CHG Issue #189: Private Credit Crisis
Private Credit may be concealing the real systemic risk in the US credit market
There has been some chatter about a potential credit crisis resulting from private credit. My first reaction to this is to roll my eyes because it is the classic behavior of looking at the last crisis and predicting it will happen again. The next crisis is never like the last crisis. The germ of a crisis is neglect, not hyper-vigilance.
Crises are surprises, they are not something you hear people talking about on CNBC before they happen. While CNBC has broadened its reach to cover all viewpoints, the recent focus on private credit makes it unlikely that any surprises will be coming from this space soon.
This principle operates on the notion that for anything to grow large and fragile enough to incite a systemic crisis, there must be unequivocal assurance in its resilience. This absolute confidence renders the thing susceptible to unforeseen events due to lack of preventive measures or excessive confidence. Conversely, heightened concern about potential issues tends to mitigate their occurrence.
Stability breeds instability
Hyman Minksy
Aside from this the most obvious reason why private credit is not a systemic threat is that it is not held in large amounts on bank balance sheets. The housing crisis wouldn't have resulted in the GFC if all the banks hadn't been holding multiples of their capital in mortgage-backed securities that ultimately took huge losses. Private credit today is largely owned outside of the banking system so a credit event within the private credit market is not going to reverberate through the economy in the same way the housing crisis did. To understand the stakes, we need to look to the overall corporate credit market, it’s structure, and key players to understand the dynamics that may result from a contraction in credit.
The amount of outstanding US corporate bonds was $11.2 trillion (38% of GDP) at the end of 2024 according to SIFMA while the US leveraged loan market was $1.4 $trillion (4.8% of GDP) according to Morgan Stanley. This compares to the US High Yield market of more than $1.5 trillion outstanding in mid-2024. According to SIFMA the high yield market saw just over $300 billion of issuance in 2024 compared to $1.6 trillion for corporates and $1.3 trillion for the leveraged loan market. The new issuance in the US leveraged loan market represents almost a full turn of the market as refinancing and repricing drove new issuance. This frenzy of activity in the loan market has been driven by the rising interest rates which increase the demand for floating rate bonds and the popularity of private credit investments.
In their Q1 High Yield and Bank Loan Outlook Guggenheim draws attention to an interesting trend in the speculative grade credit market that has been underway for nearly a decade: The average credit quality of the high yield market has been increasing as lower-credit borrowers are increasingly funding their businesses in the bank loan market. This has caused the average credit rating of issuers in the bank loan market to fall with the average bank loan borrower a single-B credit today. At nearly 40% of GDP the corporate bond market represents a systemic threat, however because less credit-worthy borrowers are increasingly funding their operations in the bank loan market the risk in the corporate bond and high yield market have decreased while the risks are accruing in bank loans.
In today's market the label "bank loan" is a misnomer as most of these loans are not held on bank balance sheets. While banks may originate these loans for their private equity sponsors, who are the borrowers for nearly half of the loan market issuance, they typically sell these loans to investors or securitize them in the CLO market. Japanese investors rank among the biggest investors in CLOs today alongside traditional US investors like insurance companies, money managers, and hedge funds. It is these investors who ultimately bear the risk in these bank loans.
As the traditional bank loan market has grown and transformed private equity borrowers have increasingly launched funds of their own to make these sorts of loans themselves. This is what has come to be known as the private credit market today. This growth in credit availability for less credit-worthy borrowers has been a tailwind for the private equity industry as it has allowed them to refinance or reprice their heavily indebted portfolio companies an average of 2.3 times and it has allowed them to pull equity out of these companies through dividend recapitalization transactions. However, the tailwind for PE sponsors is starting to represent a headwind for debt investors as there has been a divergence in credit performance between the loan market and high yield bonds.
Rapid growth, easy credit conditions, scandalous pricing, and now diverging credit performance is conspiring to fuel the present fears of a private credit crisis. Borrowers have taken more interest rate risk through the shift towards more floating rate issuance which leaves them vulnerable to higher interest rates. At the same time, investor demand for floating rate debt has allowed borrowers to reduce near-term default risk by terming out their borrowing but has also put pressure on interest coverage ratios.
While the near-term refinancing risk in the market has decreased, the high leverage still leaves the market vulnerable to a drop in growth or recession. While the debt backing these companies will be at risk, the private equity funds that own these highly indebted companies are first in line to take the losses.
In terms of systemic risks, the large private equity companies like Blackstone, Apollo, Carlyle, and KKR likely present more of a systemic credit risk than the private debt market itself. These four alone make up nearly $3 trillion in AUM (10.3% of GDP) and are the marginal capital provider for a large swath of the US economy. The trio of Blackstone, Apollo, and KKR have outpaced the broader market since the depths of the pandemic with only Carlyle slightly lagging the market after the recent downturn. As these companies have grown, they have spread their tentacles into the far reaches of the financial system with firms like Apollo venturing into more traditional industries like insurance through its subsidiary Athene which was the largest issuer of annuities in 2024 with $36 billion in sales.
Given the growth and far reach of these firms, a significant credit event in their portfolios could have far-reaching impacts across their businesses and as a result the US economy since these companies have become systemically important cogs in the US economic machine. Our friend Jared Dillian has been on top of this for some time and created a Drudge-themed website called “Short Private Equity” to document not just the growing fragility of these firms but also the deleterious effects they have on their portfolio companies.
Amongst the largest investors in private equity are family offices and university endowments. Some of the largest family offices are those of the PE founders themselves but those investors tend not to be as heavily invested in PE funds as other family office investors. This is mostly because the founders already have a large exposure to their firms and utilize their family offices to achieve diversification, but the more "institutional" family offices generally don't focus as much on traditional GP/LP funds because they seek more active or direct investments, partly to avoid the high fees and lack of control in GP/LP funds. Alternative investments, headlined by PE funds, have been a staple of the university endowment investment model pioneered by David Swenson of the Yale endowment. However, recently it seems that these universities may be rethinking that model as it has been reported that several are seeking to offload significant portions of their PE holdings.
It is important to remember that one person's debt is another person's asset so when we talk about deleveraging and credit crises it is important to understand who owes what to whom. After nearly two decades of stimulative monetary and fiscal policies, the tide started turning with the record Fed rate hikes in 2022. The stock market and private equity market have been supported by the credit markets over this time and all sorts of excesses have accumulated. Companies have been able to fund their operations with increased amounts of low-cost debt but as the ability to continue to do so diminishes the risk of deleveraging in the corporate sector increases. Given the current dynamics in the US credit markets and concentration of risks in the portfolios of a few large private equity firms, the risk of a deleveraging turning into a systemic crisis hinges squarely on the fates of these firms.
Cedars Hill Group is a boutique investment bank built by investors. We invite you to explore our Knowledge Base to learn more about how you can run your business or portfolio like the best.
At CHG, we connect clients and experts to drive innovation and solve complex problems in today's fast-paced and rapidly changing financial markets. Get in touch to learn how we can help you navigate your financial future.