Private credit boom leads to new crisis

If this is the “golden moment” for private credit, where will things go? What are the risks? High interest rates and turmoil at regional banks early this year have fueled growing confidence in the recovery of private credit. The market is expected to grow from $1.6 trillion this year to $2.8 trillion, according to data provider Preqin. BlackRock adopts a more optimistic view, predicting that the market will grow to $3.2 trillion.

Mark Rowan, CEO of private equity firm Apollo, sees “de-banking” in its early stages, while John Gray, Chairman of BlackRock, coined the phrase “golden moment” to describe conditions in private capital early in the year. The current one.

If we consider the new banking rules under Federal Reserve regulations as a catalyst, the capital required to support the commercial banking industry in the United States has the opportunity to increase by as much as 35%, according to Oliver Wyman – the world’s leading management consulting firm – and it is no wonder what Jamie Dimon said. , the head of JP Morgan, said that private credit providers “will be very happy.”

How things evolve in the market will be a pivotal issue, not only for large companies and banks in the private market, but also for traditional asset managers who have begun to exploit the capabilities of the private market to avoid the extreme rise of passive asset management. This coincides with at least 26 traditional asset managers purchasing or launching new private credit units in the past two years.

This transformation confirms the extent to which the structure of the financing market has changed. I mentioned, 20 years ago, in a research paper when I worked at Morgan Stanley, that investor flows would be divided into something similar to a barbell. On the one hand, investors would flock to passive, exchange-traded funds to obtain record returns that were cheap and comfortable. On the other hand, investors seeking higher returns will leverage asset allocation with specialized fund managers who invest in private assets, hedge funds and real estate. As for traditional “core” fund managers, trapped between the two, they will be under pressure to modify their investment engines to become more specialized, or to merge together to increase their sizes, which has already been achieved.

ETFs have grown from $218 billion in 2003 to $10.3 trillion last October, according to ETFGI, but what is surprising is how unbalanced the situation has become in terms of revenues, with half of management fees in the investment industry likely to go toward… to alternative asset managers in 2023, up from 28% in 2003.

Central banks are currently reducing their quantitative easing, which they implemented to support economies and markets, which in turn supported the profits of traditional companies. Without these tailwinds, the pressures on fund managers will become more severe. So, how will the transition to private credit proceed?

Currently, Preqin estimates that just 10 companies have accounted for 40% of private credit resources in the past 24 months. There are three reasons why private credit growth may asymmetrically favor these larger companies.

The first is that a good amount of growth is expected to come from regional banks’ sales of investment portfolios that need to reduce their debt, and often forcefully sell good assets. The Fed’s new rules indicate the inability of large banks to advance. Purchasing these assets is a specialized endeavor, in light of the large portfolio sizes and the speed required for transactions, which is in the interest of large companies that are able to guarantee the risks.

The second is that the increasing size of deals requires more money, and August saw a new record for the largest loan, which reached $4.8 billion to the financial technology company Finastra. The third, and most important, reason is that banks want to enter into partnerships so as not to lose access to customers. While stricter rules likely herald a need to divest assets, banks will want to continue lending and partnering to help manage deal flows, which in turn will benefit larger companies.

Several large banks have already concluded deals, and more are expected to follow. Citi is the latest bank that reports indicate its intention to launch a new unit in 2024.

The changing interest rate regime means that loan losses will rise as financing costs normalize and weak balance sheets are revealed, which will be a source of challenges for private credit providers. New companies trying to capitalize on growth may be imprudent. This requires selectivity and a strong focus on the risks and returns of deals, and it also requires expert teams in reconciliation, which many of the major players in the market have.

Certainly, there will be niche opportunities, such as distressed debt or energy infrastructure lending, which are places where talented institutions can tap, but they may not be of the scale needed to boost opportunities for traditional companies.

In general, a complete and comprehensive change in the allocation of capital awaits us, which requires a major shift towards private credit, according to what Howard Marks recently said, but the coming tide will not smooth all boats.