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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Private credit has been getting it in the neck. Even before Jamie Dimon piled on last week with a warning about the magnitude of potential loan losses, some investors were getting increasingly miffed to discover an asset class that supposedly offers outsized returns in return for illiquidity turned out to be [checks notes] illiquid.
But while poor investor returns and an inability to exit might be upsetting for investors, this is not really what financial system worrywarts care about. The reason the IMF, BIS, and various major central banks have been focusing on private credit is because they see it as new and untested, opaque, with the potential to amplify monetary transmission and contribute to financial stability risks. So when a new paper came out arguing the opposite (to at least the last of these points), Alphaville’s attention was piqued.
Franz J. Hinzen, Paul Rintamäki, Giorgio Mondini, and Sascha Steffen argue that rather than amplifying credit supply shocks, private credit has so far worked to dampen them.
They start from the premise that borrowers are going to borrow. And the sort of borrowers that borrow from private credit funds are the same sort of firms that borrow in the broadly syndicated loan market.
As background, the US BSL market, at around $1.5tn, is a little larger than the US high yield bond market, but a little smaller than the US private credit market. It’s reckoned to be around three times as cyclical as old-fashioned bank lending, and the kind of firms that borrow in the BSL market, just like those accessing private credit funds, are mid-sized sub-investment grade companies.
Examining over eighteen thousand loans issued into the private credit and BSL markets, the authors found just over a quarter of borrowers had funded from both markets at some point over the past two decades. Furthermore, this share has risen to almost half of borrowers over the last couple of years:
Leveraged loans tend to come with lower spreads than private credit loans. So surely any borrowers with the choice will tap the BSL market? Maybe. But remember, it’s also a pretty choppy market, financed by things like collateralised loan obligations, demand for (and from) which is highly cyclical.
When leverage loans turns squally, the academics found borrowers heading over to private credit land. The authors have t-stats and p-stats to provide strong evidence linking private credit activity to lending standards and excess premiums in the leveraged loan market, as well as log CLO volumes. We could show you their Newey-West robust standard errors to account for heteroscedasticity and autocorrelation of residuals. But we think this line chart tells their story without the need for Nurofen:
When the cost of leveraged loans rise and availability of this channel of finance diminishes, so the proportion of borrowers switching to private credit increases. And when leveraged loans become cheaper and the market opens up, switching slows.
As such, at a headline level, private credit lenders “behave counter-cyclically, expanding their market share when traditional leveraged loan markets tighten”.
And looking at the firm level, they find that borrowers switch from BSLs to private credit during periods of credit market stress — basically using private credit as a backstop. They find this to be especially true of PE-sponsored borrowers, “consistent with the hypothesis that financial sponsors actively steer portfolio companies to the most available liquidity source.”
Having a backstop wall of money has been great for borrowers. And it has meant that private credit has worked as an ameliorating rather than an exacerbating force in the credit cycle, dampening rather than amplifying monetary transmission, taking the edge off the credit cycle, and curbing financial stability risks.
As long as the private credit wall of money continues to seek out market share, we’re reasonably persuaded that the asset class will continue to be a counter-cyclical backstop. By implication, should its impressive fundraising streak be interrupted for whatever reason, we’d expect this backstop to fall away.
Much of the official sector’s analysis so far has focused on the size and scope of private credit’s presence in the financial ecosystem. This paper’s interesting because it, in effect, asks what the asset class’s absence might mean.
Further reading:
— Everything you always wanted to know about credit (but were afraid to ask) (FTAV)
— Who cares if private credit goes kaput? (FTAV)
