Tread carefully in private credit

PRIVATE credit has been a favourite among high-net-worth investors, thanks to a strong push by private banks. It offers a steady and attractive yield; you are likely to be invested with a respected manager; and you may even enjoy some liquidity through an evergreen fund. What can go wrong?

In recent months, however, concern has been rising over this asset class, which came into its own after the 2008 financial crisis.

Following the recent bankruptcy of car-parts supplier First Brands Group, JPMorgan Chase chief executive Jamie Dimon warned that more “cockroaches” may be lurking in areas of credit.

Participants in the private debt market bristled at this, but the reality is that there has been a surge of monies into the asset class, now estimated by some to exceed US$3 trillion in total assets.

As more funds are pitched to retail investors, pressure is rising to deploy funds quickly, and underwriting standards are likely to suffer.

Morningstar chief research and investment officer Dan Kemp said: “Most people seem to agree that there is more capital being invested in private credit than there are currently opportunities to deploy the capital at high returns. That means returns are coming down.”

Questions are being raised over credit quality, but getting a handle on this is challenging due to the lack of transparency and timely valuations. Morningstar noted in a report that net inflows into unlisted business development companies (BDCs) have risen despite falling returns. BDCs are a vehicle for investors to access for private credit assets.

In the nine months to end-September, the median unlisted public BDC returned 6.2 per cent, lagging the Morningstar US High Yield Bond Index’s 7.2 per cent return, and matching the Morningstar US Core Bond Index at 6.1 per cent.

This surely was not what investors signed up for, given private credit’s limited liquidity and high fees. Credit risk spreads have tightened and with the US Federal Reserve set to reduce interest rates, returns are likely to slide further.

The prospect of lower income could spur funds to take on higher risk. S&P Global has sounded a warning over the “alarming surge in selective defaults”. The traditional default rate, it said in a September paper, is narrowly defined as missed payments or bankruptcy.

“It often overlooks instances like conversion of cash-pay interest to PIK (payment in kind), amortisation holidays or maturity extensions without adequate offsetting compensation.” In a PIK arrangement, interest payments are deferred and added to the principal.

Lincoln International, which values private loans, noted an uptick in the proportion of “bad PIK” loans, where borrowers resort to PIK arrangements which were unavailable at the deal’s close. This is an indication of financial stress.

The proportion of private credit deals reviewed by Lincoln that were bad PIKs has reportedly reached 57 per cent, Fortune reported; this translates into a shadow default rate of 6 per cent, up from 2 per cent in 2021.

To be sure, nine months of performance data do not make a trend. Still, investors would be prudent to tread cautiously in their search for yield.