Private credit is now so big that it's rivaling more traditional forms of lending and fueling a debate about whether this relatively new asset class poses risks to the economy. And yet, it feels like a new private credit fund is being launched daily. And even banks (the very things private credit is displacing) are getting in on the act and creating their own private credit offerings for investors. In this episode, we speak with Ben Emons, senior portfolio manager at Newedge Wealth, about the macro impact of this new form of lending. He talks about where private credit's alpha actually comes from, how it stacks up against bank lending, and what to watch out for in terms of the risks it might pose to the broader system. This transcript has been lightly edited for clarity.
Key insights from the pod:
Why people are interested in private credit — 5:29
Correlation, defaults and private credit — 7:15
Lender protections in private credit — 10:39
Why would companies choose private credit? — 12:54
The role of retrenching banks — 14:52
Regulation and the boom in private credit — 17:39
Illiquidity in private credit — 21:37
What would cause a collapse of private credit? — 24:17
Transparency in private credit — 27:54
How is private credit structured? — 29:48
How to short private credit? — 32:53
The economic impact of private credit — 34:30
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Tracy Alloway (00:10):
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal (00:14):
And I'm Joe Weisenthal.
Tracy (00:16):
Joe, it's a new year.
Joe (00:18):
Happy New Year!
Tracy (00:19):
Happy New Year. This is our first podcast recording of the year. And I think it's fair to say that we are going into a different environment, in terms of sentiment, than we were going into 2023. So this time last year, everything was very pessimistic. Lots of people were expecting recession, the hills were alive with the sounds of inverted yield curves and things like that. And this year feels a little bit better. Stocks are up. Lots of talk about a soft landing. Of course, the irony is that if there is going to be a recession — and, you know, [there’s a] 100% chance there will be a recession in the future, it's closer than ever. And yet we feel a lot better about it.
Joe (00:59):
Yeah, it is funny, the optimism that we really felt in December about soft landings and bull markets and rates coming down and normalization. Interestingly enough, we're recording this January 3rd, so far, I guess this is, we're looking at, we've had a few down days. You know, whatever. A few days here or there, it doesn't make a big difference.
Tracy (01:18):
I call it profit taking, Joe. But anyway, new year, new themes to discuss.
Joe (01:25):
Are you taking profits Tracy?
Tracy (01:26):
I wish. But one of the things that's still with us is this concern about whether or not the economy can escape the full force of these very dramatic interest rate hikes that we've seen over the past couple of years. Whether or not there's still a shoe to drop, basically.
Joe (01:45):
Yeah, you know, it gets to the lags debate. We talked about it with Anna Wong at the end of 2023. The market expects rate cuts, obviously, some people think as soon as March, [it’s] unclear when or if that will be, that theoretically is taking off some of the pressure from markets, particularly credit markets. But yeah, we had this really big rise in rates. Some people think that the lagged effect still has yet to come. And so sort of trying to understand what's changed from when we were at Zirp to when we're at 5%, I think is still an important conversation to have.
Tracy (02:18):
Absolutely. And in my mind, one of the big areas of concerns, and it also goes to the idea of what's changed over the past few years, has to be private credit. Right? We've seen this absolute swelling of this particular asset class at a time when interest rates have been going up and there's still lots of concern over whether or not this new source of funding basically knows what it's doing.
Are these managers, are these investors, getting it right? But then the other thing I keep thinking about, and we've talked a little bit about this, but this idea of the macro impact of private credit. If you have a body of money that is now $1.3 trillion or $1.6 trillion outstanding, depending on which estimate you're looking at, that is more or equivalent to the size of the entire junk-rated corporate bond market. So there's basically this like new pool of money in the economic system at a time when interest rates are going up and we're not really sure what impact it's having.
Joe (03:24):
And I'll just add onto that, that part of the interest obviously is, okay, but what does it mean for this cycle? Higher rates, etc. But this asset class that's exploded, it's not going to go away regardless. And the expectation is that it's going to over time continue to grow. So I think there's just a lot of need and interest, but I would say need, to sort of understand, as you say, the macro impacts from this space.
I'm also curious about the source of excess returns. We talked about it a little bit, but it's always sort of important when thinking about an asset class is like, okay, what is it specifically that's being exploited here for above average returns? How correlated/uncorrelated is it. I think it's still worth trying to untangle the impact and the role of this asset class.
Tracy (04:09):
Absolutely. So we've done one episode on this topic previously. We spoke with Laura Holson from New Mountain and she basically gave us the elevator pitch for why this asset class has been growing so dramatically in recent years. But in this particular episode, we're going to dig a little bit more into the macro impact of private credit, how it competes with other types of funding, and per Joe's point, where the source of those excess returns is actually coming from.
And I'm very pleased to say we have the perfect guest. We're going to be speaking with Ben Emons. He's a senior portfolio manager at NewEdge Wealth. Some of you might remember that we spoke to him last year about the contraction in bank lending after the collapse of Silicon Valley Bank and a few others. He's had a very wide-ranging career. He was at Pimco for a long time. So really a great person to give us an overview of how private credit is interacting with the rest of the financial system and the economy. So Ben, thank you so much for coming back on Odd Lots.
Ben Emons (05:10):
Tracy. Joe, it’s great to be back. Happy New Year. Thank you for having me.
Joe (05:13):
Happy New Year. Thank you for coming back.
Tracy (05:16):
Yeah. So maybe to begin with, tell us what's your particular interest in private credit? Sitting at Newedge, you're a portfolio manager, what is the offering posed by private credit?
Ben (05:29):
It's driven much by client interest and demand for this asset class. In part maybe because the type of clients at Newedge in these case services, are working in the private credit industry themselves, ironically. So they're interested in investing in other private credit strategies.
But it's also, I think, borne out of clients who have connection with the companies that these private credit lenders are lending to or have some sort of involvement in that and are interested in allocating the effort to this asset class as opposed to, let's say, the retail approach of like ‘Well, okay, I heard about private credit. There may be an ETF on it, so let's buy this ETF and I'll go to a wealth management firm like Newrdge and they will help me with that.’
That’s far less so, the investors that we talk to are very involved in private credit themselves. So it gives you an interesting angle on it because once you start to talk to these clients, you know, you have to really learn about what this asset class truly is about. You know, it's far less an asset class about the way we're trading public markets. If you look at Treasury bonds, that's not what private credit is really – how it's traded or how it is functioning. So I find it a really interesting different alternative way of investing, something I had not looked at in my career previously, until I really started getting into the registered investment advisory business. And so, interesting to watch this, to see this unfold.
Joe (06:58):
So what is it for an investor, you know, you think about an overall portfolio, people have some equity and they have some maybe risk-free government debt, etc., and whatever it is. What is it about private credit? What does it deliver for a portfolio?
Ben (07:15):
So it is truly diversification. And it is an asset class that's traditionally non-correlated to equity or fixed income. Even though, you know, all the loans that are in these private credit funds are all based on the secured overnight funding rate, the SOFR rate, right? So there's obviously a connection with interest rates. But it has been long-term uncorrelated based upon how the returns have behaved relative to returns and equities and fixed income.
I think what detracts people is that the loans that are being issued by those private lenders, they have been at extremely low default rates for a really, really long period of time. Now, I always talk to the private credit managers with a bit of caution here. Because coming from a world of total return and fixed income trading, you immediately take a step back like ‘wow, okay, low defaults, really?’
Tracy (08:11):
Yeah! It's sort of true of every new asset class, right? Like ‘Oh, the history's limited, so there aren't many defaults.’
Ben (08:17):
Exactly. Very good point, Tracy. That's one reason. On the other hand, it's about, okay, the individual companies that they lend to have had a good credit history so far, at least in many of the funds that we looked at, that's been the case. Very little impairments have happened.
Second, the private lenders are in control, so they set the covenants. It's not like a bank [is] involved or another intermediary that is controlling the contract. It’s really Blue Owl, Blackstone, KKR, those companies, they set the terms and they also are very good at enforcing those terms. And I think this gives clients a confidence that these loans are staying current and we're not getting any major impairments of anything.
Now, what I think is otherwise attractive to clients is that it is an asset class that is not out on the screen. It is privately managed and traded. The private credit funds are nothing like a mutual fund or ETF or a hedge fund manager. They are very selective in how they pick their different companies to lend to. I think all of those things play a role in why investors are interested in this asset class.
Tracy (09:29):
So a lot of this reminds me of the debate around cov-lite in sort of like the middle 2010s when there was an explosion in cov-lite bonds or a dramatic deterioration in the amount of protections that investors were demanding in order to lend to companies. And I remember that time there was an argument sort of for and against.
So, you know, some people were arguing, this is terrible. This is the result of the search for yield. It basically means people will lend money to anywhere they can get a return and they're not going to ask for any protections because they're just desperate to get any sort of yield. But then the offsetting argument was that, well, actually it sounds bad. Cov-lite sounds bad. The idea of investors giving up protection sounds bad, but if something were to happen, if there were a recession, then it could end up being a good thing because it means companies have more flexibility to refinance. They don't have as many restrictions around what they can do. So I always remember there were sort of pros and cons to the cov-lite argument. And it feels similar in private credit.
Ben (10:39):
Maybe to an extent Tracy, but I would say the managers that we've spoken with, and you know, we’ve talked to over a hundred managers in that space, what we've read from most of those covenants, they're not light, they're actually stricter. And I think it is because of the personal relationships that these private lenders have with the companies that they're lending to.
And they told us that. We've actually gotten examples, they've shown also, you know, a presentation of the different companies that are actually in the fund, who have basically, let's say, a long-term standing relationships between, say, Blackstone and that company itself. So what I'm trying to get at is that the covenants are sort of maybe like customized covenants. They certainly don't read to us as light.
You know, there's a very strict control on payments of interest. And it's about trying to really help the company move ahead. So there's also I think a private equity aspect to this. And that's typical in private credit anyway, where you have a sponsor that is involved in the structure of the private credit fund.
But having that private equity approach sort of, let’s say empowers those companies to do the right thing with that money and invest it the right way. And therefore the covenants, although they look really strict, are not necessarily going to be at some moment like ‘Okay, you can't pay off those loans. We're going to really put the screws on this company. We're going to take the keys,’ right? Literally, and therefore the company becomes totally impaired and dysfunctional. That doesn't seem to be the case so far. Even though from what I read, those covenants, they are strict compared to, say CLOs, where that covenant lite showed up in the mid-2010s. Yeah
Tracy (12:42):
So what would cause a company to decide to go the private route versus, either issue a bond or take out a loan from a bank in the public market?
Ben (12:54):
So I did analysis on the BCRED fund, for example from Blackstone, and all those companies in there are non-listed. All of those companies, from our conversations with them, have no interest in going public at all. And thirdly, what I did find, and I did say that to Blackstone, about 10% or so of that pool, there's very little information I can find on these companies when I go online, I don't see much of any kind of information.
So some of our really, really private, private type companies, we’re talking about literally like services companies, like car wash or some technology services company, that you've never heard of before. And so these companies, I think, are also not in the position to just go to the public markets unless there's a bank that is really that easy in terms of its lending standards, that is willing to give these companies money or allow them to come to market.
On the other hand, I mean, some of these companies may be in a position where they get better and better revenues, they get more traction and get more attention to their business model. And at some point some big investor comes like ‘Hey look, we can help you go public and raise equity.’ We've not found those examples in these pools so far.
Joe (14:06):
How much of the rise of this asset class, in your view, is simply about scale and capacity within the banks? Or maybe lack thereof? Because if the story is, alright, the companies are not listed, they're not particularly well-known, so you're sort of starting from scratch on due diligence or familiarity perhaps. The covenants are bespoke in many cases as you've described, they're tailored. So that obviously takes legwork on the part of whoever is making lending decisions. So is this a story of essentially in a post Dodd-Frank world where banks are constrained, etc., that essentially it just makes more sense in many cases for third parties who have the capacity and scale to specialize in creating that relationship?
Ben (14:52):
That's spot on Joe. I think the other part of that story is that as banks have scaled back in the syndicated market, that created a void. And I think that was part of the story too, of these companies automatically getting towards a private lender as opposed to going to a, let's say midsize or smaller bank trying to get a loan or business loan.
But as I mentioned, the personal aspect I found really fascinating of how personal relationships they've had. Now, any private banker has this, right? If you go to, I don’t know, think of any of the major banks, there's a personal relationship, but I think in this case it's very driven by personal long-term relationships. So that void of the banks not, you know, lending as much in that syndicated loan channel is one reason why there is a lot of demand for private lending. On the other hand, it's really the personal relationships I think that's driving it.
Joe (15:50):
Tracy, it still strikes me as perverse that the banks that failed in 2023 were like the banks where they actually took private relationships seriously. It sort of bothered me, like oh, this is what I think banking should be, like really getting to know the client, bespoke offerings, that isn't just like some generic website.
Tracy (16:08):
There's a difference between getting to know the clients and doing whatever they want you to do.
Joe (16:12):
I guess that's it. But it still feels like, man, like I think that's what bankers should be doing. But I guess apparently not. That's not what the market said.
Tracy (16:19):
Well, I mean, just going back to the regulation, a lot of this was by design. I remember when the leverage lending guidelines came out again in the mid-2010s, that was back when the market was going absolutely haywire. And the regulators came out and said ‘Hold on, you guys have to take a breath here and stop doing so many things that are risky.’ Basically forcing that activity into what we used to refer to as the shadow banking system. I don't see that term as much as I used to, but that is exactly what private credit is, of course.
But just on this note, I remember there was a really interesting chart. I think I put it in one of the Odd Lots newsletters, maybe a couple months back, but it showed commercial and industrial bank lending in the US versus US GDP. And for most of the history of that time series, they pretty much moved together. So if there are more commercial and industrial loans, then GDP tends to be growing, but over the past couple of years they've kind of decoupled, and in my mind it really raises the question of what is driving GDP growth if it isn't bank lending? Maybe it's government funding. We've seen a lot of infrastructure spending and things like that, but maybe it is also the more than $1 trillion of private credit that now exists.
Ben (17:39):
I think that's right, because, you know, the fact that it is $1.3 trillion going to literally companies that are making $25, $50, $100 million dollars of gross revenues a year, that's part of the really small mid-sized backbone of America. That's driving GDP. And again, doing research on these companies from the information that I've found on this, you can really tell their business models have expanded very rapidly over the last several years.
In part I think because of the infusion of private credit and the availability of private credit. Again to that question of Joe, like if the availability is from private lenders, not from banks, it does eventually show up in GDP, maybe not because of the commercial industrial loan contractions you're seeing there, but through the other channel of private credit extension.
I think also that the impact in itself of leveraging, gearing in the financial markets is actually none from private credit. There has been one CLO now issued off Blackstone's BCRED fund. That was very, very recently. It was about a $500 million deal. They took the most, I think the best loans that they had in their fund, and bundled them together and sold them to investors at a very tight spread compared to where high yield is and anything else.
So very conservative, but not much more of that is happening yet. So if you think of impact from private credit on the economy, it would go through leverage and securitization as an example. So that may be the next stage in the future as Blackstone sort of dips [into] the waters there and figured out ‘Hey, there is investor demand. Instead of of direct into our fund, we can securitize.’
If they were to pick up that securitization, I would think you're going to get an even more compounded effect from this. And then maybe the fears about the risk of private credit will become more justified. Because — I'm maybe jumping ahead of another question — but if you think of macro impact on the economy and you think of risk, I would think the real risk of private credit is the leverage that's in these funds, which tends to be about one and a half, two times, most of the funds that have that sort of leverage.
That gets compounded by securitization of the loans in the funds. And we haven't gotten to that stage yet. So the actual leverage itself, I think [is] relatively low if you compare that to the public markets. I think investment grade leverage is still three, four times earnings as opposed to one or two times.
Joe (20:15):
I've brought this up in a few different conversations, but it always blows my mind so I keep asking the same question. But people like the fact that it's not on a screen. You mentioned that. And so there's this attraction to prices that I guess you don't have to look at every day, and if the market's red one day and the stock market's down 2%, but you look at your private credit...
Tracy (20:37):
It’s easy to be diversified if you're not trading on a daily basis.
Joe (20:39):
Yeah. It's like ‘Oh hey, my private credit exposure was totally fine!’ even though implicitly that's a lie. Here's what I don't get about that. So A) is that real, that premium that people pay for the appearance of non-diversification? And B) it seems to me that the people who should really pay up for the privilege of not having to look at their quotes are like individual retail investors who are prone to panic and selling at the worst time and buying at the top, etc.
But for the sophisticated investor, which I imagine is most people who are allocating to private credit, you know, they're not mom and pop, they're people moving serious money and sophisticated, like they're pros at this. Shouldn't they be able to bear to look at their portfolio on a day-to-day basis? Why do they need to not have the screen money?
Ben (21:27):
Yeah I know. And that actually has happened because if you take a step back and go to the fourth quarter of 2022, there was suddenly this news out that institutional investors in Asia were taking the money out of BCRED. And that was the first news of sort of this redemption starting. And that did spill over to the US and cause a little bit of a nerve, including with some of our clients.
We got redemption requests, and because it's a gated fund where they only pay out up to 5% of the total pool per quarter, and that's on an auction type basis, so you don't get your, the 5% is a pro-rata idea – I did think make people wary of that, to your point, it's not on the screen, it's not mark-to-market, but there are marks clearly. And if you follow the 10-Q, 10-K filing every quarter, you can see that the change of the value, this is what I do obviously, because I have to do this for my job.
And yeah, some stresses have built in over the last year and you could tell also from the spreads on those loans, they were, when I started at Newedge, somewhere in the three to 500 basis points over SOFR. More than 50% of the pools that I'm looking at right now are more like 500 to 700 basis points over SOFR. So a change has happened.
So I think the sophisticated investor looks at this similarly, saying ‘I'm getting wider spreads than in high yield. Almost double now, currently. And the marks are indeed somewhat deteriorating.’ Now the default rates stay low, that’s because of the total pool, that's how they present it, but if you break it out by different sectors, and a lot of these, by the way, these private credit pools are allocated significantly to software and healthcare.
And that's where the weaknesses have been in the economy. So you could tell that those spreads are wider than they were a year ago. There's also, I think from the marks on the loans from when I looked at different 10-K filings, yeah, some default rate picked up there. And some impairments have been reported that are also showing up.
And, again to the covenant and the control, that seems to be quite tight. And that I think is why it hasn't been a floodgate of redemptions coming out of these funds, but that it is ongoing, is, I think, a sign that people are looking at the asset class saying ‘We want more transparency, not so much opaqueness, I'd like to better understand what the liquidity truly is, and therefore I'm also reserved, cautious.’ So it's not all in private credit and it's fantastic and you don't have to do anything. I think there are a lot of investors out there that have caution.
Tracy (24:17):
What would be the proximate cause or catalyst for — this might be an unfair question — but the doomsday scenario in private credit? Because I keep thinking like, okay, one of the strengths of the asset class is that in some respects it's very illiquid and you don't have to mark-to-market on a daily basis. And so you can kind of withstand short-lived down cycles. But at the same time, I imagine if those pressures were to build up enough, at some point you would have to crystallize losses. At some point you would have investors running for the gates, per your example. So what would be the sort of trigger for that to actually happen?
Ben (25:04):
That's the burning question on the mind of every client I talk to about this. There's different ways to analyze that, I think, because on the one hand, as I described, there's some level of stresses building into these pools. And in a way you would think that maybe, just because of how the economy is evolving, over time it gets softer and weaker, and you get some impairments. There will be some companies that will be behind in payments.
On the other hand, it's about the liquidity aspect, that yes, people have tied it up their liquidity in that vehicle and want it out. And so that BCRED example is one example of people trying to maneuver the liquidity out and keep redeeming from it, with the good news that all these funds are gated. So you don't get a run on those funds because that would be the normal financial trigger – I have a hedge fund or ETF out there and people are like ‘Okay, this is wrong, I'm pulling all my money out.’ And that effect it could have on broader markets.
It's not the case with private credit funds. But I think that what people will look at carefully is the realization that the loans that they've extended to these companies, if there are issues with fraud cases or other types of issues, that that will become a trigger of realization of ‘Hey, there's actually been some deterioration of lending standards that have actually taken place.’ And as a result, investors start to react. They start to look at ‘Okay, I'm going to start redeeming more from these funds.’
Now there's little evidence of this currently, I think because of the state of the economy where we are, or there's not been much report on this yet. I want to mention this because as this podcast gets out there, the private credit fund managers will listen to this. One of the complaints I had was that the opaqueness of the funds is also expressed in that for some of these companies, there's very little information available.
So as an investor, I would want to know if I put $1 in that fund, and you're going to lend that out to company X, Y, Z that I cannot find any information on, I at least want to know what that company's really about. So I've been kind of messaging this to the different managers, but I think this is a concern, especially with other investors too. And probably it's one of those, what you say, ‘trigger’ ideas of, if it shows up more and more that we're lending to companies that we can find little information on, that would be a concern.
Tracy (27:26):
Yeah, and also there is clearly a tension in that part of the investment case of this asset class is the idea of lenders building really strong relationships with private companies, doing really good due diligence, and very like customized deals. But then it's weird if none of that work actually shows up for the end investor. Like, if there's no way for you to actually check it out, and you're sort of buying into it on blind faith almost.
Ben (27:54):
Yeah, you're buying into a pool of loans that is presented as ‘this is a low default vehicle, it's very steady in its yield and payout and therefore you don't need to worry about those nuances and details.’ And yet I think as investors you should worry about that.
Because, you know, in the end, the money that you put into that fund gets to those companies, and so that due diligence should really matter. And you get a lot of assurances that that due diligence process is watertight and the covenants are very strict. And I have to say, from what I read, that's true.
But we know from subprime lending, we know from other types of lending, that it could not always work out that way. Especially if you have an exuberance that we're dealing with currently. So the private credit market is in an exuberance phase currently, you know, because everybody's focused on it a lot and a lot of money is being allocated to it.
And nowadays, a lot of mutual fund companies, for example, are jumping to the opportunity too, coming very late in that race. And that would be interesting to watch too, right? Kind of how, if they're starting to become private lenders, what are their lending standards practices compare to the experts in that space, say, the well established firms like Blackstone and KKR and Blue Owl, who have years of experience with lending to private companies.
Joe (29:11):
I guess on some level this is every credit cycle, right? I mean in the sense that, at some point, people want to start lending money to people who can't pay it back. And then some people will make a lot of money doing that and then someone will lose a lot of money doing that. Can you talk a little bit more about the leverage and the fund structure? So Company X launches a private credit fund, hw much is it sort of like equity investors in that fund, and then how much would they theoretically borrow from some bank or someone else to add leverage, or sort of juice the fund? How does that work?
Ben (29:48):
Yeah. So you have this sponsor, a private equity firm. That's the main capital provider. And as the fund then gets launched, yes, they use intermediaries to fund. Because ultimately the companies who borrow from that private credit fund, they're facing essentially a bank. Same idea. But the private credit fund itself gets capital backing from a private equity firm, but still has to use intermediaries to raise the funds in order to lend.
Now on the other hand, it's also about, I think, the combination of other types of leverage. So what I've noticed was that a lot of these funds do partially invest that pool into CLOs. That's obviously where the financial leverage to an extent comes from. I found that interesting. Even though it's a very small portion, it tends to be like 1% to 2% of the total pool, but it's I think another source of their leverage of funding, if you call it. On the other hand, it's a very low leverage though, compared to other lending vehicles that are out there. I mean, if you talk about, say, the total notional of the fund, it’s levered one to two times max, most of them are more like one to one and a half.
Joe (31:07):
So they're not going crazy at this point.
Ben (31:09):
No. It's quite conservative. So that's I think why I’m not so concerned about the leverage unwind idea of like, what we've seen with SPVs during the financial crisis, right? Some off-balance sheet vehicle, 50 times levered, and it has to unwind, and we get all the disaster that follows. That I think that is not so much the worry.
It's more that opaqueness and the issue about lending to companies that although [they have] strict covenants, turn out to have issues that we didn't know about. And therefore we're dealing with the deterioration of the pool and we have to reassess the risk. And as I mentioned, if you could tell from the change of the spreads on those loans over the past year, then there's some risk that’s creeped in. So I think that's the bigger risk.
Ben (31:54):
But back to your original question, I think it's really the structure of having this sponsor company providing the majority of that capital, which is also maybe what gives a lot of clients confidence. Like you have a private equity company involved, that's kind of like a chokehold on a particular company, right? Because private equity is very keen on ‘We want our equity, so you're going to have to stick by these covenants that we set on these loans.’
And at the moment that there's a change they will come in and make changes to make sure that you stay current. But there's been examples that they actually have to take in what they call the keys of the company. The company can no longer do it and they have to take in the keys. And I think that's when the unwind process happens and where the private equity manager then has to just divest. And I think that's the other part of this risk, that turning in keys becomes more problematic, wider than this leverage unwound. So leverage is quite low.
Tracy (32:53):
Is there any way to short private credit? Because, well, if I think about a corporate bond, there are all sorts of ways, primarily using derivatives, but I could short a CDX index or something like that, or I could do an individual CDS tied to that specific bond? Is there something similar for private credit?
Ben (33:14):
Well, you would have to go back to the financial engineering. I think there's three ways to do it. One is to short the stock of the company itself. Now if you have shorted the stock of Blackstone, that would not have been a good trade. It was pretty bad. There is a senior loan ETF out there, several of them. So those are actually loans that are very similar if not coming out of private credit funds, you could technically short that. There's, I believe, even a private credit ETF in there that has invested in different private credit funds and bundled it in an ETF. So I guess that's another way of shorting it.
Joe (33:55):
Here you go. VPC?
Ben (33:56):
That's the one.
Joe (33:57):
[Virtu] Private Credit.
Ben (33:59):
I believe that's the one. But there's no derivatives on private credit or anything like that at this moment.
Tracy (34:05):
I sense an opportunity. Maybe just to bring it back to the macro impact, I mean, what does it mean for the functioning of the economy and the wider financial system if we now have this pool of money that really wasn't there before or, if it was there, it was in a different form. Like what does that mean for the future?
Ben (34:30):
Wow. On the one hand it's positive because we found an avenue to fund small mid-sized companies, without having banks involved in a way that, you know, could lead to more subprime lending and financial stresses, that could ultimately end up to the negative, to the detriment of those companies. Those companies of the private credit market have created competition too. So the regional banks are in more competition now with those funds, which lowers the cost of funding potentially.
And then as I mentioned, the cost of funding. I mean, currently that seems quite high. If you think of the all-in yields on those loans being anywhere from 8% to 11% to 15%, that’s quite high. But I think the other positive is that as much as there's high interest, these companies have a stable source of funding and are not dealing with any other sort of restraints, other than their covenants on that loan.
So therefore they can go back to that same source and keep tapping it as long as they continue to perform and return the loans, pay off the loans and make money as a company. So the macro impact I think is getting more significant, I think, in that sense.
It would be interesting to understand better though, the different areas where this lending is taking place. We can think of coastal areas as usual, just like with the residential mortgages, because as I mentioned, the big component in these pools is technology and software. So we know that that's obviously concentrated in East and West coast parts and maybe a little bit down South. But what would be interesting is that if there's more expansion in the industrial area, manufacturing area, through private credit, that would be, I think, meaningful in terms of the economy. So it is very much a stable source of funding, making credit available to companies that may not be able to get that elsewhere. I think that's the macro impact.
Tracy (36:30):
Alright Ben, thank you so much for coming back on Odd Lots and talking to us. Not bank lending this time, but an alternate form of lending. Appreciate it.
Ben (36:39):
Thank you Tracy, Joe, it was great to be on.
Joe (36:41):
Thanks for coming back.
Tracy (36:55):
Joe. That was really interesting. There was so much to pick out there. One of the things I keep coming back to is this idea of outsourcing the due diligence to a private equity company or a sponsor or something like that. And it's a bit of a cliche to reach for subprime, but Ben did mention it and it sounds a lot like the rating agencies, right? Like you're kind of relying on an entity to do that due diligence for you and maybe it'll work out, maybe it'll all be fine, but it seems like there's a big question mark there.
Joe (37:26):
I mean it kind of makes sense to me, just intuitively, that banks only have so much scale. And obviously there's only so much balance sheet that banks can allocate, how much they can lend out. But there's also going to just be a constraint on how much due diligence and how many relationships they can build and the types of industries that the individual bankers at the banks truly become familiar with enough to lend. And particularly for smaller companies that may not be mega fee generators, or whatever. So I guess intuitively it makes sense that we sort of see the breakup of the bank, and that more and more of the credit extension part would essentially be from individual specialist companies of various sorts.
Tracy (38:12):
Well and also going back to the regulation, I mean, again, by design, right?
Joe (38:17):
By design. Exactly.
Tracy (38:18):
Regulators decided they didn't want banks to take so many risks in the aftermath of the 2008 crisis. And so they put in restrictions on various types of lending. And a lot of that activity got squeezed to private credit, business development companies, that type of thing. So it makes some sense.
And to Ben's point, if we have basically established a way for small to medium-sized companies to get stable funding, this was always a concern in the public markets, right? That if you're a smaller or medium-sized company, you are probably not going to be issuing a massive leverage loan in the same way. A mega corporation can do it. So if there is an alternative, that seems like a good thing.
However, I still kind of wonder about that cataclysmic trigger, because it seems like the incentives are all really well-aligned for the time being. So if you are the lender, you can keep lending money because you don't want to crystallize a loss and take a default, and you have that relationship with the company. But if that ever changes, and we're talking about companies that don't have access to alternative forms of funding, they can't go to a bank and get a loan. Often that's why they're knocking at private credit store. I don't know. Maybe I shouldn't worry about the worst case scenario.
Joe (39:40):
No, I mean, I would maybe go down the middle on this question, which is that the worst case scenario will happen. In other words, at some point – because there have been banking cycles and credit cycles and people wearing the rose-colored goggles probably since the first loan was made. None of us really know the timing, but we definitely know that there will be some point in which lenders basically lend to bad credits, make loans. Maybe the terms are too nice, maybe the spreads are too narrow. Maybe the conditions end up being neglected. I mean we know this is a phenomenon, right? Maybe the terms and the conditions, the covenants are solid now, but it's only a matter of time before that deteriorates. The longer you go without defaults, this is how it's going to work. We don't know the timing, but it just seems like no matter what the lending category, at some point someone is going to come along and lend to bad borrowers at too favorable prices.
Tracy (40:43):
I guess the thing to watch out for is the leverage question. Like whether or not you start to see leverage built on private credit, at which point it would become a systemic issue.
Joe (40:53):
And securitization, allowing end investors, as Ben said, securitization, allowing them to sort of layer onto their own credit. This will happen. It will, we don't know when, it'll happen eventually, because this is what humans do.
Tracy (41:07):
A very philosophical start to the new year. It is true. Alright, I am just going to say that we are going to talk more about private credit and we actually have a really interesting guest lined up, something we've never done before.
Joe (41:20):
I'm excited about that one.
Tracy (41:23):
Hopefully that'll be out relatively soon after this one. But in the meantime, shall we leave it there?
Joe (41:28):
Let's leave it there.
You can follow Ben Emons at
@Marcomadness2
.