Sharp falls to stock markets on Monday, with a partial rebound on Tuesday, are being analysed for signs that something more serious could be happening to the US, and world, economy.
What has already started to raise red flags for certain investors and institutions such as the International Monetary Fund, however, is the rapid ascent of private credit and non-bank lending. While the IMF does not yet think this activity poses a systemic risk, the organisation’s warning note of a few weeks ago was, perhaps, the first major discordant note for an area that has boomed. Family offices, among others, are taking notice.
At Sydney-based – a firm running global equities both in a long-only and long-short form – risks that stem from forms of credit are very much front of mind.
“We are looking to avoid credit-sensitive businesses, and that is the key,” Vihari Ross, investment director at Antipodes, told this publication in a recent interview.
Antipodes is looking at the private credit space as a potential source of risk. “We look out for tail risks and this is a key part of what we do,” Ross said. Credit risk can also be useful information in playing the short side as well – betting against a stock. The firm, which also has offices in Toronto and London, has $6.5 billion of assets under management and is affiliated with Pinnacle Investment Management, a global multi-affiliate investment management firm, with AuM of $100.1 billion.
The Antipodes Global Fund – Long – UCITS structure has delivered returns of 8 per cent in the year to date (in dollars); the MSCI All Country World Net Index chalked up a result of 13.1 per cent over the same period. (The UCITS fund is registered in the UK and Ireland.)
Cracks in the wall?
“Private credit is a fissure,” she said. The pace of growth in the private credit market and how it is a relatively unregulated space are both risks to consider.
“With a high degree of leverage, and with rates where they now are, debt servicing costs have escalated. If the Fed cannot cut rates, there is a tail in this part of the market that can start default. Defaults rates have started to increase, if from a low base,” Ross continued. The chart below illustrates what is at stake.
A decade of ultra-low rates (now over) and a structural shift from listed to private markets, have fuelled rapid growth. Low rates meant that investors tolerated illiquidity in private markets to grab returns. Tighter capital rules on banks after the 2008 crash pushed money into alternative spaces. Another reason for all this ferment is that fees for private funds can be 1 to 2 per cent for the annual management fee, with an incentive fee of 15 per cent above a certain threshold. It is not surprising that funds’ general partners are keen to promote their wares, given the revenues on offer.
The sector is still a relatively new one for RIAs, multi-family offices and others, although not as obscure as it once was. According to the International Monetary Fund, assets under the management (deployed and committed) of private credit managers in the US reached $1.6 trillion in June last year, growing at an average annual rate of 20 per cent over the last five years. Private credit now accounts for 7 per cent of the credit to non-financial corporations in North America, comparable with the shares of broadly syndicated loans and high-yield corporate bonds.
Spillover effect?
Antipodes’ Ross said there can be a “transformation” of risks between private markets and public, listed ones, rather than a cut in risks because pooled private credit structures are themselves also geared with debt provided by commercial banks and public markets alike.
The growth in private credit has meant that it is now the equivalent size of leveraged loans and high-yield, aka junk lending which has taken a share from bank lending channels, she said. Private credits are individually negotiated with a private sponsor; if there are issues with repayments then this can be renegotiated, and the details are opaque and often not widely disclosed. One result is changes towards more payments-in-kind, Ross said. “We have found that payments-in-kind have increased dramatically.”
Other risks to watch include the hit to jobs if rates squeeze firms that have used private credit. About 20 per cent of the US population works in firms backed by highly geared structures such as private equity, credit, and others. “This is not a sideshow,” she said.
Ross gave a specific example of how risks on the credit side should be considered.
“Higher rates have led to rising delinquencies and deteriorating interest coverage across all debt profiles, but assessing the extent of risk building in private direct lending is incredibly challenging since it’s very opaque,” Ross said. “Ares Capital Corporation, one of the largest listed business development corporations which provides credit to small and medium sized businesses in the US, reported that interest coverage has halved to 1.6x for the average corporate borrower within their structure as servicing costs have increased to over 10 per cent."
The following chart illustrates the lag between rate changes and new US bankruptcy filings
“This structure itself is also geared at 1:1 debt to equity supported by banks and public markets. Peer comparisons suggest similarly worrying statistics. Zooming out, companies and structures that employ a high degree of leverage, including private credit, support businesses across technology, retail, healthcare and services which we estimate together account for more than 20 per cent of employment in the US. It’s not difficult to see that if policy remains tight there can be much broader implications for the real economy,” Ross said.
Inflation
“Should inflation and therefore rates stay higher for longer, then the second order effect of that is that something might break. That something could very easily be a spate of defaults in these highly levered, cash flow negative companies backed by private credit and private equity capital or more likely a catalyst for employment to start to falter as these companies cut costs to stay afloat. We expect this scenario would also bleed into listed assets more broadly as the premium for risk is repriced,” Ross added.
Signs of stress don’t always show up in simple pricing and default data, Ross said.
Another potential measure of borrower stress is a look at payments-in-kind (PIK) where lenders accrue interest to the balance of the loan instead of taking a cash interest payment from the borrower. This is typically something offered on the loans of liquidity constrained borrowers (such as those with inadequate or negative cash flows to pay their interest) to avoid default.
Terms of PIK may vary greatly ranging from a cessation in payment altogether through to partial payments activated under predetermined conditions. PIK interest payments have surged for BDC portfolios.
“We estimate that more than 20 per cent of BDC loans have payment-in-kind features as of 4Q 2023, and we may be on the cusp of increasing negotiation of payment terms of this nature if credit conditions remain tight,” Ross said.
Approach
Ross said the firm focuses on “pragmatic value,” not just the cheapest valued stocks but those that are cheap relative to their business resilience and growth.
“We will invest across the spectrum of low to high growth but pay the right price,” Ross said.