PRIVATE-CREDIT FUNDS ARE SHOWING SIGNS OF STRAIN / THE ECONOMIST

Private-equity firms

Private-credit funds are showing signs of strain

Some panicky investors are running for the exit

An illustration of multiple safes arranged in a circle, toppling into one another like dominoes, with banknotes spilling out as they fall. / Illustration: Fortunate Joaquin

Buttonwood Tree Capital buys Main Road Incorporated, a manufacturing company, for $1bn. 

Who picks up the bill? 

One half is settled with cash from Buttonwood’s latest private-equity fund, whose investors have locked up their capital for a decade. 

The other, the “leverage” in this leveraged buyout deal, is borrowed from America’s credit markets.

Historically the fund’s first call would be to bankers at Goldman Sachs or Deutsche Bank, who would gladly cover the cost of the deal before selling the debt to investors as either bank loans, which have floating interest rates, or junk bonds, which typically have fixed ones. 

But in recent years Buttonwood’s partners have opted instead to cross Park Avenue and borrow from one of their own competitors.

The latter is private credit: private-equity firms borrowing from other private-equity firms to buy companies. 

This simple trade, which was relatively rare a decade ago, is now the cause of much alarm in posh offices on Wall Street and drab ones inside central banks. 

The outstanding stock of such loans is tricky to measure but is about as big as the markets for leveraged loans ($1.4trn) and junk bonds ($1.5trn).

The rise of private credit partly reflects regulation that reduced risk-taking by banks after the global financial crisis of 2007-09. 

Unlike leveraged loans and junk bonds, private loans never expose a bank directly to borrowers. 

Firms like Blackstone and Apollo have been transformed from private-equity houses to credit superstores whose main business is lending.

Cracks have started to appear in business-development companies (BDCs), a type of fund which raises money from retail investors to make private loans. 

BDCs were created by Congress in 1980 to expand lending to small businesses, but became huge by financing private-equity buyouts. 

In aggregate their assets, and those of similar funds, have ballooned from $230bn at the end of 2021 to nearly $600bn now (see chart).

BDCs come in two flavours. 

Traded BDCs allow investors to buy and sell their shares in the fund on the stockmarket, as they would an ordinary company. 

Private BDCs, which involve more novel structures, do not. 

Such funds grow by issuing new shares through wealth managers to individual investors, who can sell them back to the fund once a quarter at a value set by the fund manager, the net asset value (NAV).

Sell the stake, not the fizzle

Investors have decided they hate both. 

One reason is that a combination of lower interest rates and an excess of capital chasing deals has caused the returns of BDCs to fall. 

Another is that during the past decade private-equity funds have spent one in every three dollars buying technology firms, which means BDC loan portfolios are similarly exposed. 

During the first buyout wave, in the 1980s, Main Road would have paved roads; today it sells traffic-management software. 

None predicted how quickly artificial intelligence would alter perceptions of the business models of such firms.

Investors in public BDCs can simply sell their shares. 

But a gulf has opened between what lenders say shares in their funds are worth (the NAV) and what investors are willing to pay for them on the stockmarket (the share price).

Funds with assets of more than $3bn trade at a median discount-to-NAV of 25%, compared with 16% at the start of the year and almost no discount a year ago. 

KKR, the investment firm whose buyout of RJR Nabisco, a food and tobacco conglomerate, was immortalised as a symbol of the excesses of the 1980s, now partly manages a fund called FS KKR Capital Corp.

It can be purchased for less than half of its NAV. 

One interpretation is that rates of return for BDCs will be lower than their cost of equity. 

Put differently, investors believe the value of their loans is overstated.

Holders of private BDCs also want out, but face a different problem on their way to the exit. 

They can get the price they want in theory, since their shares are always redeemed at NAV, but there may not be a market in which to sell them. 

Private BDCs allow their managers to limit redemptions to 5% of shares each quarter, to avoid selling illiquid loans in a panic. 

Redemption requests now exceed that limit, causing panic, which in turn is causing more investors to ask for their money back.

The problem is not, as some have suggested, so much that investors do not understand what they have bought. 

It is more that asset managers cannot decide what they have sold. 

Some see the 5% limit as the hard rule that, contractually, it is. 

Ares, Apollo and BlackRock each limited redemptions to 5% in their private BDCs during the first quarter despite requests of 11.6%, 11.2% and 9.3% respectively.

Others have strained to please their investors. 

The largest single BDC, launched by Blackstone in 2021 and now managing an astonishing $83bn of investments, redeemed 7.9% of its shares in March, partly by injecting $150m of cash from its staff. 

Oaktree allowed 8.5% of shareholders to leave one of its funds last week, paying some of them with cash from Brookfield, the asset manager’s parent firm.

The messiest such case is Blue Owl, a lender focused on tech firms which has grown from $50bn of assets under management in 2021 to more than $300bn today. 

In January it allowed more than 15% of shares in one of its funds to be redeemed in the hope that investors would be satisfied that the fund had adequate liquidity. 

That has not stopped them running for the exit. 

Blue Owl suspended redemptions at another fund which it appears to be winding down. 

Shares in the asset manager have lost two-thirds of their value since their peak at the beginning of last year.

The spiral of redemptions is likely to continue for as long as investors can redeem their shares in private BDCs and buy shares in similar funds at a discount on the stockmarket. 

They would be foolish not to. 

The more investors who exercise this option, the more others will worry that the best loans will be sold to meet redemptions. 

While funds dangle the prospect of exceeding the 5% cap on redemptions, those who limit them will cause panic.

Some funds are particularly vulnerable. 

Cliffwater, a relatively unknown asset manager, reportedly faced redemption requests of 14% for its corporate-lending fund this quarter. 

It has grown from less than $20bn of assets in 2023 to $42bn today. 

Rather than making loans to companies like most funds, around 40% of its holdings are other investment vehicles. 

Private BDCs make up 8% of its total investments. 

Not only does that add another layer of leverage on top of these funds, but it creates the possibility that redemptions by investors in Cliffwater’s fund could cascade through other funds. 

At the end of last year one of its largest investments was in a private BDC run by Barings, in which it owned almost a third of all shares.

Who PIKs up the tab

The turmoil has inspired righteous disbelief among lenders, who contend private credit is in fine enough fettle. 

True, capital being yanked from some funds has been offset by inflows from new investors. 

And more than once private markets have caught flak for loans they didn’t make. 

First Brands, a car-parts company, and Tricolor, a lender (both alluded to last year as “cockroaches” by Jamie Dimon, the boss of JPMorgan Chase) had mostly borrowed from banks rather than private-credit funds before they were accused of fraud and collapsed into bankruptcy.

A common defence is that the loans in private-credit funds are nowhere near as distressed as the market thinks they are. 

The number of borrowers conserving cash by tacking their interest payments onto a loan’s principal rather than settling in cash—known as payment in kind (PIK)—is not much higher than a year ago. 

Lincoln International, an investment bank which values assets for many private-credit funds, says critics ought to distinguish between firms with “good PIK”, where firms are utilising a long-standing option not to pay interest in cash, and “bad PIK”, where the option was added later. 

(Surely, though, “good PIK” can be exercised by companies that are downright bad.)

One analyst at Bank of America was more direct. 

“Media still obsessed with private credit”, ran the headline of a note dismissing concerns about the industry earlier this month. 

At the same time traders at the same bank were recommending their clients bet against European financial firms exposed to private credit (it later withdrew this recommendation).

Other banks are pitching similar wagers to hedge funds. 

Traders with long memories say that a wave of corporate defaults is overdue. 

Only a short memory is needed to become seriously worried about the loans held in private-credit funds. 

Before central banks raised interest rates in 2022 private-equity funds were frenetically striking deals at high prices. 

The 25 largest buyouts of publicly traded software firms between 2019 and 2022 were consummated at nine times the target firm’s revenue. 

Today the median listed American software firm trades at three times revenue.

Eventually the debts taken on in these deals need to be refinanced: much like governments, companies that borrow heavily are at the mercy of their lenders’ judgment. 

According to S&P, a rating agency, the median software company held by private-credit funds has borrowed around eight times its annual earnings. 

Half of these firms have negative cashflows.

Managers of private-equity funds could argue that they just need to invest in the companies they own to make them worthy vehicles, rather than helpless victims, of AI disruption. 

But they will probably struggle to convince lenders of that. 

The industry has only a middling reputation when it comes to actually improving the operations of the companies it owns. 

And when software companies fail, lenders fear they will end up being left with office chairs, MacBooks and unopened snacks. 

What intangible assets software companies do hold are maintained by workers who, in such a case, would have seen their own shares in the company become worthless. 

The prospect of lower rates of recovery on defaulted loans will push up interest rates, making defaults more likely.

But before lenders lose a penny, investors in private-equity funds must lose their shirt. 

These investors are an unlikely set of scholars, schoolteachers and sheikhs. 

Ivy League universities were sold on private equity back in the 1980s. 

Around 40% of their massive endowments is invested in such funds. American public-pension pots and sovereign wealth funds from the Middle East are also up to their knees.

The next-biggest losers are private-markets firms themselves. 

If simple structures like BDCs can cause so much trouble, what future is there for the more exotic vehicles they want to sell to retail investors, like exchange-traded funds which hold private assets? 

Nevertheless, on March 30th America’s Labour Department announced a proposed rule enabling 401k retirement accounts to invest in private assets. 

Just in time, cynics say, for institutional investors to offload their unwanted stakes in private-equity and credit funds.

Shares in private-markets firms have fallen by more than a quarter this year. 

The ratio between the market value of Goldman Sachs and Blackstone is a good proxy for the transformation of American finance from a system dominated by banks to one reliant on investment firms. 

After five years of being worth roughly the same, Goldman Sachs is now worth nearly twice as much as Blackstone, as it was for most of the 2010s (see chart).

If the pain stops there, among investment funds and their managers, regulators will congratulate themselves on a job well done. 

Yet none are celebrating. Instead, the complicated links between private credit and the corners of the financial system where failures can be catastrophic make them question how much safer the redesigned Wall Street really is.

Start with the banks. 

In recent years banks have been keener to lend to other lenders than to make loans directly to risky companies. 

Over the past decade loans from banks to non-bank financial institutions have grown three times as much as have their total assets.

That includes to BDCs. 

For every dollar a BDC raises from investors, another is borrowed either from the bond market or banks—similar to the buyout deals which they ultimately finance. 

Researchers at the Federal Reserve estimated that at the end of 2024 banks had committed to lend $87bn to BDCs. 

JPMorgan Chase and Wells Fargo are among the busiest lenders. 

So are smaller American banks and big European ones. 

Despite falling outside the 50 biggest American banks EverBank holds the 17th-biggest book of loans to non-bank financial institutions (EverBank is itself owned by private-equity investors). 

Barclays and Deutsche Bank have both said that a little more than 5% of their loans are to private-credit funds.

Then there are the insurers. 

Private credit and life insurance have transformed each other. 

Apollo started Athene, its insurance arm, in 2009. 

A decade later its rivals started copying the idea. 

Today all the large private-markets houses either own insurers outright or have agreements to manage huge swathes of their assets. 

The logic is simple: insurers invest in illiquid assets with higher yields, and asset-managers get scale to more efficiently make those loans and collect fees.

Struggles in private-equity portfolios would show up in two corners of life insurers’ balance-sheets. 

One is collateralised loan obligations, which pool mostly bank and, increasingly, private loans into tranches and sell the risk to insurers (and also to banks, often in Japan). 

At the end of 2024 they represented 4% of assets owned by life insurers, according to Moody’s, a rating agency, but as much as 18% at one firm, Security Benefit.

In the second corner is a pair of mechanisms used by insurers to invest in private-credit funds: rated-note feeders, where insurers are awarded a high credit rating while investing in private funds; and collateralised-fund obligations, which pool stakes in private-markets funds. 

According to KBRA, a rating agency which works on both, new issuance jumped to more than $17bn and $26bn respectively last year.

Keeping bankers sour

These numbers look reassuringly small. 

But it is easy to imagine a scenario where the complexity of this rewired lending system ceases to be a virtue. 

If the run on BDCs continues, funds would call on their undrawn loan commitments from banks to meet redemptions. 

In such a case it is likely banks would begin to dispute the fund’s valuation of the loans. 

What happens next depends on the terms of the bank’s loan. 

Sometimes banks can simply mark down the portfolio and demand more collateral. 

More often a third-party valuation firm is called in to settle the messy dispute.

Life insurers are not funded by runnable deposits like banks, but thanks to weak regulation the industry’s relationship with private credit has taken on new wrinkles of complexity that obscure risk. 

The use of private ratings for their assets is one. 

In 2024 Egan-Jones, an upstart rating agency, reportedly rated more than 3,000 assets with just 20 analysts.

Another wrinkle is the use of offshore finance, which has exploded. 

Assets reinsured in the Cayman Islands, where oversight is notoriously poor, have increased from $23bn in 2020 to $101bn today. 

Then there are the derivatives that life insurers buy to protect themselves against movements in interest rates. 

In a shock insurers could quickly find themselves selling illiquid private assets to cover margin requirements on these interest-rate swaps.

When credit markets convulse, traders often search for a historical guide. 

The worried money is settling on two. 

One is the end of the 1980s junk-bond boom, when life insurers exposed to high-yield bonds collapsed (it was from the lifeless carcass of Executive Life, an insurer, that Apollo got its start buying distressed debt). 

Another is the end of the shale-oil boom in America in the mid-2010s. 

Back then highly leveraged oil companies, rather than software firms, were the biggest borrowers. 

The fallout caused yields on junk bonds to reach double digits in 2016. 

That should worry software investors.

The strangest thing about credit markets today is that while one segment is coming under pressure, another is booming. 

The divergent moods reflect the same technology shock from AI. 

Between them Alphabet, Amazon, Meta and Oracle have sold around $220bn of investment-grade bonds since the start of last year to fund their investments. 

CoreWeave and Nebius have issued risky bonds to build data centres for big tech. 

Securitisation of debt tied to these factories is at record levels.

These parallel stories in credit markets ultimately rely on the same investors, which means the sheer volume of new debt will push up the cost for everyone. 

They also involve the same lenders. 

Blue Owl is a big lender to data-centre projects. 

So is Blackstone. 

One view is that these firms have successfully moved on to the next big thing. 

Though how much longer the boom will continue is hard to know. 

The cost of insuring against defaults on Oracle’s bonds has soared recently. 

Not a cockroach, but perhaps a canary.