Private Credit’s “Muppets” Moment?

We just got back from dropping off the kids for their first ever overnight camp, 5 nights sleeping under the stars in Yosemite! To say that I wish I were them is an understatement… Our road trip to achieve said drop-off in the Bay Area was a true ode to California’s natural beauty and to the people we met along the way. We shared an impromptu meal with Laurel and Sam, a lovely couple from Point Reyes Station, and their gorgeous dog Ruthie. Her shiny black robe was a reminder that grace and beauty endure. Laurel and Sam told us about the soft-serve water buffalo gelato at the Palace Market. When you order your soft serve, go for the large serving… This is not when you should practice self-restraint!

While we were on the road, I was startled by the steady uptick in articles about private credit and its migration to the “retail” market, i.e., households as opposed to institutional investors. I found myself somewhat troubled by the drumbeat and then the “big news” hit that Blackrock was launching a private credit offering for retail investors. Is private credit asset management’s new “Muppets” show? I hope not, but there is a bit of yuck in the air, especially if you’re a student of incentives in “product innovation” in the asset management industry. As Bloomberg put it, this is a “tricky time” for private credit. Let me explain.

I am a major Matt Levine fan. Matt writes for Bloomberg and he did an incredible job recently capturing what may be the simplest yet most important fact about the economy and markets at this moment: “Debt Costs More When Rates Go Up.” If you’re confused about anything over the next few months, just whisper to yourself those seven words like a mantra. Until 2022, the whole system had tuned itself up to ever declining interest rates for decades, then in 2022 and 2023, rates jumped… a lot! And that takes us to private equity (PE) and private credit (PC).

Imagine you work for a PE investment firm and you’re a PE “guy.” You find a company you think has potential, but you’re convinced you can manage it better than the current “guys.” If you’re right, the company could be worth more after you whip it into shape. How do you maximize the return to you and your clients for managing it better? Easy, you turn the whole company into a big “call option” by buying it using whole bunch of cheap debt (Remember, we’re before 2022 and rates are low). Here is a simple example. Assume that the company is worth $100 to start and that you borrow $80, so you have $20 of equity in the whole thing. We’ll call that 5-to-1 leverage. You get to work, you do the PE “better management” routine, and the company ends up being worth $160. The debt is worth $80 but your equity is now worth $80 also, or 300% more. But imagine you do all the PE “better management” playbook and somehow the company doesn’t do all that much better as a business. Your equity is could well be worth $10 now, so you’ve lost 50% and the company is now levered 10 to 1. That’s a lot of debt against little equity, not leaving much room for bad things to happen. And then imagine that interest rates go up a lot, the whole company could be in jeopardy quickly.

Private credit is the debt side of what we just went through. Think of it as a “product innovation” related to private equity. Imagine you’re the PE “guy,” dealing with, well, the equity side of things. You usually get debt from banks. Then we have the Great Financial Crisis, new regulation, and banks are told to cool it with risky loans to private equity. That makes your job as a PE “guy” harder. But then the lightbulb goes off! What if you also did the debt side of the transaction? You can do more PE deals and you get to tell your investors about this cool new asset class called “private credit.” Private credit grew in the 2010s, and then in 2022, rates up, debt costs more, and that’s especially true for the floating-rate debt used in private credit. As a result, while nearly every other asset class produced losses in 2022, private credit ended up doing well. Something that did well when everything else did poorly, you say? A dream for product marketers, because investors tend to buy assets that have done well recently (a psychological bias called “return chasing”) even though past performance is not indicative of future performance.

But here is the issue: With rates as high as they are now, the debt burden that many highly levered companies face could turn them into “zombies” (and eventually outright deadbeats), making 2022 a particularly poor reference point because in the end lending to deadbeats (no matter the interest rate) is just not a great business model. And against this backdrop, Blackrock is launching a private credit offering for “retail investors.” A tricky time indeed.