Why Some Large Private Credit Funds are Struggling

Private credit is an established and valuable asset class for yield-seeking investors. But some large blue-chip investment managers like Blackstone and Blue Owl have recently taken write-downs in their private credit offerings. The asset class remains strong, but certain private credit strategies are inherently flawed.  

Private Credit Goldrush

Prior to the Covid-19 pandemic, inflation and interest rates were very low.  Investors who traditionally would have held bonds for their income potential were discouraged by the low yield and wary of the inevitable price deterioration that would follow a rise in interest rates.

Private credit was an attractive alternative for yield-seeking investors.  Fund managers, unburdened by the regulatory capital requirements facing banks, could make loans to non-investment grade businesses at higher interest rates and pass that return on to investors.  Private credit funds employing minimal or no leverage could return 8% or so when bonds were yielding almost zero.  Private credit became a hot asset class.

As the asset class grew, the large global fund managers launched their own offerings.  They raised tens of billions of dollars, with some raising over $20 billion in a single fund.  It was a gold rush and the big players were determined not to miss it.

The Deployment Challenge...

Having successfully raised a large private credit fund, there is a significant challenge to deploying the capital.  In a public markets strategy, deployment is relatively straightforward, even at scale. Assets can be purchased on a screen from deep, liquid traded markets. But a private markets strategy requires the manager to source investments or lending opportunities that by definition cannot be found on a Bloomberg terminal.  It’s hard work, and origination and due diligence costs can be high.  And the more capital one has to deploy, the more difficult the challenge.  Private debt investors expect yields exceeding the public bond markets.  A portfolio manager holding a stack of T-bills while searching for investment opportunities is under intense pressure to deploy the capital – and quickly.

… Leads to Strategic ‘Drift’

To get cash deployed and generating yield, private credit managers should search for transactions within their stated investment strategy and when those opportunities are discovered, make investments.  However, for a multi-billion dollar fund it is a very difficult challenge to get fully deployed.  Individual deal sizes, by practical necessity, need to get much larger, often hundreds of millions of dollars. 

Companies that are credit-worthy at that level will likely have other options other than private credit. They may have access to a corporate banking facility, the broadly syndicated loan market or maybe even the high yield bond market, all of which offer much lower cost financing than what is typical in private credit.

Faced with competitive price pressures from banks, public markets, and broadly-syndicated loans as well as the pressure to deploy capital at pace, managers of large private credit funds may drift off-strategy with unattractive compromises:

- Holding Cash

From a credit perspective, it is clearly preferable to hold cash until suitable deals can be sourced rather than making unsuitable deals.  However, a manager that fails to deploy capital will see fund returns decline and investors become frustrated.  Investors expect private credit level yields, not cash yields. Understandably, few private credit managers hold cash for any extended period.

- Increasing Deal Sizes

There is an axiom in banking and lending that it’s just as much work to underwrite a $100 million loan as it is a $10 million loan, so one might as well focus on the $100 million loans.  This fails to appreciate that increasing deal size reduces portfolio diversification, which is a critical risk mitigant in private credit portfolios.  With a diversified portfolio, no upside potential is surrendered, but downside risk is significantly reduced.  Conversely, a concentrated portfolio of large deals is inherently riskier.  Despite this, we have observed a trend among larger private credit managers toward larger deals.

- Adding Leverage

As managers find themselves pitching deals to larger, higher quality borrowers, they end up having to compete with lower cost credit products, such as senior loans or high yield bonds.  To win the deal, the manager may lower price but in doing so will reduce the yield to its investors.   Adding leverage to the fund can partially compensate for this.  However, borrowing capital to add more assets means that the investors’ subordinated capital is exposed to more risk.  This may not be fully understood by investors who assume they are taking credit risk but are unaware that that risk is being compounded by leverage..

- Reducing Credit Standards

This is the area of greatest concern particularly when coupled with larger deals and leverage in the fund.  As the large managers have found themselves attempting to attract high quality borrowers, one of the tools available to them is the ability to offer more flexible deal structures to borrowers than would be available in the syndicated loan or high yield markets.  When managers talk about ‘flexible’ deal structures, what they are really referring to are reduced credit standards.  Removing or relaxing credit covenants can be attractive for borrowers but adds risk which might not be fully contemplated – or compensated - by the interest rate charged.   Similarly, some lenders offer payment-in-kind (PIK) interest which allows a borrower to defer all interest payments until final payment of the loan.  Again, borrowers love this because it greatly improves their cash flow but investors are taking on much greater credit risk.

In a nutshell

With the recent growth in private credit and the emergence of very large private credit funds, managers have grappled with how to deploy such large sums of capital.    When a manager increases portfolio concentration through larger deal sizes, adds leverage, and reduces credit standards, the probability of losses inevitably increases.  It is therefore not surprising that a number of these funds have struggled recently.

Investors can protect themselves from unanticipated risk by understanding the strategy and its source of yield prior to investing and then monitoring their investments for changes in strategy. Kilgour Williams Capital has long espoused a rigorous approach for private credit investing (see for example, “Don’t get fooled in Private Credit”).  We would welcome any inquiries about how our strategy is designed to avoid these pitfalls.