Latest / The Issue at Hand by Madison Investments / Private Credit: How Early Success Created Today’s Risks
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- speaker-0: Since private credit has grown to the extent it has, it has never really been through a full credit cycle where losses are taken and the the bad things are cleared out. And so to some extent we just don't really know how exposed they are to how dodgy a credit that is out there. speaker-1: Hello and welcome back to the issue at hand. I'm Chris Alamon and today I'm joined by Bill Ford, head of Reinhardt Fixed Income here at Madison Investments and Portfolio Manager. Today we're gonna be talking about private credit, and I feel like that opens up a can of worms in terms of what we're talking about, but what we're trying to talk about is private credit and how speaker-0: Thanks, Chris. speaker-1: Investors and advisors can look at simplifying what's actually happening. So I think I want to start there at the be at the base of this. What is private credit? speaker-0: Private credit is lending that is not done by banks and not done in publicly traded bonds, that is usually related or historically has always been related to more complex, long-term, and in some ways carrying other risk type of lending that banks were not well suited to do and that didn't really fit well within the publicly traded bond. speaker-1: Well you hit something there. I think the the idea of long term. And I think to your point, like banks probably steered clear of this. So who were, I guess, the initial investors in products like this that that wanted long term assets? speaker-0: Well, really, it's it's been a lot of the more classic institutional investors. The the two main ones would be pension funds and life insurance companies, because both of those have extremely long-term liabilities where they have a lot of funding that is locked up for years, if not decades, that they need to be able to try and get a long-term superior yield on. But because the money is locked up for so long, they don't have to worry about liquidity. They don't have to worry as much about market moves, and they can deal with a lot more of the complexity. And especially the illiquidity of of the asset class. And so there are natural fit for for those investors' liabilities. speaker-1: So I think when when we mentioned life insurers, like I think the initial point that you're making there is that there was a need for this type of asset and they had the investors that were that actually wanted something like this. So that makes total sense to me. Right. Everything seems fine. Right. So then what happened when annuities kinda started getting into the mix with private credit? speaker-0: Well, what we've really seen is that private credit has grown beyond its natural demand in terms of the natural investors for it. It's also grown in a lot of ways, likely beyond the natural demand of private credit borrowers. And so that you're now seeing a case where the the private credit managers are bring trying to bring in more funding and more money than their traditional speaker-1: Demand has just increased as financially. I get you. Okay. speaker-0: We're also trying to push out a lot of the investments being made beyond what has historically been a good fit for for really speaker-1: What what do you mean by that? They're trying to push out the investments. Well speaker-0: Well, it it's just a case where the asset class has grown so much where you initially started off, especially following the pullback of the banks after the great financial crisis, of private credit stepping in to do a lot of lending that banks had historically bone done but no longer were doing. The amount of money that has come into the asset class ⁓ and the amount of money that it is trying to be invested in the asset class has really grown a lot beyond that. And whenever that happens, what you're going to have is More marginal investments are going to be made because the the next the next best opportunity to invest is usually the one that you would have left off before, but now you're going to go and pursue. And so what you're starting to see is both in terms of trying to raise the funds and trying to find places to invest the funds, the asset class has on both sides of that perhaps grown out a little beyond its traditional borders. speaker-1: Okay. Well then let's stop there. So when you're saying it's grown this much, I feel like a lot of the things that have come out on the news recently, we're starting to see cracks in that. Whether it's some of these companies that are actually taking losses, we're starting to see some of the redemption requests and some of them not even getting fulfilled. So I guess what cracks are you seeing right now that I guess people should be made aware of? speaker-0: I think some of the the cracks that we're start starting to see are on both sides of what you were talking about. One is that you are starting to see losses that are related to some of the high-profile bankruptcies or other issues. First brands has probably been the most high profile, and the one that started a lot of conversation about this. Now, that was a case where first brands was relying on a lot of private credit funded factoring platforms. But ultimately, it's not that a private credit funded factoring platform is an issue, it's that first brands was just a massive fraud and speaker-1: Yeah, I think that's the other thing that I want to get across is that there was a need for some of these types of investments. But it's again when you have some bad players getting into it, we have to be wary of that. Sorry, I cut you off. Continue. speaker-0: No, that's no problem. ⁓ and then what you're seeing on the other side is that private credit has grown in terms of the investor base beyond just a lot of the traditional pension funds and life insurers. And what you've started to see there was these business development companies was an effort to expand the ⁓ the funding of private credit managers, ⁓ really moving more into more retail types of investors who have not historically had the ability to deal with illiquidity in long time frames. And so what you're really starting to see there is either the The non traded business development companies are what you're hearing a lot about right now, where people are making redemption requests. But by by contract, when you invest in one of those, they can limit their redemptions to a certain percentage. And it it turns out that that had never really been an issue for retail investors because nobody really had a lot of redemption requests. Now they do. And so now a lot of these business development companies are capping the redemptions to say, no, five percent is the limit and we're gonna hold to it. That that on its own is not a bad thing because that is what allows private credit to make a lot of the investments that they do is the idea that the money is locked up. It's not like in a bank or or somebody's retirement account where they can say, No, I need the money right now and you have to give it to them. So that in a lot of ways that is kind of the point. speaker-1: Well I think this goes back to your earlier point is demand has just grown so much that to your point, like the traditional investors, it's not them anymore. And I think one of the things I kind of want to wrap this back in, like what we do here is we also try to make here is an example. So we try to say, hey, what's the what's the best case for this, what's the worst case for this? So I don't wanna I don't wanna say it's all grim. So when we're looking at what could potentially help, I guess, in the current environment for the private credit and I guess related to annuities. What do we need to have happen? Do we need to continue to just the economy just needs to trudge along and we'll be fine? Or do we need some another catalyst to happen? And then on the flip side, I guess what happens if we have an economic slowdown? What is what could potentially happen from there? speaker-0: I think what we would see the the upside case or the good case is like you said, the economy continues to to trudge along or muddle along. There will be losses in this asset class. The the let the people managing private credit funds will take losses. ⁓ it is a riskier asset class than a than a high quality investment grade bond portfolio, but they also are receiving yield that should compensate them for that. And so is speaker-1: In that scenario, you're a set you were okay. Some acceptable losses are okay, but again because you didn't compensate it for the yield. That makes speaker-0: Acceptable losses are okay. I would advise caution in the sense that for pay for players that are newer or less established and haven't been doing this for as long or and that are seeing s really, really significant asset growth, I would question do they really have that many suitable opportunities or are they or are they sort of pushing the edges and pushing the boundaries and moving into some of the more marginal opportunities, which is where you're going to see losses that are that are beyond What a yeah. speaker-1: So what happens, I guess, I don't know if it's the worst case scenario, but an economic slowdown. Maybe not even crazy, but just a little bit of an economic slowdown. What happens to these types of assets? speaker-0: Again, I think most of them will probably be in good place in a good place. They will certainly see more losses than what you would see in a lot of higher quality ⁓ credit types of things. But again, this is something where if you're a long-term investor, you're going to look at it and say the higher yields that I'm able to get over very long time periods will will compensate me for the losses I may take in some of these short-term ⁓ types of credit events and types of credit cycles. Now Backing off to temper that is the idea that since private credit has grown to the extent it has, it has never really been through a full credit cycle where losses are taken and the the bad things are cleared out. And so to some extent we just don't really know how exposed they are to how dodgy a credit ⁓ that is out there and what they will actually face in an actual credit cycle. speaker-1: And in that case, I guess I wanna we wanna prepare our advisors and our clients. What are the types of questions that either the advisors should be asking about, either the private credit industry in general, or even their clients asking about, like how their annuities are structured? What are the types of questions that we should be thinking about? speaker-0: Sure. ⁓ one of the first ones that you should ask any time you're offered an investment that offers you a lot of y additional yield is you additional yield does not come without some type of additional risk. Right. And understanding what are those risks, is it really s complexity and structure and liquidity, or is it just worse credit? Okay. ⁓ and understanding what are what is the risk that's generating that additional yield. You also really want to look at who owns that risk or who takes the first loss on that risk and who's backing it up and where do you fit in that structure of when losses happen. speaker-1: What is it? Who owns it? Okay. Yeah. speaker-0: ⁓ there's questions about how liquid is the investment, but when you're talking about private credit, one of the whole points of it is it is it is by design illiquid, that it is meant to be locked up for a long time. And that and in part that's because these things are so complicated and have all these different risks that if they it would in a lot of ways be difficult to mark them to market. And if they were marked to market every day and people were moving in and out based on that, that that that just wouldn't work for the types of investments that the ⁓ private credit funds are trying to make. ⁓ again, how are they valued? These are not publicly traded, these are very speaker-1: Yeah, I feel like we're gonna run into a little bit of an issue in terms of the valuation, but I think again, at a at a minimum, we need to figure out what it is, who owns it, how liquid it actually is it, and then is there some value to it? I think that's gonna be the summation of what people should be ad asking. Well, I think that's a I think that's a good place to stop for now. So I want to thank everybody for listening. I want to thank Bill for joining me today. Explain about private credit. For more information disclosures, please visit Madison Investments.com. And if you haven't already clicked subscribe. Please do so. Thank you for joining us today and take care.