Two separate reports point to potential problems with private credit.
One is from Goldman Sachs Asset Management, LP, which interviewed and quoted several top private asset management executives, including Howard Marks, co-founder and co-chairman of Oaktree Capital Management, and Michael Arougheti, co-founder and chief executive officer of Ares Management Corporation.
Arougheti said most private credit “is direct lending to small- and medium-sized businesses largely owned by private equity sponsors”. So private credit and private equity, are in fact, intimately interwoven.
The other report, from Moody’s Ratings, also notes that many of the companies on its distressed debt watch list are predominantly owned by private equity and “serve as proxies for the upper‑tier issuer segment of private credit”. According to Moody’s, actual defaults within this group have been limited “but distress remains persistent”.
It’s enough to wonder if there are parallels with the events that led to the global financial crisis in 2008. According to Marks, there isn’t.
He acknowledged that the structure of typical direct lending investment vehicles “introduces serious concerns around pricing and liquidity” but added that “I don’t see the same systemic exposure here as was the case in the run-up to the GFC”.
He said that “because demand for private equity was growing, demand for financing from private lenders to lever up transactions was also increasing”, leading to the gold rush that created the current situation where “the vast majority of firms engaged in direct lending today not in business 20 years ago”.
Private lending is inherently harder to manage than private equity. Private debt needs to be continuously serviced, unlike private equity investments, where company management can be left to run and enhance the business. And, as Marks said, “lending can be done well or poorly”.
Despite the alarming questions it raises, the Goldman Sachs report broadly concludes that current stresses in private credit do not amount to a systemic risk on the same level as the global financial crisis.
According to Marks, the fundamental creditworthiness of underlying indebted companies, low levels of leverage on private credit funds, and the absence of counterparty risk between private credit funds should act together to insulate the wider financial system from a collapse in the asset class.
That said, prospects for a painful default cycle are still very real, which may prove quite distressing enough for current investors in private credit.
The final outcome may be a healthier, more prudent private credit environment, but there is likely to be plenty of short-term pain to offset that long-term gain.
