Is a private-credit meltdown the next financial crisis? | The Economist

If we start first then with what private credit  actually is. Mike, you're our Wall Street editor. Explain it to us. This is a it's it's actually a  surprisingly tough question. You ask two people, even two people working in private markets, and  you'll get three opinions as to what private. credit actually means. I think the the broadest  version of this is it's loans lent by firms that. aren't banks, alternative asset managers often,  and lending that's not done in the bond market. So anything that comes between those two things uh  is fair game as the broadest definition of private.

credit. It's typically bought by a third group.  Um so it will be bought by insurance companies, pension funds down the line. So the private  markets firms are originating this debt. There's a narrower definition that applies more  uh cleanly to transactions done between private. equity companies where a lot of the growth of  private credit has come. But that's it. It's more. illiquid than a lot of other forms of debt.  It's not as traded as definitely as corporate.

bonds. Uh it's not as traded as bank syndicated  loans. And it's also generally lent to midsize. slightly riskier companies. And that difference  in definition probably explains why thinking about. the size of the market is really hard as well.  I've seen estimates from $1.5 trillion to three. something like $3 trillion. But what we do know  is that this has grown very rapidly. Josh. So, so tell us about that. Yeah, so the big growth  decade for private credit was the 2010s and.

there were two factors driving that. Uh, one  was the pull back in bank lending that we saw. after the financial crisis due to the the uh more  stringent capital rules that regulators imposed. on them after the financial crisis. Private credit  institutions rushed in to fill that gap. But then. a second thing happened as Mike mentioned a lot  of this lending is to support buyouts done by. private equity firms and those boomed in the  2010s. So private credit both had this kind. of benign regulatory environment for their growth  and this boom that was happening that they could.

support. What's kind of interesting about that  growth is you think of kind of bank lending and. private credit lending as very separate. Actually  it's a lot of the same people. I was I was before. I was a journalist, I was working with some of  these private credit firms during the 2010s. And I remember being at a conference in about  2015 where we were talking about the amazing. growth of this kind of newly resurgent asset  class and somebody on stage said, "One sec,

but I'm looking around the room and I'm looking at  all of the people who do the lending decisions for. the private credit lenders and you know you used  to work at Lloyds and you used to work at HSBC and. you used to work at RBS and there was this kind  of sense that because regulation had changed the. lending had shifted from banks into private credit  institutions, but that's because the people making. these decisions had shifted and were kind of the  same people as before. So, it's it's kind of a way. in which the financial system changed while still  looking kind of the same from personnel wise.

And what's the appeal of private credit, do you  think? Um, if if you're an if you're an investor, if you're a buyer of these loans, well, I mean,  the returns to start with, you're talking about, you know, high singledigit often low doubledigit  returns. That's very nice. Um I I think to go. beyond that, one of the most appealing things and  one of the slightly unintuitive things is people. generally think of more liquid financial assets  as being more valuable, right? You can get in,

you can get out. That's not actually true for all  types of investors. And if you go to the sort of. conferences where people talk about these things,  there's actually not a huge appetite to see things. marked to market precisely because when things  start to go badly, you have to reflect that pretty. immediately on your balance sheet. You have to  start talking to your own investors about the fact. your assets are worth less. If they're not liquid,  you just often don't have to do that. So there is. actually a sort of illquidity premium. And I think  especially companies like life insurers, they just.

don't want to recognize the fact that these assets  might now be worth le worth less than their face. value worth less than they'd paid for them. So I  think that has actually ironically driven quite a. bit of the growth. The fact that it's private  thinly traded has been an advantage to some. of the big investors. Now, what you had late last  year was a private credit fund called uh OBDC2 uh. issued by a company called Blue Owl. Now, you may  not have heard of Blue Owl. It's not a household.

name. It is increasingly uh in the financial  media now. It's a big alternative asset management. company. It's grown from about $50 billion under  assets under management in 2021 to more like 300. billion today. So, it's really really aggressively  expanded. It's a big player in private credit. this vehicle was seeing more redemptions than  the fund wanted to satisfy and it said, "Okay, no more redemptions." It tried to organize  a tie-up between that fund and another fund.

Didn't really work. And earlier this year, assets  from three funds at Blue Owl, including uh OBDC2, uh were sold. So, they said, "We're selling  uh $1.4 billion worth of assets. We're going. to redeem these investors. they're just going to  be redeemed in chunks as we see fit. And as they. said, as you said at the beginning of the episode,  they they closed the fund down. This has sort of. accelerated the feeling of of panic. Even though  these assets were sold for effectively face value,

it's just crystallizing a moment of concern about  what's really going on. People are worried about. asset quality. They're worried about the ability  of other completely unrelated semi-liquid vehicles. to to fulfill these investor requirements. And I  think that's really fueled the problem. So it's. that semi-liquid vehicle that's the really  important one where they've tried to merge. something liquid and something illquid and ended  up with something that's maybe not satisfying for. anyone. And um not a week seems to go by without  more stories about redemptions from from funds.

Josh, where where else have we been seeing this?  So OBDC2 is the really kind of noteworthy one, but you know news is trickling through all  the time. Absolutely. Yeah. So after OBDC2, we've seen funds gated at much bigger firms at at  ones that are kind of verging on household names, right? So Apollo, uh, Aries have have limited  withdrawals, funds run by Morgan Stanley who. have limited withdrawals and Black Rockck as well.  Uh, Blackstone went in a different direction. So.

Blackstone also faced a wave of withdrawals, but  they decided uh, not to impose their 5% cap. They. decided to wave that rule and basically uh give  all the cash back to investors that they de they. demanded which ended up being about 7%. But in  order to do that their own executives stumped up. the cash to to give it back to investors. I guess  what we're seeing it's kind of a it's a knock on. effect from the fact that people don't really  know what went on at Blue. You know, maybe this.

was a kind of an idiosyncratic problem at one fund  whose liquidity arrangements didn't quite work. But because we don't know because we don't know  whether it was that or a kind of more potentially. widespread problem with this semi-liquid model.  That's what's making investors panic. That brings. uh me to a question from Alfred Hills uh who  who asks whether there's a systemic risk here. from private credit. Allah the 2008 crisis and  how does the size of the problem compare to the.

subprime meltdown and say the Leman story. And  I have a bit of a be in my bonnet about this. 2008 comparison because I I feel like it can be  a little bit of a straight jacket when thinking. about financial shocks. It's like asking someone  how was your day and and you know the previous. year they'd been hit by a high-speed train or  something and it's like your day is always going. to be relatively good relative to the day you  were hit by a train. It's maybe never going to. be as bad as that. Two key points to me. One is  that these assets aren't perceived as safe and.

they never have been. Everyone knows they're  risky. Now, maybe they're riskier than people. thought they were. But actually, when it comes  to the most severe financial crisis, in my view, it's the assets people think are safe that are the  problem, not the assets people think are risky. If. you think a mortgage bond is safe, you're willing  to leverage massively up against it. That was one. of the problems in 2008 in the Euro crisis.  People thought Portuguese government debt was. the same as German government debt. It wasn't.  And it's when the thing that you thought you.

were being conservative about becomes extremely  risky. Nobody thinks that about private credit, right? And so the leverage ratios involved are  nowhere near where they were. The other side. of that is that you won't see this all  come in one blow up. The opacity of it, the slow burning nature of it means it it may  crop up for quite some time. So it may be that. we're years down the line and you realize some  of these insurance products are maybe not as well. backed as you would have liked them to be. You can  see the economic impact, I think, trickle out for.

quite a bit further. It won't be a a one moment  explosion like the collapse of Layman Brothers.