In the world of credit, "there's nothing new under the sun. Lending and borrowing are an ancient line of work," said Jim Grant, founder and editor of Grant's Interest Rate Observer.
Which is why he's warning pension funds and other institutional investors to proceed with caution when investing in private credit.
"What's new this time is the intensity of competition," he said. "Credit sounds respectable. But it's the same as an IOU." Grant's long been a contrarian on Wall Street, and lately has said inflation isn't going anywhere, and that rates will remain at a permanently higher level.
Private credit newcomers have not been through a complete boom-and-bust cycle, Grant said.
"Competition is likely to lead to less thorough due diligence and reduced returns. Private credit quality is weaker, almost by definition, than in the public markets."
Grant has other concerns about what Bloomberg data shows is now a $1.7 trillion private credit market, including the high returns. BlackRock in 2023 forecast that figure will balloon to a $3.5 trillion market in five years.
"The dispersion of terrific outcomes comes in part from the dispersion of marks on the loans" in private credit. There's no secondary trading and thus "no public visibility, and that's the basic yellow light of this asset class. It's a little in the shadows."
His concern is highlighted in a Fitch Ratings report noting private credit borrowers face "higher debt service burdens from rising policy interest rates and slower EBITDA growth amid macroeconomic headwinds." Most private credit lenders "have yet to experience an observable stress event to test their acumen, as much of their growth occurred in benign economic periods."
When the direct lending private credit market traversed the $1.7 trillion in assets mark, Andrzej Skiba took notice.
Skiba, head of U.S. fixed income for RBC Global Asset Management, is not investing in private credit; he expects to see a wave of defaults this year. He has concerns about private credit being in bubble territory. So does PIMCO, which has said it will only invest once the bubble in private credit pops.
"That $1.6 trillion number includes a lot of animals," Skiba said, including private debt issuers in infrastructure, special situations, distressed, mezzanine funds, and business development companies, or BDCs. The latter two have now grown to be a substantial portion of the total private credit pie, and "we do see excesses," he said.
"We struggle to reconcile a few things. In 2023, a few quarters ago, a fair amount of people expected a recession. I heard people say to stay away from public, high-yield junk bonds, but that private credit is a safe haven. What is the rationale? That makes no sense."
His other misgiving: "There's no mark to market," or transparent pricing, in private credit.
"Managers can charge higher fees or originators can charge more fees than in public securities," he said.
There's no doubt the risk-reward of the private credit asset class is attractive.
"Banks are no longer able to invest because of regulatory changes, and the midcap space is moving away as well from banks to direct lenders," he acknowledged.
Aksia estimated that returns across hundreds of diverse private credit investments typically range from 7% to 15% annually, according to a 2023 report.
Some worry about the lack of public ratings, while others say that's been the industry practice for years.
"There's very little transparency. There's a whole other debate going on for criteria to rate those instruments. Are they conservative enough?" Skiba asked.
Ratings agencies Moody's Investors Service, Fitch, Kroll and S&P Global Ratings now offer expanded private credit ratings in an effort to keep up with the growth.
However, there's little regulation of private credit at the federal level, he noted.
Private credit veterans point to their long history in the asset class.
"One of the appealing things to companies in borrowing here is you don't require a rating," said Stephanie Rader, global co-head of alternative capital formation at Goldman Sachs Asset Management. In public markets, "you go through a ratings process, a pre-market process, and then the actual syndication. In private credit, it's bilateral agreements between one or more lenders. It doesn't require a ratings process. It leads to swifter execution and less operational complexity."
Her view is that the private credit opportunity "will deliver. Pension funds are underallocated and are looking to increase exposure."
Goldman Sachs manages roughly $110 billion in private credit assets, including direct lending, mezzanine and hybrid funds, she said.
Many pension funds and insurers are expanding into private credit, says Matt Douglass, senior managing director at PGIM Private Capital. But they should consider players who've been "through many cycles. A lot of the capital has formed since the global financial crisis— they haven't been tested yet. We know how to manage illiquid situations. You can't trade your way out. We've done this for over three decades and through many credit cycles." PGIM manages $1.3 trillion in assets, of which $300 billion is private market alternatives; $200 billion of that is real estate, $100 billion of private credit and $3 billion in private equity secondaries.
Antonio Rodriguez
One pension fund executive believes private credit has a role in portfolios, but in a high-rate environment, private credit funds may be extracting returns from other asset classes.
Antonio Rodriguez, director of investments at Building Service 32BJ Funds, a $10 billion pension fund system, is building out an internal team and moving the plans away from an OCIO model and into an in-house team overseeing the portfolio. He was previously with the New York City Board of Education retirement system.
Rodriguez said that among the 11 funds in the 32BJ retirement system, four invest in private credit.
The question for pension plans, as Rodriguez sees it, is "what are you replacing with private credit? Some pensions and institutions historically focused on private equity, and that money might gravitate to private credit. But private credit does move you up the risk spectrum."
Now that financing costs have skyrocketed, Rodriguez said, private credit funds "can't lever up as much, or the borrowers pay more and more interest. For any one deal that doesn't matter. But from a portfolio perspective, if I'm in equity and debt, where are my returns coming from?"
Rodriguez talks with peers in pension funds about the returns on "our private credit portfolios, mostly direct lending, being really high. Are (private credit investments) extracting that from our private equity investments, with sponsored lending? The cost of financing is higher, and private credit managers dictate the terms — by its very nature that financing cost can be passed on to their customers. Where does that land us as investors" in both credit and equity funds, he asked.
In prior decades' low-interest-rate world, pension funds' fiduciary duty to generate returns for their retirees might have pushed them to use alternatives to public markets, RBC's Skiba said.
At that time, "documentation was strong, and excess compensation for investing in those assets was significant. It made sense," Skiba said.
But in a high-interest-rate environment, and "from a fees standpoint, you're better off in public high yield. You don't have to make a bargain with the devil for those extra returns."
