One hundred and three years ago, in his seminal book on investing, Edwin Lefèvre wrote: “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills.”
You’d be forgiven for forgetting that if you were paying to attention to the rise in stature of the once-hot realm of “private credit.”
Private credit over the past decade gave every indication of being an enviable invention. Major asset managers such as Blackstone and Apollo, as well as upstarts with names like Blue Owl, amassed a trillion-dollar pool of investor money to make loans to companies that they said traditional banks wanted to avoid. Private credit firms said they could take reasonable risks while also producing high returns for their investors.
This year, however, the narrative has lurched in the opposite direction. Traders, investors and even some private credit executives say the industry expanded far too quickly and extended tens if not hundreds of billions of dollars in loans to borrowers — particularly those in software-adjacent businesses — who won’t be able to pay them back.
Since the start of the year, investors have gotten nervous about the prospect of rising defaults, and many of private credit’s biggest players have blocked investors from getting their cash back. This week, Blue Owl announced more limits on its largest publicly traded funds, including one in which 38 percent of investors tried to withdraw their money:
How did this all begin?
Private credit is essentially a rebranded version of high-interest-rate lending that was first popularized under the term “junk bonds” in the 1980s and later became a subset of “distressed” or “special situations” investing.
In prior iterations, these practices centered on banks, which amalgamated money from deposits and divvied out loans. This had advantages — it was heavily regulated and relatively transparent — and disadvantages, in that it put the banks’ ordinary savers at risk.
Laws enacted after the 2008-9 financial crisis made it far more difficult for banks to be directly involved in such loans. The demand for financing from fledgling companies didn’t disappear, so private equity firms stepped into the void under the name private credit and began lending money.
What’s the problem?
One short-term challenge stems from how private credit firms raised money to lend out. In a zeal to collect enough money to make loans, private credit firms aggressively and successfully sought cash from individuals and retirees. They promised monthly updates on investment performance (which the funds have universally reported as superlative, although they have wide latitude in that area) and regular opportunities to cash out.
Until very recently, the industry was growing so fast that funds were able to pay out investor withdrawals with cash from new investors, as opposed to having to sell down investment portfolios or otherwise tap the proceeds of their loans.
That is no longer possible, as investors overall are now pulling more money from the industry than they are putting in.
Jamie Dimon, chief executive of JPMorgan Chase, wrote in his annual shareholder letter this year that “private credit does not tend to have great transparency or rigorous valuation ‘marks’ of their loans.”
He added, “It has always been true that not everyone providing credit is necessarily good at it.”
JPMorgan itself, along with other banks, stands to suffer to a degree because it has lent to the private credit firms. Moody’s, the credit ratings agency, said in a recent report that banks had $1.4 trillion of loans outstanding to private credit lenders.
Will Washington step in?
The Trump administration has proposed rules that would permit “alternative assets” such as private credit in 401(k) plans. That could be an enormous help to asset managers in this space looking for new cash to replace their exiting investors.
Paul Atkins, chairman of the Securities and Exchange Commission, has endorsed the move. Before joining the government last year, he was a member of the board at Cliffwater, one of the largest and now most pressured private credit players.
Jerome H. Powell said in April, when he was still the Federal Reserve chair, that he was watching private credit “super carefully” but saw no reason to panic. His successor, Kevin M. Warsh, has not addressed the topic since his May swearing-in.
What’s next?
During the first half of this year, several private credit funds capped withdrawals at 5 percent per quarter, even though investors asked in some cases for eight times that much money back.
Private credit lenders say that by limiting withdrawals, they are avoiding having to sell any assets at a loss to raise money to back investors. They argue that over the long term, these investments will perform well, and that borrowers will be able to repay the principal at the end of the loan terms.
(Until the loans are sold or a company defaults, any losses remain theoretical.)
In the meantime, the private credit fund managers continue to collect a flat “management” fee on the size of their loan portfolios — another reason to keep investor money longer.
If they don’t, in the end, pay back all of what they say they can? Predicted Mr. Dimon: “You should assume that retail investors, even though they were told about some of the risks, will seek remedy in the courts.”
