Financiers fret over ‘leverage on leverage’ in private credit By Reuters

Written by Paritosh Bansal

(Reuters) – For some elite financiers gathered in Los Angeles for a Milken Institute conference, excessive debt in private markets reminds them of the risk-taking days before the 2008 financial crisis.

In the halls of the Beverly Hilton Hotel and in meetings across the city last week, I spoke with more than a dozen investors, bankers and fund managers involved in the booming $1.7 trillion private credit market, in which investment funds lend private equity firms and other corporate money. . Many financiers fear the consequences of accumulating debt in this market, which often operates outside the sight of regulators.

Of particular concern to them are loans to private equity funds against portfolio companies that have already been leveraged, lending that has grown rapidly as a longer high interest rate environment hinders these companies' ability to sell assets.

In many cases, money is raised to pay dividends to investors in these funds, such as pensions and endowments, to meet payment demands, financiers said. This also enables fund managers to ask investors for new funds, generating more fee income. In some cases, the funds are used to support distressed portfolio companies or to invest in them for growth, and to finance new acquisitions.

“Now that we have a real gap in their ability to exit a lot of these (investment companies), they have struggled with cash flow,” said David Hunt, CEO of $1.3 trillion Prudential Financial (NYSE:). PGIM director, referring to private equity firms. “In order to deal with that, they've now added leverage to the fund level. So, they have leverage on leverage.”

“They're trying to get liquidity everywhere they can get it, and we're not participating,” Hunt said, pointing to the loan market for private equity funds as the place to look for “something that would squeak in the night.”

Private credit has grown significantly over the past few years, as banks have drawn down their balance sheets due to tightening regulations. Major fund managers such as Oaktree Capital Management, Apollo Global Management (NYSE:) and Ares Management (NYSE:) as well as Wall Street banks such as Goldman Sachs and Morgan Stanley are active in the market. In the United States, the amount of private credit is now comparable to leveraged loans and high-yield bond markets.

The sheer size of the market means that excessive debt and financial engineering are causes for concern, as losses from an economic slowdown or other shocks could threaten broader financial stability. Moreover, market ambiguity can undermine confidence in the system and complicate regulatory response if problems occur, as has been evident in shadow banking debt issues elsewhere, such as China.

One financier said they attended a recent forum where regulators from some of the major agencies were asking about the links between banks and private credit markets to try to understand what was going on, both for the health of the banking system and for their own. Ability to intervene if they need to.

Downside protection

To be sure, some financiers have said that while deflation could lead to losses and reduce investor returns, the chances that problems in the private credit market will lead to a broader financial crisis are low.

One said that even though their company would be writing large checks worth hundreds of millions of dollars, they had spent time properly underwriting the loan and writing protection. For example, in their dealings with more sophisticated private equity firms, they build in protections that prevent the borrower from removing assets from the loan's collateral pool or prevent them from incurring further debt.

But this person and other financiers said that may not be true in the market. During a panel discussion, Tony Yoseloff, managing partner at Davidson Kempner Capital Management, cited Bank of America data to say that 22% of direct lending borrowers generated negative operating cash flows, and that 8% of them had enough cash for two years or less.

Lower returns

Rapid growth means increased competition, with more money and players flowing into the private credit market. There is also renewed competition from public markets. As a result, the interest lenders can charge on these loans has shrunk in recent months, and some have said there may be a race to the bottom.

Many expect the default rate to rise in light of the economic slowdown and lead to lower recovery rates for lenders.

While many financiers said their investors are pressuring private equity firms for loans to pay their dividends, leaving them with no choice, Christopher Ellman, outgoing chief investment officer at the $336 billion California Teacher Retirement System, said he'd “rather see them.” “They don't add leverage.”

“General partners do it themselves,” Ailman said, referring to general partners or fund managers. “They're used to 2% management fees, and this market is completely frozen.”

Once they pay dividends to investors through the loan, “they come right back and ask you to recommit to this next fund,” he added.