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

if we start first, then with what private credit actually is. Mike, you are Wall Street editor. Explain it to us. This is a it's actually a surprisingly tough question. You asked 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, is fair.

game as the broadest definition of private credit. It's typically bought by a third group. So it will be bought by insurance companies, pension funds down the line. So the private market firms are originating this debt. There's a narrower definition that applies more, 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. It's not as traded as banks indicated loans. And it's also generally lent to mid-sized, 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 tell us about that. Yeah. So the big growth decade for private credit was the 20 tens.

And there were two factors driving that. One was the pullback in bank lending that we saw after. the financial crisis due to the the, 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 20 tens. 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 is 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 20 tens. 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 set.

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 Orbis. 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 kind of a way in which the financial system changed.

while still looking kind of the same for personnel wise. And what's the appeal of private credit? Do you think? If you're in it, if you're an investor, if you're a buyer of these loans? Well, I mean, the returns to start with, you talking about, you know, high. single digit, often low double digit returns. That's very nice. 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 mark 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. that your assets are worthless if they're not liquid. You just often don't have to do that. So there is actually a sort of illiquidity premium.

I think especially companies like life insurers, they just don't want. to recognize the fact that these assets might now be worthless, worthless in 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 ob Dc2 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, 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 ob Dc2 were sold. So they said it was selling, $1.4 billion. worth of assets were 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 closed the fund down. This has sort of accelerated the feeling of the 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 illiquid. and ended up with something that's maybe not satisfying for anyone. And, 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 OB Dc2 is the really kind of noteworthy one. But you know, it's trickling through all the time. Absolutely. Yeah. So after IBC two we've seen funds gated at much bigger firms, at ones that are kind of verging on household names. Right. So Apollo areas of have limited withdrawals, funds run by Morgan Stanley have limited withdrawals and Blackrock as well. Blackstone went in a different direction.

So Blackstone also faced a wave of withdrawals. But they decided not to impose their 5% cap. They decided to waive that rule and basically, give all the cash. back to investors that they did not they demanded, which ended up being about 7%. But in order to do that, their own executives stumped up the cash 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. It blew out.

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 kind of more potentially widespread problem with this semi liquid model. That's what's making investors panic. That brings me to a question from Alfred Hills. Who who asks whether this is 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 Lehman story? And I have a bit of a bee in my bonnet about this 2008 comparison, because I feel like. it can be a little bit of a straitjacket when thinking about financial shocks. like asking someone, how was your day? And, you know, the previous year they'd been hit. by a high speed train or something. Yeah. Your day is always going to be relatively good relative. 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 crises, 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 were 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 one moment explosion like the collapse of Lehman Brothers.