So, if I’m following: Banks are lending to private equity firms to fund purchases of businesses.
Many of these businesses are SaaS which means their valuations are tumbling.
It seems possible that valuations tumble so much that the private equity owner no longer has any incentive to operate the business, bc all future cash flows will belong to the bank. What happens in practice then? Will banks actually step in and take operational control? Will the banks renegotiate terms such that the private equity owners are incentivized
to continue as stewards? Or, will they prefer to force a business sale immediately?
> Banks are lending to private equity firms to fund purchases of businesses.
Yes some businesses are SaaS but here's the real problem: Many businesses' sole purpose is _leveraged buy-outs_ which really is the devil in disguise.
It goes like this: A VC specialising in veterinary clinics finds a nice, privately owned town clinic with regular customers and "fair" prices, approach the owners saying "we love the clinic you've built! We'll buy your clinic for $2,500,000! You've really earned your exit!".
So now the VC lends the money from the bank, buys the clinic, and here's the important part: _they push the debt onto the clinic's books_. So all of a sudden the nice town clinic has $2,500,000 in debt, raise prices accordingly, ~~burn out personnel~~ slim operations accordingly, and any surplus that doesn't go to interest and amortization goes straight to the VC.
> So all of a sudden the nice town clinic has $2,500,000 in debt, raise prices accordingly...
From a financial engineering perspective this is wrong.
Both equity and debt have costs of capital. Debtholders expect interest, capital holders expect RoE. The money going to debt interest is money that would previously have gone to equity, but now does not because the equity is replaced with debt.
Crucially, the costs of debt is lower than the cost of equity because of the interest tax shield. Therefore, the vet clinic now requires less revenue to maintain or even increase its return to equity.
> now the VC lends the money from the bank, buys the clinic, and here's the important part: _they push the debt onto the clinic's books
This approximately-correctly describes an LBO. They are done by PE firms. Not VCs. And the debt isn’t “pushed” onto the company’s books, it’s never on the sponsor’s books in the first place. In many ways, it’s capital-structure arbitrage.
Private credit, on the other hand, involves e.g. Blue Owl borrowing from a bank to lend to software businesses, usually without any taking control or equity. It’s fundamentally different from both LBOs and VC. (Though some private credit firms will turn around and lend into a merger or LBO. But in that capacity they’re just competing with banks again. Not VC.)
They're not so silly as to have any personal or professional liability, they probably spin up a special purpose vehicle or llc to hold the bag if it all goes south
The usual arrangement for an LBO is to saddle the bought company, the vet in this example, with the debt,or spin off a secondary company from the vet with the poorest assets and most to all of the debt. It's all a scummy business.
If the VC borrows money from the bank and lends it to the clinic, the clinic is not on the hook to the bank. The clinic is on the hook to the VC and the VC is on the hook to the bank. Which means that if the clinic goes under, the VC takes the loss because it still has to repay the bank.
Nope. The clinic is the collateral to the bank. VC stand to loose nothing.
It does not happen overnight. But what happens is after they take control of the clinic or company they change the sales model to boost reoccurring revenue, this then allows the clinic or target company to take loans out. Because they look good on paper. The company then pays VC back when then pays bank back.
This can be done in about 6mo to 1 year process with some companies. The initial out of pocket expense is small and paid back very quickly.
I also forgot. Sometimes they will take the newly owned company and merge it. During that process they extract more money and load more debt onto the remaining entities, again making the VC money.
In some cases they can even get huge tax benefits by loading the company with debt which offsets the tax bill of the final entity.
When these transactions are done, within the span of a day multiple companies are created and merged and absolved.
So yes, PE funds are probably overvalued right now and there are a lot of PE funds getting rich off management fees while not providing promised returns...but this comment is so wrong I don't know where to begin.
First, VC stands for venture capital, which is a subset of private equity that does zero LBOs and doesn't even acquire any businesses. VC funds buy equity in startups, and take on zero debt to do so. You have your boogiemen totally confused.
Second, the entire point of a PE fund that uses a leveraged buyout strategy is that they need to sell the acquired firm at a profit to make any returns to the fund. LBO funds don't 'cashflow' businesses, and saddling a business with a bunch of debt is antithetical to that purpose anyways.
Third, this is not "risk free revenue." It's a high risk strategy to use the debt to increase the value of the business by improving operations enough that you can sell it for a profit to the fund. If you saddle a company with debt and DON'T increase the value of the business beyond the debt you took on, the PE fund will not be in business for fund 2.
The risk-free revenue while the fund is alive comes from the management fees that investors in the fund pay (usually 2%, which is way too high IMO, but has nothing to do with the debt or the acquired businesses).
Please do not write confident sounding comments about things you don't understand, it spread misinformation and makes the internet a worse place.
It is absolutely possible (and even likely!) that a bad PE fund was the cause of the issue you're talking about. But there is also a media hysteria around PE, and a lack of understanding among the general public of what it is.
It's just as likely the business that was acquired was already failing or unsustainable to begin with (hence why the owner wanted out at low multiples). LBO funds don't acquire promising businesses at 5-10X revenue like tech companies do, they usually buy businesses at low multiples that are past their prime or failing in an attempt to revitalize them (with debt, since you can't raise capital by selling equity in a failing business).
Obviously this will not always work out great, given the trajectory of target companies was already not great to begin with. Momentum is the strongest factor in all markets.
The problem is, Private Equity has become a conspiratorial catchall boogieman and scapegoat for every problem under the sun, so it's hard for me to assess without further details of the situation.
Nit: beta is the strongest factor in all markets. Which is actually relevant for the success for PE funds in general, as a rising tide lifts all boats and people taking on debt to finance equity generally post outsized returns in bull markets.
Anyway, the rest of the stuff you're saying I agree with.
Yes, beta is the overwhelming source of returns. I was referring to factors in the sense of the University of Chicago research on market inefficiencies (where momentum is the strongest factor for inefficiency).
If you buy a “factor-weighted” etf the idea is it’s tilting you into those “factors” away from pure beta like buying whole market.
PE you could argue is largely just leverage plus an illiquidity factor play, since if PE just returned beta (which these days it might!) you’d be smarter to buy the S&P500 with equivalent leverage and not pay crazy fees.
Background: I work for a PE-owned company and I have friends in PE (associates up to MDs).
On your second point: LBOs aren't the only tool in the toolkit, and it's not as popular as it was decades ago, so I would lean towards the parent simply conflating "buying an ownership stake in a business in some capacity using other people's money" with the strict definition. Regardless, yes PE firms need to figure out how to get 20%+ IRR throughout a short timeframe (usually a 5 year holding/funding cycle) -- however this is through any means necessary. Philosophically, it's about increasing efficiency of operations and growing the business. In practice, it's financial engineering because PE firms do not have the operational skills to make any value-added changes to firms besides driving costs down.
Saddling a business with debt is reductionist. I've seen absolutely nonsensical financial structures that make no sense for a layman, but in practice end up "using the business' finances to 'own' (beneficially) the business" (see: at the most vanilla, the strategy of seller financing in SMBs). No this is not technically "putting debt on the books" but it is in all practical respects a novation/loan transfer that can leave the purchased co financially responsible for servicing any debt that was used in its purchase.
On your third point: what I wrote above can be used as context. It's not risk free revenue, frankly it's very risky unless you're in an inflationary environment where your assets will grow regardless of your business operations solely because the overarching economy is growing and you're riding a tailwind. However, it again boils down to financial engineering. It's not as simple as assets - liabilities = equity. The calculations used to determine valuations are so ridiculously convoluted. The amount of work that goes into financially analyzing businesses and finding "loop holes" that can justify higher prices is the core business model. The debt factors into it, but there's ways to maneuver around it through various avenues.
For example:
* debt-to-equity conversions (reclassification of debt as equity)
* refinancing
* sale-leaseback (selling company's assets to a 3rd party and using that money to pay down the debt, then leasing the equipment back)
* creative interpretations of what is actually debt (e.g. reclassifying real debt as a working capital adjustment or a "debt-like")
* dividend recapitalization (a nasty trick of loading the company with debt, paying that out as a dividend to the holdco, then selling the company at lower enterprise value. They still extracted value for their LPs/investors, despite the exit being lower)
* separating the debt from the operating company into a different holding company that services the debt
Private equity is a huge inflation driver. I'm thrifty, and for years I enjoyed a $10/mo phone provider, ~$12.39 with taxes. I even evangelized this carrier with some young parents who were struggling to get financial traction while paying off student loans.
Our affordable plan came to an end when the rates tripled! Turns out a private equity firm bought the company, jacked the rates on every customer, and sold it off again. This was not a fundamental cost being passed on in slightly increased fees -- it was private equity extracting millions from the people who can afford it the least. Across my financially optimized life, I see this happening repeatedly.
Personally, I can afford a more expensive cell phone bill. But I would imagine that many who have a $10/mo plan do not have many other options. I would like to punish the banks who are funding attacks on consumers. If by no other means, then by letting them fail.
> Banks are lending to private equity firms to fund purchases of businesses
Not quite. Private credit is to debt what private equity is to equity. (Technically, any non-bank originated debt that isn't publicly traded is private credit. Conventionally, it's restricted to corporate borrowers.)
So bank exposure to private credit generally means banks lending to non-banks who then lend to corporate borrowers.
You'll find plenty of talking heads on YouTube right noe claiming exactly this. Time will tell if private equity is actually wound up as tight as housing was in the GFC.
I don't think you're wrong if the following holds true: Before the housing bubble burst, banks lent funds to countless borrowers who couldn't, ultimately, afford their mortgage payments (because the banks didn't do their due diligence when underwriting the loans). This was widespread across pretty much every bank and mortgage banker. Not sure of the actual percentage of borrowers who, when all was said and done, had no business getting a mortgage for a house or condo, but suffice it to say it was well into the double digits percentage-wise (there's much more to this than simply banks and borrowers with Wall St. playing a major role in the collapse, but just keeping things simple).
In this private credit situation the analog for the banks are these private credit funds that have raised the capital they've lent from institutions and high-net-worth individuals (as opposed to banks, which have funds from consumer deposits). The analog to the individual mortgage borrowers from 2008 are actual companies.
To connect the dots, if the private credit funds were like the banks pre-2008, where due diligence was an afterthought, then this could turn out to be similar. So the real question is: are the borrowers (businesses in this case) swimming naked? Or do you believe the private credit funds when they say they actually conducted a good amount of due diligence when extending their loans? Once you know the percent of the companies that are naked you can evaluate whether this could/would end up similar to 2008. Nobody knows that yet, even, I suspect, the private credit funds themselves.
> This is just another form of that "shadow banking" system isn't it?
Private-credit lenders are literally shadow banks [1]. But I'd be cautious about linking any shadow banking with crisis. Tons of useful finance occurs outside banks (and governments). One could argue a classic VC buying convertible debt met the definition.
That said, the parallel to 2008 is this sector of shadow banking has a unique set of transmission channels to our banks. The unexpected one being purely psychological–when a bank-affiliated shadow bank gates redemptions, investors are punishing the bank per se.
Wouldn't they still owe interest to the banks on the money they borrowed, as well as the money they borrowed? I mean if all the money I make goes to the bank to pay off my mortgage my solution is not quitting my job, even though life is not very good under that situation.
Imagine you got a loan to buy a bunch of laundry machines to run a laundromat. But your laundromat earns $8,000 a month, and the loan payment is $10,000.
You can decide to sink $2,000 of your personal money into the laundromat every month, or you can give up.
Trouble has been brewing in private credit for quite a while, but lenders and investors have been reluctant to write anything down, resorting to all kinds of "extend and pretend" games to avoid write-downs.[a]
You can always tell when there is a problem. When things are fine the companies keep the profits to themselves. When things start to get dicey - foist it off onto retail investers.
Private equity (PE) is increasingly being introduced into 401(k) plans, driven by a 2025 executive order encouraging "democratization" of alternative assets. - Google AI
It's why as a retail investor, never buy things that would otherwise have not been available to you (but was to those "elite"/institutional investors previously).
Think pre-IPO buy-in. Investors in the know and other well connected institutional investors get first dibs on all of the good ones. The bad ones are pawned off to retail investors. It's no different with private credit and private equity. These sorts of deals have good ones and bad ones - the good ones will have been taken by the time it flows down to retail.
Even for good assets there's a price you shouldn't pay. People are joking(?) about triple-layer SPVs where you can get pre-IPO exposure but at higher-than-IPO price.
Google and Apple didn't go through ten funding rounds like today's startups do. Apple had one angel and three rounds, Google had one angel and literally just an A round after that; then retail investors could capture all the upside. Now there's way more time for private investors to pick the bones clean before it gets dumped on the public.
So unlike money-market funds, these private-credit funds can gate withdrawals and extend and pretend by turning cash coupons into PIKs. So I don't actually see credit concerns directly driving liquidity issues for the banks that didn't hold the risk on their balance sheet glares Germanically.
Instead, I think the contagion risk is psychological. Which is an unsatisfying answer. But if there are massive losses on e.g. DBIP and DB USA halts withdrawals, then the 2% stock loss Morgan Stanley suffered when it capped withdrawals [1] could become a bigger issue.
I believe the gated feature can be waived though it causes a precarious situation. It ends up with same psychology of a bank run -- people (institutions) concerned because they can't access funds or they think that the queue to exit a failing fund is too long - filled each quarter (i.e. by the time they redeem NAV has collapsed).
As Buffett said, "only when the tide goes out do you learn who has been swimming naked" - luckily, skimming the news, there's no obvious huge exogenous macroeconomic shocks on the horizon that could cause "the tide to go out" so to speak, so everything should be ok for now.
My understanding is that many private credit funds have been very lax about conducting basic due diligence on the creditworthiness of borrowers.
For example, take First Brands, a multi-billion-dollar company which filed for bankruptcy last year. First Brands had pledged the same assets as collateral for loans from multiple private-credit funds. Those loans were being carried at a fantasy NAV of 100 cents per dollar, until suddenly they were not. Did none of these lenders submit UCC filings so other lenders could check which assets had already been pledged as collateral? Did none of these lenders ever check to see which assets had already been pledged? Did all these lenders make loans based on blind trust?
Failing to check and verify that assets have not been pledged as collateral to other lenders is an amateur mistake. It's reckless, really. The equivalent in home-mortgage lending would for a mortgage lender never even bothering to check that a homeowner isn't getting multiple first-lien mortgages simultaneously on the same home, then forgetting to put the first lien on the property title.
My take is that for many private credit funds, NAVs are basically fantasy.
Do you know if First Brand's actions are considered fraud? Or was this entirely on the lenders to make sure they were in the clear regarding the collateral? Doesn't excuse the lack of diligence, but curious if there was some assumption of good faith that may have played a role in what diligence was or was not done.
If lenders are in fact not performing due diligence and passing off good credit as bad...sounds suspiciously like a 2008-like era where noone cared about the credit worthiness but just wanted to generate lines of credit.
Once you get outside of things that are highly standardized (like home loans to individuals) you quickly find out that no matter how regulated, finance is done on a handshake.
Unless I'm misunderstanding something, this isn't that big of a number in the larger scale of US banking; According to the numbers in the article that's only about 2.5% of all bank lending (300B/1.2T, with the 1.2T being ~10%)
> this isn't that big of a number in the larger scale of US banking
It's not. It's just that we're seeing potentially 10% losses on the portfolio level [1], which could imply up to–up to!–5% losses to the banks' loans to those lenders.
Again, tens of billions of dollars of losses are totally absorbable. But Morgan Stanley's stock price took a hit when it gated one of these funds [2]. And some banks (Deutsche Bank, somehow, fucking again, Deutsche Bank) have small ($12n) but concentrated portfolios where a single wipeout could materially impair their ~$80bn of risk-weighted assets.
Washington Mutual had $307 billion in assets, and one credit downgrade and a bank run of $16 billion in September 2008 was enough to get them shut down.
These private credit numbers are estimates provided by Moody's, who were famously clueless about the scale of mortgage bond risk even as they stamped them all with a AAA rating.
Someone else owns all the other credit. This is the 1st domino.
The liquidity challenges of a $1.2T shock to the economy is meaningful, because it has knock on effects on equity as well.
When private credit (which is propping up private valuation) falls, private equity also falls and then everyone realizes that everyone else has been swimming naked.
Update: original comment should be. 300B/1.2T*(10% of bank funds) = 2.5%. If I'm reading comment correct. Also I believe the whole private credit ecosystem is about 1T.
In a catastrophic scenario: if the whole asset class went to 0 (on the banks asset sheet they would lose 2.5% - absorbable pain assuming its not leveraged through creative financial mechanisms).
I would wager that risk is more concentrated on certain institutions instead of across the board so acute pain likely.
I've been told by the head of compliance of the largest European banking group that 2.5% is exactly the threshold at which they begin to be very worried/ at systemic risk
Apparently they operate on very low level of tolerable risk (way lower than I thought)
>2.5% is likely still survivable, but i think risk departments + regulators are all a lot less risk tolerant after seeing how quickly things went south in 2008 and worries about an out of control spiral
For those that want a broader context on private credit, the Bank for International Settlements has been publishing some great material on the topic, including the connections between private credit and other corners of the financial system. Some examples follow.
Yeah, I'm going down a bit of a rabbit hole this morning. Turns out Wells Fargo's $59.7bn of private-credit lending is equal to 44% of its CE Tier 1 capital [1]. Meanwhile, Deutsche Bank got back to being Deutsche Bank while I was not looking [2].
I'm re-running some of the Fed's stress tests and, somehow, still find myself flabbergasted that DB is at the top of my risk list. Despite only having $12bn of exposure, if they see a 60% loss on that risk alone (assuming 60% recovery and 1.5x leverage), they breach their 4.5% capital requirement. That's the lowest threshold I'm finding across all of the banks the Fed stress tests.
Now 50% loss means wipe out. But given the size of the portfolio, there is also the concentration risk. A single private-credit firm going bust shouldn't take out a bank. But that seems–seems!–to be what I'm seeing.
With the current concentration of wealth and banking, it almost seems like there is an incentive for banks to ruin themselves when they end up in a little trouble.
If the bank has trouble, shareholders/executives lose - if the banking system has trouble... then QE will solve the bank trouble.
Are you saying that they're using their private-credit portfolio as a Tier 1 capitalization to meet their regulatory demands (not sure if the ~10-15 something% rule has come back yet?)
> they're using their private-credit portfolio as a Tier 1 capitalization
Banks' private-credit lending constitutes part of their risk-weighted assets. So yes, it's part of their CET1 [1], which is part of Tier 1 capital, and since it's equity measured it incorporates fucking everything.
4.5% is the U.S. minimum. Regulators start throwing their toys out of the pram when a bank breaches 7%. To be clear, I'm not seeing anyone in the near future breaching those limits. Deutsche Bank, the stupidest of the lot, seems to have let DB USA stuff most of the risk in its German AG.
I wonder if anyone can say if there’s much risk of sub prime private credit? Not sure if that’s the right term. My understanding is that synthetic CDOs are the rise again, this backed by private credit - which the article is discussing
The concern here seems to be that the credit risk on the underlying borrowers is being transferred to banks through the loans made by the banks to the private credit firms. But the banks' lending to the private credit firms is subject to the same regulations and constraints as their lending to other borrowers (the same regulations and constraints that led them not to lend to the underlying borrowers in the first place). When banks lend to private credit funds/firms, it tends to be through senior, secured loans which will be less risky than the underlying loans.
> secured loans which will be less risky than the underlying loans
So, it's sort of like bundled mortgage securities, where you take some bad loans and mix them together to get a "less risky" loan, since the chance of them all defaulting at once is less than the chance of all but one defaulting.
Presumably, since banks (by definition, an intermediary) are involved, those are then recursively repackaged until they have an A+ rating, or some such nonsense, right? Also, I'm guessing there's no rule that says you can't intermingle these things across separate "independent" securities, even if the two securities end up containing fractions of the same underlying bad loans?
Clearly, like with housing, there's no chance of correlated defaults in a bucket of bad business loans that's structured this way!
In case you didn't quite catch the sarcasm, replace "housing loans" with "unregulated securities" and note that my description switches from describing the 2008 financial crisis to describing the Great Depression, or replace it with "bucket shops" (which would sell you buckets of intermingled stocks) and it would describe every US financial crisis of the 1800s.
> where you take some bad loans and mix them together to get a "less risky" loan, since the chance of them all defaulting at once is less than the chance of all but one defaulting
Yes. This is mathematically sound.
> those are then recursively repackaged until they have an A+ rating, or some such nonsense, right?
AAA-rated CLOs performed with the credit one would expect from that rating.
The problem, in 2008, wasn't that the AAA-rated stuff was crap. It was that it was ambiguous and illiquid.
> I'm guessing there's no rule that says you can't intermingle these things across separate "independent" securities, even if the two securities end up containing fractions of the same underlying bad loans
Defining independence in financial assets like this is futile.
> there's no chance of correlated defaults in a bucket of bad business loans that's structured this way
Software companies being ravaged by AI fears.
> replace "housing loans" with "unregulated securities" and note that my description switches from describing the 2008 financial crisis to describing the Great Depression
It also describes a lot of successful finance that doesn't reach the mainstream because it's phenomenally boring.
I don't think that's a true etymology of "bucket shop," which per my recollection of Livermore was just an off-track-betting parlor for ticker symbols, but where nobody actually bought the shares (bundled or otherwise). Strictly a retail swindle, having nothing directly to do with the risk/maturity bundling work you are criticizing above.
> No. Non-bank financial institutions (NBFIs a/k/a shadow banks) compete with banks. They also borrow from banks.
How is this inconsistent with what I said? I was just making the point that the reason for the rise of private credit is that banks are less willing / able to lend, particularly to riskier borrowers, as a result of post-2008 banking regulations. So private lenders have stepped in to fill that gap.
> the reason for the rise of private credit is that banks are less willing / able to lend, particularly to riskier borrowers, as a result of post-2008 banking regulations. So private lenders have stepped in to fill that gap
That may have been true once. It's rarely true now. Banks and shadow banks compete for the same borrowers.
My normal bank was acquired by Wells Fargo in 2008 and they also owned my mortgage.
When I went to pay off my mortgage in 2012 they required a cashier's check for the final payment of around $80.
I asked if we could do it electronically like all of the previous payments and they said no.
So I walked into my local bank asking for a cashier's check of that amount and the bank teller told me that most people would accept a personal check for that little. I said yeah but YOU don't. She looked at me funny.
So she asked who to make the cashier's check out to. I said "Wells Fargo" and she looked at me funny again and said "Wells Fargo is us, the check comes FROM Wells Fargo. Who do I put on the TO line" and I said "Wells Fargo"
She again looked at me funny and I explained that I am paying off my mortgage. Wells Fargo is where I have my bank account and my mortgage. She said "Can't we just do it electronically?" to which I said "You would think but apparently your employer can't handle that and told me to get a cashier's check and FedEx overnight to them."
Actually I believe they're just actually complying with new laws to disclose their balance sheets for these types of loans. Many other banks like JP Morgan have much higher amounts of these loans on their balance sheets, but refuse to report and are exploiting certain loopholes.
The requirement to disclose has only existed for a year I believe, but many are kicking the can or claiming that it would cause them issues.
- when a bank creates a loan, this has an effect on money supply in total
- when a private credit company "gives" a loan, it has no effect on total money supply and from balance sheet perspective its an accounting exchange on the asset side
A private credit firm is a non-bank entity that raises money from wealthy investors, pension funds, etc to loan out to businesses. The funds are generally locked up for several years to match the duration of the loans.
They also borrow money from banks to add leverage to this basic setup.
Not who you asked, but I think making the nuance between retail and corporate credit. With firms being corporate credit (i.e. we aren’t talking about individuals / retail).
- bonds. Loans interned to be bought by a range if investors and traded over time. Arranged and unwritten by investment banks.
- bank loans. The classic loan. The bank takes depositor money (that the depositor can take back anytime!) and loans it to someone or some company. The bank holds the loan
- private credit. Like a bank loan, but they get their money from long term investments by wealth people and institutions, add bank loans for leverage, and then hold the loan.
These are mostly syndicated. The traditional difference between loans and bonds was bank versus investment bank. The modern difference is in underwriting technique, degree of syndication/securitisation and loans mostly being floating and bonds mostly being fixed.
Convergent evolution in finance is actually a pet interest of mine. It seems like it's mostly driven by regulation. But the more you stare, the more the regulation appears like a canyon wall and the hydrology customs and connections. I'm not sure what the underlying geology is, however. Something bigger than customs or laws, but not so grand that it becomes ethereal.
The Banks get in trouble, and Gov has to step in. So Gov, reasonably, add regulations and restrictions. But the law can't be really specific, it requires gov employees to actually examine the bank and make decisions (eg about risk levels, etc).
The banks have a really large incentive to chip away at the effectiveness of the regulation. They hire lots of lawyers, consultants, notable economists, etc and just keep pushing on these rank and file gov regulators. They buy influence with politicians, and use that to pressure the regulators. They hire some of the regulators at very high pay, sending a signal to the others: play ball and a nice job awaits you.
Over time, they just wear down the regulators. The rules are interpreted to be mostly ineffective and nonsensical. Often at that point the politicians come in and just de-regulate.
The banks just have the incentive and focus to keep at it every day for years. No one else with power is paying attention.
That's not correctly stated. "Private Credit" is defined as non-bank lending. Banks are doing "public" lending in the sense of being regulated. Private lending is any sort of financial instrument issued outside of those guard rails.
It's generally felt to be risky and volatile, but useful. Basically, it's never illegal just to hand your friend $20 even if the government isn't watching over the process to make sure you don't get scammed. This is the same thing at scale.
It is. (EDIT: It's a mixed bag. OP was correctly calling out a definitional error.)
Banks have loaned $300bn mostly to private-credit firms. Those firms then compete with the banks to do non-bank lending. It's a weird rabbit hole and I'm grumpy after a cancelled flight, but it feels like I'm in the middle of a Matt Levine writeup.
He's one of the "Big Short" guys but more importantly he has great guests on. Everyone is trying to teach & inform, not sell.
He's been calling this risk out for over a year, especially once the White House started trying to allow retirement accounts access to private credit. For a lot of people that was the big alert, even before Jamie Dimon said he saw "cockroaches".
I can't remember the names. Best bet if you don't want to listen is to just get summaries or transcriptions of the episodes you can an LMM questions on.
The info on his podcasts isn't telling you who to short. It's more who has gone under & general knowledge.
There is so much misinformed fear-mongering about private credit right now.
Important Facts:
1) The majority of private credit funds are classed as "permanent capital". When you put money into these vehicles, you give the Asset Manager discretion over when to give the money back. Redemptions are often gated at ~5% per quarter.
(So there cannot, by definition, be a run on the bank)
2) Credit is senior to equity, so if you expect mass defaults in private credit, it means the majority of private equity is effectively wiped out. Private equity has to be effectively a 0 before private credit takes any losses.
3) The average "recovery rate" for senior secured loans is 80%. Even if private equity gets wiped to 0, the loss that private credit incurs is cushioned significantly by the collateral backing the loan. These are not unsecured loans the borrower can just walk away from.
(The price of senior secured loans dropped by ~30% in 2008, as a worst case datapoint)
4) Default rates on many of the major private credit managers is ~<1% in recent years. There are other estimates stating higher default rates, but that often classifies PIK income as a default. A loan modified and extended with added PIK that ultimately gets repaid is not a "true" default.
5) Finally, it's true that NAVs are likely overstated, but generally it's by a modest amount. Every Asset Manager today could go out tomorrow, mark NAVs down by 20% and suddenly there is no crisis.
(The stocks of Asset Managers have already traded down such that this seems expected and priced in anyway)
> Private equity has to be effectively a 0 before private credit takes any losses
Technically yes. But the overlap between private equity as it's commonly described and private credit is slim.
> average "recovery rate" for senior secured loans is 80%
Oooh, source? (I'm curious for when this was measured.)
> A loan modified and extended with added PIK that ultimately gets repaid is not a "true" default
True. It's a red flag, nonetheless.
> Every Asset Manager today could go out tomorrow, mark NAVs down by 20% and suddenly there is no crisis
Correct. The question is if 20% is enough, and if a 20% markdown creates a vicious cycle as funding for e.g. re- or follow-on financing dries up.
You seem knowledgable about this. I'm coming in as an equities man. Would you have some good sources you'd recommend that make the dovish cash for private credit today?
> Oooh, source? (I'm curious for when this was measured.)
It depends when you measure, but you can Google around and find figures in the 60-80% range. 80% may have been a bit on the optimistic end of the range. But it's important to note that a "default" doesn't imply a 0.
Of course this will depend on the covenants, underwriting standards, type of collateral.
I would guess software equity collateral recovery rates are lower than hard assets like a building. (Which is why I personally don't like Software loans, nothing to do with AI)
> Correct. The question is if 20% is enough, and if a 20% markdown creates a vicious cycle as funding for e.g. re- or follow-on financing dries up.
I think it's almost certain that new fundraising for private credit will be materially hindered going forward. But this just limits the growth rate of these firms, does not introduce any "collapse" risk.
They may move from net inflows to net outflows and bleed AUM over a period of some years.
If NAVs were inflated previously, they may be forced to mark down the NAV to meet redemptions rather than using inflows to payoff older investors.
In the world of credit, 20% is an enormous haircut. Again, senior secured loans fell by around 30% peak to trough in 2008.
We have the public BDC market as a comparison point where the average price/book is around 0.80x. So the public market is willing to buy credit strategies at a 20% discount to stated NAV.
The real systemic risk here, if we were to reach for one, is really that these fears become self fulfilling.
If investors pull funds out of credit strategies en-masse, there is no first order systemic issue, but it means borrowers of many outstanding loans may not be able to secure refinancing as money is drying up.
This could lead to a self-fulfilling default cycle. But this would be a fear driven default cycle, there is no fundamental issue with cash flows of borrowers or otherwise (in aggregate, currently).
Finally, in regards to the asset managers themselves, many are quite diversified.
Yes, they have private credit funds, but many have real estate funds, buyout funds etc. OWL is one of the biggest managers of data center funds, for example (which they also got hammered for on AI bubble fears)
Given how depressed pricing is in public REITs, for example, I expect a lot of asset managers to pivot towards more real asset funds.
So, if I hold a bunch of Private Equity, and my holdings need a continuity of business loan, would I:
(a) have the holding take out the debt, exposing 100% of my stake
or,
(b) have the holding divest a piece of itself, giving me control of the existing and new entities, then have that piece take out the debt, exposing 0% of my stake?
I imagine any PE firm worth its salt would go with option (b).
Presumably regulators would sometimes try to block such deals, but I cannot imagine that happening during the current administration. (Do the regulators even still work for the US government? I thought they were mostly fired.)
Similarly, I can imagine the banks refusing to lend in scenario (b), but I cannot imagine bank leadership being allowed to make such a decision if the PE firm is politically connected to the current administration.
It sounds like you're effectively describing some fraud scheme.
A smart lender will not issue loans without real collateral. If you create a subsidiary, that subsidiary has to have sufficient collateral and cashflow to secure a loan.
Well, the question isn't "is there any consequence for the bank managers"? The answer to that is "No, never, not even during the French Revolution".
The question is "How long can they keep extracting money before the economy implodes?"
The people producing macroeconomic indicators in the US were fired about 6 months ago for putting out an honest report. Since then there's been very little correlation between public sentiment on the economy and the official indicators.
So, we're definitely in some sort of overhang situation, where the economy is imploding, but the stock market goes up. I think that's unprecedented in the US. In developing countries, when this happens, it usually leads to things like hyperinflation.
So, I guess the real questions are: "How do you short the dollar?", and "How can you tell when the banks start doing it?" so you know when to jump off the merry-go-round.
It’s more accurate to say that the private credit market was created by the government adding new regulations, not removing them. Business development corporations have existed since the 80s but they didn’t explode in popularity as business loan originators until Dodd Frank and other post-2008 regulations made it more difficult for banks to lend money. This led small and medium size businesses to seek out credit from firms like Ares et al instead.
And to make matters worse, those who remove regulations then get voted out, but show up on infotainment "opinion" shows disguised as news broadcasts....and whine that those who were voted in to fix the mess aren't fixing the problem fast enough, so those who caused the problem should be voted back in. And lo and behold, they get voted back in, to cause more damage.
Its un-fixable. The situation cant be explained simply enough for the majority of americans. Even if some of them do mange to understand, it will be quickly forgotten amid the flood of trump sewage we are sprayed with every day.
I think we'll get there (to explanation), but it'll be through the lizard-brain-level pain of poverty instead of rational understanding unless we get much better at communicating to the least willing to listen among us.
So, if I’m following: Banks are lending to private equity firms to fund purchases of businesses.
Many of these businesses are SaaS which means their valuations are tumbling.
It seems possible that valuations tumble so much that the private equity owner no longer has any incentive to operate the business, bc all future cash flows will belong to the bank. What happens in practice then? Will banks actually step in and take operational control? Will the banks renegotiate terms such that the private equity owners are incentivized to continue as stewards? Or, will they prefer to force a business sale immediately?
> Banks are lending to private equity firms to fund purchases of businesses.
Yes some businesses are SaaS but here's the real problem: Many businesses' sole purpose is _leveraged buy-outs_ which really is the devil in disguise.
It goes like this: A VC specialising in veterinary clinics finds a nice, privately owned town clinic with regular customers and "fair" prices, approach the owners saying "we love the clinic you've built! We'll buy your clinic for $2,500,000! You've really earned your exit!".
So now the VC lends the money from the bank, buys the clinic, and here's the important part: _they push the debt onto the clinic's books_. So all of a sudden the nice town clinic has $2,500,000 in debt, raise prices accordingly, ~~burn out personnel~~ slim operations accordingly, and any surplus that doesn't go to interest and amortization goes straight to the VC.
Debt and collateral on the veterinary clinics.
Risk free revenue to the VC.
> So all of a sudden the nice town clinic has $2,500,000 in debt, raise prices accordingly...
From a financial engineering perspective this is wrong.
Both equity and debt have costs of capital. Debtholders expect interest, capital holders expect RoE. The money going to debt interest is money that would previously have gone to equity, but now does not because the equity is replaced with debt.
Crucially, the costs of debt is lower than the cost of equity because of the interest tax shield. Therefore, the vet clinic now requires less revenue to maintain or even increase its return to equity.
> now the VC lends the money from the bank, buys the clinic, and here's the important part: _they push the debt onto the clinic's books
This approximately-correctly describes an LBO. They are done by PE firms. Not VCs. And the debt isn’t “pushed” onto the company’s books, it’s never on the sponsor’s books in the first place. In many ways, it’s capital-structure arbitrage.
Private credit, on the other hand, involves e.g. Blue Owl borrowing from a bank to lend to software businesses, usually without any taking control or equity. It’s fundamentally different from both LBOs and VC. (Though some private credit firms will turn around and lend into a merger or LBO. But in that capacity they’re just competing with banks again. Not VC.)
> Risk free revenue to the VC.
How is that risk free? If the clinic goes bankrupt the VC will be on the hook for the rest of the loan. It’s not free money.
They're not so silly as to have any personal or professional liability, they probably spin up a special purpose vehicle or llc to hold the bag if it all goes south
No bank would agree to such nonsense
It’s analogous to a mortgage in a non-recourse state. If the borrower defaults the bank gets the leveraged company, but can’t go upstream.
It's called "financial engineering" and banks and courts agree to it on the daily.
The usual arrangement for an LBO is to saddle the bought company, the vet in this example, with the debt,or spin off a secondary company from the vet with the poorest assets and most to all of the debt. It's all a scummy business.
"So now the VC lends the money from the bank"
"lends" -> "borrows", right?
No dude. Read it again.
The VC lends (the money from the bank) which the vc borrowed, to the clinic.
They are a sort of middle man. It the clinic is on the hook to the bank and the Vc takes fist cut before playing the bank.
Eg. The vc only risked the company they were buying, and gets paid first.
If the VC borrows money from the bank and lends it to the clinic, the clinic is not on the hook to the bank. The clinic is on the hook to the VC and the VC is on the hook to the bank. Which means that if the clinic goes under, the VC takes the loss because it still has to repay the bank.
Nope. The clinic is the collateral to the bank. VC stand to loose nothing.
It does not happen overnight. But what happens is after they take control of the clinic or company they change the sales model to boost reoccurring revenue, this then allows the clinic or target company to take loans out. Because they look good on paper. The company then pays VC back when then pays bank back.
This can be done in about 6mo to 1 year process with some companies. The initial out of pocket expense is small and paid back very quickly.
I also forgot. Sometimes they will take the newly owned company and merge it. During that process they extract more money and load more debt onto the remaining entities, again making the VC money.
In some cases they can even get huge tax benefits by loading the company with debt which offsets the tax bill of the final entity.
When these transactions are done, within the span of a day multiple companies are created and merged and absolved.
There is little to no risk for the VC
If hours of preparation for college testing taught me anything, it's the difference between lend and borrow.
The Mars family is doing that with the vets.
They also own a large part of the pet food industry. Given how much health is affected by diet, that's a huge conflict of interest.
So yes, PE funds are probably overvalued right now and there are a lot of PE funds getting rich off management fees while not providing promised returns...but this comment is so wrong I don't know where to begin.
First, VC stands for venture capital, which is a subset of private equity that does zero LBOs and doesn't even acquire any businesses. VC funds buy equity in startups, and take on zero debt to do so. You have your boogiemen totally confused.
Second, the entire point of a PE fund that uses a leveraged buyout strategy is that they need to sell the acquired firm at a profit to make any returns to the fund. LBO funds don't 'cashflow' businesses, and saddling a business with a bunch of debt is antithetical to that purpose anyways.
Third, this is not "risk free revenue." It's a high risk strategy to use the debt to increase the value of the business by improving operations enough that you can sell it for a profit to the fund. If you saddle a company with debt and DON'T increase the value of the business beyond the debt you took on, the PE fund will not be in business for fund 2.
The risk-free revenue while the fund is alive comes from the management fees that investors in the fund pay (usually 2%, which is way too high IMO, but has nothing to do with the debt or the acquired businesses).
Please do not write confident sounding comments about things you don't understand, it spread misinformation and makes the internet a worse place.
As someone who's life is currently being affected directly by PE middle-manning something I spend a LOT of time on, I am sensitive to this issue.
IF you have problems with the vocab and terms, fine. But I have seen personally this issue in my life, that is affecting my bank account.
And we have seen example after example of these LBO's ruining otherwise functioning businesses. It's happening. All over the place.
It is absolutely possible (and even likely!) that a bad PE fund was the cause of the issue you're talking about. But there is also a media hysteria around PE, and a lack of understanding among the general public of what it is.
It's just as likely the business that was acquired was already failing or unsustainable to begin with (hence why the owner wanted out at low multiples). LBO funds don't acquire promising businesses at 5-10X revenue like tech companies do, they usually buy businesses at low multiples that are past their prime or failing in an attempt to revitalize them (with debt, since you can't raise capital by selling equity in a failing business).
Obviously this will not always work out great, given the trajectory of target companies was already not great to begin with. Momentum is the strongest factor in all markets.
The problem is, Private Equity has become a conspiratorial catchall boogieman and scapegoat for every problem under the sun, so it's hard for me to assess without further details of the situation.
> Momentum is the strongest factor in all markets
Nit: beta is the strongest factor in all markets. Which is actually relevant for the success for PE funds in general, as a rising tide lifts all boats and people taking on debt to finance equity generally post outsized returns in bull markets.
Anyway, the rest of the stuff you're saying I agree with.
Yes, beta is the overwhelming source of returns. I was referring to factors in the sense of the University of Chicago research on market inefficiencies (where momentum is the strongest factor for inefficiency).
If you buy a “factor-weighted” etf the idea is it’s tilting you into those “factors” away from pure beta like buying whole market.
PE you could argue is largely just leverage plus an illiquidity factor play, since if PE just returned beta (which these days it might!) you’d be smarter to buy the S&P500 with equivalent leverage and not pay crazy fees.
Background: I work for a PE-owned company and I have friends in PE (associates up to MDs).
On your second point: LBOs aren't the only tool in the toolkit, and it's not as popular as it was decades ago, so I would lean towards the parent simply conflating "buying an ownership stake in a business in some capacity using other people's money" with the strict definition. Regardless, yes PE firms need to figure out how to get 20%+ IRR throughout a short timeframe (usually a 5 year holding/funding cycle) -- however this is through any means necessary. Philosophically, it's about increasing efficiency of operations and growing the business. In practice, it's financial engineering because PE firms do not have the operational skills to make any value-added changes to firms besides driving costs down.
Saddling a business with debt is reductionist. I've seen absolutely nonsensical financial structures that make no sense for a layman, but in practice end up "using the business' finances to 'own' (beneficially) the business" (see: at the most vanilla, the strategy of seller financing in SMBs). No this is not technically "putting debt on the books" but it is in all practical respects a novation/loan transfer that can leave the purchased co financially responsible for servicing any debt that was used in its purchase.
On your third point: what I wrote above can be used as context. It's not risk free revenue, frankly it's very risky unless you're in an inflationary environment where your assets will grow regardless of your business operations solely because the overarching economy is growing and you're riding a tailwind. However, it again boils down to financial engineering. It's not as simple as assets - liabilities = equity. The calculations used to determine valuations are so ridiculously convoluted. The amount of work that goes into financially analyzing businesses and finding "loop holes" that can justify higher prices is the core business model. The debt factors into it, but there's ways to maneuver around it through various avenues.
For example:
* debt-to-equity conversions (reclassification of debt as equity)
* refinancing
* sale-leaseback (selling company's assets to a 3rd party and using that money to pay down the debt, then leasing the equipment back)
* creative interpretations of what is actually debt (e.g. reclassifying real debt as a working capital adjustment or a "debt-like")
* dividend recapitalization (a nasty trick of loading the company with debt, paying that out as a dividend to the holdco, then selling the company at lower enterprise value. They still extracted value for their LPs/investors, despite the exit being lower)
* separating the debt from the operating company into a different holding company that services the debt
Private equity is a huge inflation driver. I'm thrifty, and for years I enjoyed a $10/mo phone provider, ~$12.39 with taxes. I even evangelized this carrier with some young parents who were struggling to get financial traction while paying off student loans.
Our affordable plan came to an end when the rates tripled! Turns out a private equity firm bought the company, jacked the rates on every customer, and sold it off again. This was not a fundamental cost being passed on in slightly increased fees -- it was private equity extracting millions from the people who can afford it the least. Across my financially optimized life, I see this happening repeatedly.
Personally, I can afford a more expensive cell phone bill. But I would imagine that many who have a $10/mo plan do not have many other options. I would like to punish the banks who are funding attacks on consumers. If by no other means, then by letting them fail.
> Banks are lending to private equity firms to fund purchases of businesses
Not quite. Private credit is to debt what private equity is to equity. (Technically, any non-bank originated debt that isn't publicly traded is private credit. Conventionally, it's restricted to corporate borrowers.)
So bank exposure to private credit generally means banks lending to non-banks who then lend to corporate borrowers.
What does this typically look like? Who is the intermediary here between the bank and corporate borrowers - are these buy side created SPVs?
> Who is the intermediary
Business development companies [0]. Blue Owl. BlackRock [1].
> are these buy side created SPVs?
Great question! Not always [2].
[0] https://www.reuters.com/business/finance/private-credit-fund...
[1] https://www.blackrock.com/corporate/newsroom/press-releases/...
[2] https://www.datacenterdynamics.com/en/news/meta-secures-30bn...
Am I wrong thinking this is similar to the housing loan crisis of 2008? This is just another form of that "shadow banking" system isn't it?
You'll find plenty of talking heads on YouTube right noe claiming exactly this. Time will tell if private equity is actually wound up as tight as housing was in the GFC.
I don't think you're wrong if the following holds true: Before the housing bubble burst, banks lent funds to countless borrowers who couldn't, ultimately, afford their mortgage payments (because the banks didn't do their due diligence when underwriting the loans). This was widespread across pretty much every bank and mortgage banker. Not sure of the actual percentage of borrowers who, when all was said and done, had no business getting a mortgage for a house or condo, but suffice it to say it was well into the double digits percentage-wise (there's much more to this than simply banks and borrowers with Wall St. playing a major role in the collapse, but just keeping things simple).
In this private credit situation the analog for the banks are these private credit funds that have raised the capital they've lent from institutions and high-net-worth individuals (as opposed to banks, which have funds from consumer deposits). The analog to the individual mortgage borrowers from 2008 are actual companies.
To connect the dots, if the private credit funds were like the banks pre-2008, where due diligence was an afterthought, then this could turn out to be similar. So the real question is: are the borrowers (businesses in this case) swimming naked? Or do you believe the private credit funds when they say they actually conducted a good amount of due diligence when extending their loans? Once you know the percent of the companies that are naked you can evaluate whether this could/would end up similar to 2008. Nobody knows that yet, even, I suspect, the private credit funds themselves.
> This is just another form of that "shadow banking" system isn't it?
Private-credit lenders are literally shadow banks [1]. But I'd be cautious about linking any shadow banking with crisis. Tons of useful finance occurs outside banks (and governments). One could argue a classic VC buying convertible debt met the definition.
That said, the parallel to 2008 is this sector of shadow banking has a unique set of transmission channels to our banks. The unexpected one being purely psychological–when a bank-affiliated shadow bank gates redemptions, investors are punishing the bank per se.
[1] https://en.wikipedia.org/wiki/Non-bank_financial_institution
Banks have zero appetite for taking any operating responsibility for these firms and will work tirelessly to get them off their books ASAP.
Why would banks take control? If they had that skillset or interest they wouldn't be lending to middle men to begin with.
Wouldn't they still owe interest to the banks on the money they borrowed, as well as the money they borrowed? I mean if all the money I make goes to the bank to pay off my mortgage my solution is not quitting my job, even though life is not very good under that situation.
The analogy has a lot of problems.
Imagine you got a loan to buy a bunch of laundry machines to run a laundromat. But your laundromat earns $8,000 a month, and the loan payment is $10,000.
You can decide to sink $2,000 of your personal money into the laundromat every month, or you can give up.
The business owes the money or the fund. In any case the individuals do not unless they backed it with personal collateral.
hmm, yeah ok so the collateral is the business they are buying, I forgot that one.
Trouble has been brewing in private credit for quite a while, but lenders and investors have been reluctant to write anything down, resorting to all kinds of "extend and pretend" games to avoid write-downs.[a]
tick-tock, tick-tock, tick-tock...
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[a] https://news.ycombinator.com/edit?id=47351462
You can always tell when there is a problem. When things are fine the companies keep the profits to themselves. When things start to get dicey - foist it off onto retail investers.
Private equity (PE) is increasingly being introduced into 401(k) plans, driven by a 2025 executive order encouraging "democratization" of alternative assets. - Google AI
It's why as a retail investor, never buy things that would otherwise have not been available to you (but was to those "elite"/institutional investors previously).
Think pre-IPO buy-in. Investors in the know and other well connected institutional investors get first dibs on all of the good ones. The bad ones are pawned off to retail investors. It's no different with private credit and private equity. These sorts of deals have good ones and bad ones - the good ones will have been taken by the time it flows down to retail.
This can't be a to-die-on rule though. Retail would've never bought GOOG, or TSLA, or AAPL if that were the case. Maybe I'm just being pedantic.
Even for good assets there's a price you shouldn't pay. People are joking(?) about triple-layer SPVs where you can get pre-IPO exposure but at higher-than-IPO price.
Google and Apple didn't go through ten funding rounds like today's startups do. Apple had one angel and three rounds, Google had one angel and literally just an A round after that; then retail investors could capture all the upside. Now there's way more time for private investors to pick the bones clean before it gets dumped on the public.
The only problem is allowing regulated US banks with an implicit gov guarantee to lend money to them.
There are limited ways to short these positions which would probably add some fuel to the fire.
I don't see it as adding fuel to the fire. I see it as helping the market price companies correctly
Its a balancing act.
But what will break the clock ?
> what will break the clock ?
So unlike money-market funds, these private-credit funds can gate withdrawals and extend and pretend by turning cash coupons into PIKs. So I don't actually see credit concerns directly driving liquidity issues for the banks that didn't hold the risk on their balance sheet glares Germanically.
Instead, I think the contagion risk is psychological. Which is an unsatisfying answer. But if there are massive losses on e.g. DBIP and DB USA halts withdrawals, then the 2% stock loss Morgan Stanley suffered when it capped withdrawals [1] could become a bigger issue.
[1] https://www.wsj.com/livecoverage/stock-market-today-dow-sp-5...
I believe the gated feature can be waived though it causes a precarious situation. It ends up with same psychology of a bank run -- people (institutions) concerned because they can't access funds or they think that the queue to exit a failing fund is too long - filled each quarter (i.e. by the time they redeem NAV has collapsed).
> the gated feature can be waived
Or never invoked. It's a safety feature for the fund and, arguably, systemic stability.
Totally - its supposed to prevent a collapse of confidence but at the same time can signal a collapse of confidence. Double edged sword.
You can't gate redemptions forever amigo.
People eventually want to spend their money.
As Buffett said, "only when the tide goes out do you learn who has been swimming naked" - luckily, skimming the news, there's no obvious huge exogenous macroeconomic shocks on the horizon that could cause "the tide to go out" so to speak, so everything should be ok for now.
Umm... Couldn't whole Iran debacle be such shock? If the effects are not contained?
What kind of trouble is brewing from the migration of partner capital committment to credit based on NAV?
What is the risk, probability of actualizing the risk, and the outcome of actualized risk?
The ticktock ticktock routine reads like baseless fearmongering to me.
My understanding is that many private credit funds have been very lax about conducting basic due diligence on the creditworthiness of borrowers.
For example, take First Brands, a multi-billion-dollar company which filed for bankruptcy last year. First Brands had pledged the same assets as collateral for loans from multiple private-credit funds. Those loans were being carried at a fantasy NAV of 100 cents per dollar, until suddenly they were not. Did none of these lenders submit UCC filings so other lenders could check which assets had already been pledged as collateral? Did none of these lenders ever check to see which assets had already been pledged? Did all these lenders make loans based on blind trust?
Failing to check and verify that assets have not been pledged as collateral to other lenders is an amateur mistake. It's reckless, really. The equivalent in home-mortgage lending would for a mortgage lender never even bothering to check that a homeowner isn't getting multiple first-lien mortgages simultaneously on the same home, then forgetting to put the first lien on the property title.
My take is that for many private credit funds, NAVs are basically fantasy.
Do you know if First Brand's actions are considered fraud? Or was this entirely on the lenders to make sure they were in the clear regarding the collateral? Doesn't excuse the lack of diligence, but curious if there was some assumption of good faith that may have played a role in what diligence was or was not done.
Only a court can decide if the actions are fraud, but they sure look like it to me. Fraud doesn't excuse the lack of due diligence.
If lenders are in fact not performing due diligence and passing off good credit as bad...sounds suspiciously like a 2008-like era where noone cared about the credit worthiness but just wanted to generate lines of credit.
Oh boy, if this is the case, oh boy.
Lessons not learned indeed.
Once you get outside of things that are highly standardized (like home loans to individuals) you quickly find out that no matter how regulated, finance is done on a handshake.
That's true, but only to a point. Due diligence is not uncommon, especially with more traditional forms of credit.
I resorted to the mortgage-lending analogy so others could quickly grok what multi-pledging means.
Unless I'm misunderstanding something, this isn't that big of a number in the larger scale of US banking; According to the numbers in the article that's only about 2.5% of all bank lending (300B/1.2T, with the 1.2T being ~10%)
> this isn't that big of a number in the larger scale of US banking
It's not. It's just that we're seeing potentially 10% losses on the portfolio level [1], which could imply up to–up to!–5% losses to the banks' loans to those lenders.
Again, tens of billions of dollars of losses are totally absorbable. But Morgan Stanley's stock price took a hit when it gated one of these funds [2]. And some banks (Deutsche Bank, somehow, fucking again, Deutsche Bank) have small ($12n) but concentrated portfolios where a single wipeout could materially impair their ~$80bn of risk-weighted assets.
[1] https://www.reuters.com/business/us-private-credit-defaults-...
[2] https://www.wsj.com/livecoverage/stock-market-today-dow-sp-5...
you're the only person replying to comments on this post that seems to know what they're talking about. what do you do for a living?
good explanation, thanks
You're welcome! Also, bank credit is like $20tn in the U.S. [1].
[1] https://fred.stlouisfed.org/series/TOTBKCR
Washington Mutual had $307 billion in assets, and one credit downgrade and a bank run of $16 billion in September 2008 was enough to get them shut down.
These private credit numbers are estimates provided by Moody's, who were famously clueless about the scale of mortgage bond risk even as they stamped them all with a AAA rating.
If there are credit default swaps involved anywhere, this could amplify the pain in the economy.
Someone else owns all the other credit. This is the 1st domino.
The liquidity challenges of a $1.2T shock to the economy is meaningful, because it has knock on effects on equity as well.
When private credit (which is propping up private valuation) falls, private equity also falls and then everyone realizes that everyone else has been swimming naked.
Update: original comment should be. 300B/1.2T*(10% of bank funds) = 2.5%. If I'm reading comment correct. Also I believe the whole private credit ecosystem is about 1T.
In a catastrophic scenario: if the whole asset class went to 0 (on the banks asset sheet they would lose 2.5% - absorbable pain assuming its not leveraged through creative financial mechanisms).
I would wager that risk is more concentrated on certain institutions instead of across the board so acute pain likely.
I've been told by the head of compliance of the largest European banking group that 2.5% is exactly the threshold at which they begin to be very worried/ at systemic risk
Apparently they operate on very low level of tolerable risk (way lower than I thought)
>2.5% is likely still survivable, but i think risk departments + regulators are all a lot less risk tolerant after seeing how quickly things went south in 2008 and worries about an out of control spiral
That's only loans to non bank financial institutions.
Total bank balance sheets are about $25T.
And then that 25% is 10% of US banks' entire lending portfolio, so private credit is about 2.5% of their entire portfolio.
Off by an order of magnitude.
For those that want a broader context on private credit, the Bank for International Settlements has been publishing some great material on the topic, including the connections between private credit and other corners of the financial system. Some examples follow.
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[0] https://www.bis.org/publ/qtrpdf/r_qt2503b.htm [1] https://www.bis.org/publ/bisbull106.pdf [2] https://www.bis.org/publ/work1267.pdf
For the OP: what’s your view on the overall private credit situation? Who are the bag holders and how bad is the contents of the bag?
You seem to be answering a number of other questions in the post so interested to hear your impetus for sharing in the first place.
nb: thank you for being an ongoing contributor to the site! I see your handle cropping up a lot in substantive conversations
Banks are following incentives that exist because of government policies, and in doing that they create significant moral hazard.
The finance industry's main innovation is rent seeking.
We all know what is going to happen, it's just a question of when.
Related post (submitted alongside)
https://news.ycombinator.com/item?id=47349806 US private credit defaults hit record 9.2% in 2025, Fitch says (marketscreener.com)
115+ comments
Yeah, I'm going down a bit of a rabbit hole this morning. Turns out Wells Fargo's $59.7bn of private-credit lending is equal to 44% of its CE Tier 1 capital [1]. Meanwhile, Deutsche Bank got back to being Deutsche Bank while I was not looking [2].
[1] https://www.sec.gov/Archives/edgar/data/72971/00000729712500...
[2] https://www.reuters.com/business/finance/deutsche-bank-highl...
Deutsche gonna Deutsche.
Recruitment tables should just have a banner that reads 'we've already spent your bonus on legal fees, here's some chocolate'
I'm re-running some of the Fed's stress tests and, somehow, still find myself flabbergasted that DB is at the top of my risk list. Despite only having $12bn of exposure, if they see a 60% loss on that risk alone (assuming 60% recovery and 1.5x leverage), they breach their 4.5% capital requirement. That's the lowest threshold I'm finding across all of the banks the Fed stress tests.
Now 50% loss means wipe out. But given the size of the portfolio, there is also the concentration risk. A single private-credit firm going bust shouldn't take out a bank. But that seems–seems!–to be what I'm seeing.
Time to short them?
As long as nobody knows then it isn’t risk… /s
don't worry, they're adopting AI
With the current concentration of wealth and banking, it almost seems like there is an incentive for banks to ruin themselves when they end up in a little trouble.
If the bank has trouble, shareholders/executives lose - if the banking system has trouble... then QE will solve the bank trouble.
> If the bank has trouble, shareholders/executives lose - if the banking system has trouble... then QE will solve the bank trouble
It's a game of chicken, though. The folks at Lehman and SVB didn't cash out. JPMorgan did. (Both times. Actually, all of the times since 1907.)
When can qe start ?
Are you saying that they're using their private-credit portfolio as a Tier 1 capitalization to meet their regulatory demands (not sure if the ~10-15 something% rule has come back yet?)
Been a bit out of the finance game
> they're using their private-credit portfolio as a Tier 1 capitalization
Banks' private-credit lending constitutes part of their risk-weighted assets. So yes, it's part of their CET1 [1], which is part of Tier 1 capital, and since it's equity measured it incorporates fucking everything.
4.5% is the U.S. minimum. Regulators start throwing their toys out of the pram when a bank breaches 7%. To be clear, I'm not seeing anyone in the near future breaching those limits. Deutsche Bank, the stupidest of the lot, seems to have let DB USA stuff most of the risk in its German AG.
[1] https://www.investopedia.com/terms/c/common-equity-tier-1-ce...
Link for that one is https://news.ycombinator.com/item?id=47349806
I wonder if anyone can say if there’s much risk of sub prime private credit? Not sure if that’s the right term. My understanding is that synthetic CDOs are the rise again, this backed by private credit - which the article is discussing
The concern here seems to be that the credit risk on the underlying borrowers is being transferred to banks through the loans made by the banks to the private credit firms. But the banks' lending to the private credit firms is subject to the same regulations and constraints as their lending to other borrowers (the same regulations and constraints that led them not to lend to the underlying borrowers in the first place). When banks lend to private credit funds/firms, it tends to be through senior, secured loans which will be less risky than the underlying loans.
> the banks' lending to the private credit firms is subject to the same regulations and constraints as their lending to other borrowers
Yes.
> the same regulations and constraints that led them not to lend to the underlying borrowers in the first place
No. Non-bank financial institutions (NBFIs a/k/a shadow banks) compete with banks. They also borrow from banks.
> When banks lend to private credit funds/firms, it tends to be through senior, secured loans which will be less risky than the underlying loans
Correct. Assuming 1.5x leverage and 60% recovery, you'd expect no more than half of portfolio losses to transmit to their lenders.
> secured loans which will be less risky than the underlying loans
So, it's sort of like bundled mortgage securities, where you take some bad loans and mix them together to get a "less risky" loan, since the chance of them all defaulting at once is less than the chance of all but one defaulting.
Presumably, since banks (by definition, an intermediary) are involved, those are then recursively repackaged until they have an A+ rating, or some such nonsense, right? Also, I'm guessing there's no rule that says you can't intermingle these things across separate "independent" securities, even if the two securities end up containing fractions of the same underlying bad loans?
Clearly, like with housing, there's no chance of correlated defaults in a bucket of bad business loans that's structured this way!
In case you didn't quite catch the sarcasm, replace "housing loans" with "unregulated securities" and note that my description switches from describing the 2008 financial crisis to describing the Great Depression, or replace it with "bucket shops" (which would sell you buckets of intermingled stocks) and it would describe every US financial crisis of the 1800s.
> where you take some bad loans and mix them together to get a "less risky" loan, since the chance of them all defaulting at once is less than the chance of all but one defaulting
Yes. This is mathematically sound.
> those are then recursively repackaged until they have an A+ rating, or some such nonsense, right?
AAA-rated CLOs performed with the credit one would expect from that rating.
The problem, in 2008, wasn't that the AAA-rated stuff was crap. It was that it was ambiguous and illiquid.
> I'm guessing there's no rule that says you can't intermingle these things across separate "independent" securities, even if the two securities end up containing fractions of the same underlying bad loans
Defining independence in financial assets like this is futile.
> there's no chance of correlated defaults in a bucket of bad business loans that's structured this way
Software companies being ravaged by AI fears.
> replace "housing loans" with "unregulated securities" and note that my description switches from describing the 2008 financial crisis to describing the Great Depression
It also describes a lot of successful finance that doesn't reach the mainstream because it's phenomenally boring.
I don't think that's a true etymology of "bucket shop," which per my recollection of Livermore was just an off-track-betting parlor for ticker symbols, but where nobody actually bought the shares (bundled or otherwise). Strictly a retail swindle, having nothing directly to do with the risk/maturity bundling work you are criticizing above.
> No. Non-bank financial institutions (NBFIs a/k/a shadow banks) compete with banks. They also borrow from banks.
How is this inconsistent with what I said? I was just making the point that the reason for the rise of private credit is that banks are less willing / able to lend, particularly to riskier borrowers, as a result of post-2008 banking regulations. So private lenders have stepped in to fill that gap.
> the reason for the rise of private credit is that banks are less willing / able to lend, particularly to riskier borrowers, as a result of post-2008 banking regulations. So private lenders have stepped in to fill that gap
That may have been true once. It's rarely true now. Banks and shadow banks compete for the same borrowers.
> the top five lenders in the private credit market include Wells Fargo, which leads the way with $59.7bn (£44.8bn) in lending
anything Wells Fargo leads in must be bad
Wells Fargo so big its suing itself
July 10, 2009
https://www.denverpost.com/2009/07/10/lewis-wells-fargo-so-b...
My normal bank was acquired by Wells Fargo in 2008 and they also owned my mortgage.
When I went to pay off my mortgage in 2012 they required a cashier's check for the final payment of around $80.
I asked if we could do it electronically like all of the previous payments and they said no.
So I walked into my local bank asking for a cashier's check of that amount and the bank teller told me that most people would accept a personal check for that little. I said yeah but YOU don't. She looked at me funny.
So she asked who to make the cashier's check out to. I said "Wells Fargo" and she looked at me funny again and said "Wells Fargo is us, the check comes FROM Wells Fargo. Who do I put on the TO line" and I said "Wells Fargo"
She again looked at me funny and I explained that I am paying off my mortgage. Wells Fargo is where I have my bank account and my mortgage. She said "Can't we just do it electronically?" to which I said "You would think but apparently your employer can't handle that and told me to get a cashier's check and FedEx overnight to them."
She rolled her eyes and then started laughing.
Actually I believe they're just actually complying with new laws to disclose their balance sheets for these types of loans. Many other banks like JP Morgan have much higher amounts of these loans on their balance sheets, but refuse to report and are exploiting certain loopholes.
The requirement to disclose has only existed for a year I believe, but many are kicking the can or claiming that it would cause them issues.
Meanwhile: https://www.marketscreener.com/news/us-private-credit-defaul...
To private credit firms. Most of what banks do is private credit, the news is them funding private credit firms.
No, there is a huge difference:
- when a bank creates a loan, this has an effect on money supply in total
- when a private credit company "gives" a loan, it has no effect on total money supply and from balance sheet perspective its an accounting exchange on the asset side
I don't know a lot about finance. What is the definition/significance of "firm" in this context (if that's not a complicated question)?
A private credit firm is a non-bank entity that raises money from wealthy investors, pension funds, etc to loan out to businesses. The funds are generally locked up for several years to match the duration of the loans.
They also borrow money from banks to add leverage to this basic setup.
Not who you asked, but I think making the nuance between retail and corporate credit. With firms being corporate credit (i.e. we aren’t talking about individuals / retail).
No.
There are kind of 3 types of loans:
- bonds. Loans interned to be bought by a range if investors and traded over time. Arranged and unwritten by investment banks.
- bank loans. The classic loan. The bank takes depositor money (that the depositor can take back anytime!) and loans it to someone or some company. The bank holds the loan
- private credit. Like a bank loan, but they get their money from long term investments by wealth people and institutions, add bank loans for leverage, and then hold the loan.
> The bank holds the loan
These are mostly syndicated. The traditional difference between loans and bonds was bank versus investment bank. The modern difference is in underwriting technique, degree of syndication/securitisation and loans mostly being floating and bonds mostly being fixed.
I mean the classic “it’s a wonderful life” model
Convergent evolution in finance is actually a pet interest of mine. It seems like it's mostly driven by regulation. But the more you stare, the more the regulation appears like a canyon wall and the hydrology customs and connections. I'm not sure what the underlying geology is, however. Something bigger than customs or laws, but not so grand that it becomes ethereal.
The pattern I see is:
The Banks get in trouble, and Gov has to step in. So Gov, reasonably, add regulations and restrictions. But the law can't be really specific, it requires gov employees to actually examine the bank and make decisions (eg about risk levels, etc).
The banks have a really large incentive to chip away at the effectiveness of the regulation. They hire lots of lawyers, consultants, notable economists, etc and just keep pushing on these rank and file gov regulators. They buy influence with politicians, and use that to pressure the regulators. They hire some of the regulators at very high pay, sending a signal to the others: play ball and a nice job awaits you.
Over time, they just wear down the regulators. The rules are interpreted to be mostly ineffective and nonsensical. Often at that point the politicians come in and just de-regulate.
The banks just have the incentive and focus to keep at it every day for years. No one else with power is paying attention.
> What is the definition/significance of "firm"
Broadly speaking, privately-held companies are called firms. Colloquially, it tends to connote closely-held companies.
Isn’t private credit defined in part as “lending by non-banks”?
Like, when a bank originates a mortgage, that mortgage gets traded, much like private debts don’t.
That's not correctly stated. "Private Credit" is defined as non-bank lending. Banks are doing "public" lending in the sense of being regulated. Private lending is any sort of financial instrument issued outside of those guard rails.
It's generally felt to be risky and volatile, but useful. Basically, it's never illegal just to hand your friend $20 even if the government isn't watching over the process to make sure you don't get scammed. This is the same thing at scale.
> That's not correctly stated
It is. (EDIT: It's a mixed bag. OP was correctly calling out a definitional error.)
Banks have loaned $300bn mostly to private-credit firms. Those firms then compete with the banks to do non-bank lending. It's a weird rabbit hole and I'm grumpy after a cancelled flight, but it feels like I'm in the middle of a Matt Levine writeup.
Good grief. I was responding to "Most of what banks do is private credit", which is wrong. Bank lending is not private credit.
Oh, gotcha. Sorry, got hung up on the first bit.
Highly recommend listening to past episodes on The Real Eisman Playbook podcast for more info on this topic & banking in general.
https://podcasts.apple.com/bz/podcast/the-real-eisman-playbo...
He's one of the "Big Short" guys but more importantly he has great guests on. Everyone is trying to teach & inform, not sell.
He's been calling this risk out for over a year, especially once the White House started trying to allow retirement accounts access to private credit. For a lot of people that was the big alert, even before Jamie Dimon said he saw "cockroaches".
> He's been calling this risk out for over a year
Any figures or lenders he's focussed on?
I can't remember the names. Best bet if you don't want to listen is to just get summaries or transcriptions of the episodes you can an LMM questions on.
The info on his podcasts isn't telling you who to short. It's more who has gone under & general knowledge.
There is so much misinformed fear-mongering about private credit right now.
Important Facts:
1) The majority of private credit funds are classed as "permanent capital". When you put money into these vehicles, you give the Asset Manager discretion over when to give the money back. Redemptions are often gated at ~5% per quarter.
(So there cannot, by definition, be a run on the bank)
2) Credit is senior to equity, so if you expect mass defaults in private credit, it means the majority of private equity is effectively wiped out. Private equity has to be effectively a 0 before private credit takes any losses.
3) The average "recovery rate" for senior secured loans is 80%. Even if private equity gets wiped to 0, the loss that private credit incurs is cushioned significantly by the collateral backing the loan. These are not unsecured loans the borrower can just walk away from.
(The price of senior secured loans dropped by ~30% in 2008, as a worst case datapoint)
4) Default rates on many of the major private credit managers is ~<1% in recent years. There are other estimates stating higher default rates, but that often classifies PIK income as a default. A loan modified and extended with added PIK that ultimately gets repaid is not a "true" default.
5) Finally, it's true that NAVs are likely overstated, but generally it's by a modest amount. Every Asset Manager today could go out tomorrow, mark NAVs down by 20% and suddenly there is no crisis.
(The stocks of Asset Managers have already traded down such that this seems expected and priced in anyway)
> Private equity has to be effectively a 0 before private credit takes any losses
Technically yes. But the overlap between private equity as it's commonly described and private credit is slim.
> average "recovery rate" for senior secured loans is 80%
Oooh, source? (I'm curious for when this was measured.)
> A loan modified and extended with added PIK that ultimately gets repaid is not a "true" default
True. It's a red flag, nonetheless.
> Every Asset Manager today could go out tomorrow, mark NAVs down by 20% and suddenly there is no crisis
Correct. The question is if 20% is enough, and if a 20% markdown creates a vicious cycle as funding for e.g. re- or follow-on financing dries up.
You seem knowledgable about this. I'm coming in as an equities man. Would you have some good sources you'd recommend that make the dovish cash for private credit today?
> Oooh, source? (I'm curious for when this was measured.)
It depends when you measure, but you can Google around and find figures in the 60-80% range. 80% may have been a bit on the optimistic end of the range. But it's important to note that a "default" doesn't imply a 0.
Of course this will depend on the covenants, underwriting standards, type of collateral.
I would guess software equity collateral recovery rates are lower than hard assets like a building. (Which is why I personally don't like Software loans, nothing to do with AI)
> Correct. The question is if 20% is enough, and if a 20% markdown creates a vicious cycle as funding for e.g. re- or follow-on financing dries up.
I think it's almost certain that new fundraising for private credit will be materially hindered going forward. But this just limits the growth rate of these firms, does not introduce any "collapse" risk.
They may move from net inflows to net outflows and bleed AUM over a period of some years.
If NAVs were inflated previously, they may be forced to mark down the NAV to meet redemptions rather than using inflows to payoff older investors.
In the world of credit, 20% is an enormous haircut. Again, senior secured loans fell by around 30% peak to trough in 2008.
We have the public BDC market as a comparison point where the average price/book is around 0.80x. So the public market is willing to buy credit strategies at a 20% discount to stated NAV.
The real systemic risk here, if we were to reach for one, is really that these fears become self fulfilling.
If investors pull funds out of credit strategies en-masse, there is no first order systemic issue, but it means borrowers of many outstanding loans may not be able to secure refinancing as money is drying up.
This could lead to a self-fulfilling default cycle. But this would be a fear driven default cycle, there is no fundamental issue with cash flows of borrowers or otherwise (in aggregate, currently).
Finally, in regards to the asset managers themselves, many are quite diversified.
Yes, they have private credit funds, but many have real estate funds, buyout funds etc. OWL is one of the biggest managers of data center funds, for example (which they also got hammered for on AI bubble fears)
Given how depressed pricing is in public REITs, for example, I expect a lot of asset managers to pivot towards more real asset funds.
So, if I hold a bunch of Private Equity, and my holdings need a continuity of business loan, would I:
(a) have the holding take out the debt, exposing 100% of my stake
or,
(b) have the holding divest a piece of itself, giving me control of the existing and new entities, then have that piece take out the debt, exposing 0% of my stake?
I imagine any PE firm worth its salt would go with option (b).
Presumably regulators would sometimes try to block such deals, but I cannot imagine that happening during the current administration. (Do the regulators even still work for the US government? I thought they were mostly fired.)
Similarly, I can imagine the banks refusing to lend in scenario (b), but I cannot imagine bank leadership being allowed to make such a decision if the PE firm is politically connected to the current administration.
It sounds like you're effectively describing some fraud scheme.
A smart lender will not issue loans without real collateral. If you create a subsidiary, that subsidiary has to have sufficient collateral and cashflow to secure a loan.
Related:
Veteran fund manager George Noble warns that a private credit crisis may be unfolding in real time
https://finance.yahoo.com/news/veteran-fund-manager-george-n...
Looks like we have another problem in the banking system once again, even before AGI has even been fully realized.
We are definitely in the year 2000 in this cycle [0] and between now and somewhere in 2030, a crash is incoming.
Let's see how creative the banks will get to attempt to escape this conundrum. But until then...
Probably nothing.
[0] http://news.ycombinator.com/item?id=45960032
>Let's see how creative the banks will get to attempt to escape this conundrum.
They don't need to get creative, they just need to buy congress or the administration. Same as they've done every time things get messy.
And you know what? It works every time.
Well, the question isn't "is there any consequence for the bank managers"? The answer to that is "No, never, not even during the French Revolution".
The question is "How long can they keep extracting money before the economy implodes?"
The people producing macroeconomic indicators in the US were fired about 6 months ago for putting out an honest report. Since then there's been very little correlation between public sentiment on the economy and the official indicators.
So, we're definitely in some sort of overhang situation, where the economy is imploding, but the stock market goes up. I think that's unprecedented in the US. In developing countries, when this happens, it usually leads to things like hyperinflation.
So, I guess the real questions are: "How do you short the dollar?", and "How can you tell when the banks start doing it?" so you know when to jump off the merry-go-round.
Government removes regulations, economy collapses, government bails out the wealthy, quants get ski trips and bonuses while families starve.
It’s more accurate to say that the private credit market was created by the government adding new regulations, not removing them. Business development corporations have existed since the 80s but they didn’t explode in popularity as business loan originators until Dodd Frank and other post-2008 regulations made it more difficult for banks to lend money. This led small and medium size businesses to seek out credit from firms like Ares et al instead.
I picked a bad time to rewatch Mr. Robot
And to make matters worse, those who remove regulations then get voted out, but show up on infotainment "opinion" shows disguised as news broadcasts....and whine that those who were voted in to fix the mess aren't fixing the problem fast enough, so those who caused the problem should be voted back in. And lo and behold, they get voted back in, to cause more damage.
Its a big beautiful system!
Democracy
Its un-fixable. The situation cant be explained simply enough for the majority of americans. Even if some of them do mange to understand, it will be quickly forgotten amid the flood of trump sewage we are sprayed with every day.
I think we'll get there (to explanation), but it'll be through the lizard-brain-level pain of poverty instead of rational understanding unless we get much better at communicating to the least willing to listen among us.
One guy has twice as much money as that. Can't be a big deal.
Equity/net worth is not quite the same as the liquid capital needed to cover losses or service debt.