BBB, PC, and PE: From Wall Street to Easy Street… …to Death Street?

Before we start, the abbreviations:

• BBB = Bulge Bracket Banks

• PE = Private Equity (Not P/E for P/E Ratio)

• PC = Private Credit

With those abbreviations out of the way, let's begin!

Only a few years ago, private equity (PE) was very sexy when NFTs and SPACs were all the rage. Now, in place of PE we have private credit (PC), which is perhaps, the new, glittering Wall Street darling.

But, all that glitters isn't gold!

So, Let’s discuss PC in detail now. First, let’s answer some questions:

Private Credit is fixed income, right?

It depends. It may be fixed income--but it is not always so.

So, it's safe, right?

Well...

...it depends.

Just as different credit securities have different risks, often with a corresponding credit rating provided by a third-party credit rating agency, various PC offerings also have different risk profiles.

There are also private credit ratings similar to "regular" credit ratings. But, I believe these private ratings (though offered by the same names, such as Fitch and Moody's), are not mandatory (but may still be requested by the interested parties).

Okay, so that's the groundwork. So, let’s move on to the point I wanted to raise:

In my opinion, there is a gaming of accounting standards and practices that has led to the popularity of certain investment spaces. Particularly, MTM (Mark-to-Market) is the accounting practice that I wish to address here. This is a big one because, within the PC space, one is able to skirt Dodd-Frank. This is true regardless of issuing fixed-rate PC or floating-rate PC.

With that said, though Dodd-Frank was meant for the reform of Wall Street, this sounds like Wall Street is taking the EZ street again. But, this street has a dead-end reminiscent to the GFC.

Let's figure out why.

Because of the lack of volatility within PC due to MTM skirting and lack of liquidity, many players are attracted to allocate money to private credit funds and lenders because of PC’s ability to smooth out performance of one’s portfolio. These PC funds may function as the "tranches" of times past (think CLO and quiver!) giving many eager players access to riskier returns of the PC world while creating a window dressing on their portfolio in the short term.

So, no MTM means no changes to fixed-rate PC within one’s portfolio. From the counter-party perspective (i.e., the borrower), this is okay until you need to refinance since the rate and payment size does not change (of course, if you remain a going-concern).

What about borrowers of floating-rate PC? That's another story. The default risk due to rates and the resultant payment size does not emerge at the end of the financing period as in the above fixed-rate case when the floating-rate borrower is looking to refinance. Rather, interest rate risk is an ever present concern in contrast with interest rate risk which takes the form of refinancing risk. Furthermore, for floating-rate PC, the SOFR is pretty dang high today--5.35%. Now, if we add the PC premium (liquidity-risk component ceteris paribus), and bad cost control on the debtor's PnL, you got yourself a nice white swan/grey swan. That’s not good.

Now, "Less volatile" is the sales pitch by PC lenders. This looks good in an asset manager's portfolio, and if you're bonuses are tied to portfolio performance, this looks like you can coast with PC, right?

Well, let's talk about volatility to uncover the problem that I wish to address here. Being less volatile than a public-market-credit risk-equivalent is different than being less volatile than its own hypothetical FMV-equivalent volatility. This distinction is crucial. Why? Discrepancies between private market volatility and FMV-equivalent volatility means discrepancies between price and value. Thus, we lose the signaling power of a real-time-approaching price.

Why does this matter? If price is not updated to reflect credit risk, especially as market conditions become unhospitable, many companies financed with private debt may fail collectively, triggering damage to PC Lenders that function as funds, which may cascade into systemic risks. Further, this may be a blindside because of the opaqueness of the PC space due to the above issues mentioned (illiquidity and MTM skirting).

Keep in mind that, as general market pains increase, PC borrowers are most likely the first to feel and/or succumb to pain because of the higher risk premium that is demanded by the PC lender and that impacts the recurring payment size. Further, companies that tend to go for private credit tend to be unable to access credit from banks because of their incompatible risk profile. I.e., they tend to be risky bets to begin with.

With all this in mind, on top of yield, due to the attractiveness of "no volatility" (due to a lack of MTM and price-discovery mechanisms in a private transaction), a lot of Asset Mangers (think Pension Funds--uh-oh!) will be drawn to allocate their capital under management to such PC funds. So, now, in a world of higher inflation hurdles, search for yield, and pressure to net-to-0 unfunded liabilities (like pension liabilities), the backdrop is set for a problem to brood. Private credit ratings may help, perhaps, if those credit ratings are "good"--whatever that means.

Now, pair the aforementioned discussion with private credit lending officers/personnel that operate within aggressive incentive structures, and this feels a lot like the practices that led to the GFC crisis. Also, the "cascading" I refer to becomes "systemic" when we see BBB's (remember the acronym at the beginning?), which are G-SIBs, also join the PC game in a scramble for “EZ yield”.

All in all, though Private Credit is not my expertise, I think I have this right.

And, if so, then, voila! You're free lunch is served. Thanks for reading!