term is over to get the most out of it. If you try to pull sooner, you might you know, you have a penalty or whatever. That’s not how the investment is designed to work.

Correct. So suitable investors should have sufficient liquidity elsewhere in their balance sheet. So they don’t need to tap their long term assets for unexpected needs.

And additionally, private credit is a risky asset class. And so therefore, investors should be willing to withstand drawdown periods, periods of negative performance if they are to materialize.

But it’s important to stay in your seat just like with stocks regardless of the headlines and stick to your financial plan and stick to managers and quality due diligence to make sure that we are providing a diversified portfolios and sticking with those allocations for the long term.

And so because this is a risky investment, you know, we think that this makes sense in some people’s plans. Right? But it shouldn’t be a huge part of of anyone’s portfolio.

Correct. Correct. So when we think about private credit, it continues to occupy an important place within the broader investment landscape, But it’s really only for investors who understand the long term commitment required. And private credit can still serve as a valuable source of yield and diversification, but you have to make sure you are sizing it properly and that requires a detailed plan with your financial advisor.

And so the main takeaways when we think about investing in this asset class, and this is very similar with private markets in general. Number one is that manager selection here really drives outcomes. So unlike the public markets, public stock market, public bond market, in private markets, there is a huge dispersion in performance based off of the managers and the strategies that are selected.

So you could have an asset class that has varying returns from highly positive to even highly negative. And so underlying due diligence and manager selection is truly what drives outcomes here in this space, and we spend a lot of time here at Mercer Advisors with an experienced team doing just that.

But number two, diversification always helps to reduce these idiosyncratic risks. So spreading your exposure even across managers, sectors, borrowers, structures, vintages helps to avoid concentration in areas that do experience stress. So if we start to see more stress in software, for example, we wanna make sure that we do have diversification within that space and we’re not overly concentrated with our exposures. So like I said, that’s something we’re watching still very closely, and we have a high degree of confidence in these strategies we’ve selected in the space to do just that.

But then lastly, you know, allocation sizing, which is very specific for our clients, and illiquidity planning, they’re essential. And that takes a conversation with your financial advisor or financial plan that you know you’re you have a fortress balance sheet, which we talk about here often, to plan for any allocations that are not liquid investments. And private credit should never be entered into with the thought that you can get your money back in any given, again, month, quarter, or year.

David, thanks so much for being with us here today to put this all in perspective.

Happy to help.

If you are already a Mercer Advisor client and are interested in private credit or wanted to talk about the private credit in your portfolio, don’t hesitate to reach out to your advisor. If you’re not a Mercer Advisors client, but you’re interested in more information or interested in our approach to this asset class, don’t hesitate to reach out. Visit our website, Mercer Advisors dot com. It starts with the phone call. Thank you so much for being with us here today on Market Perspectives.