The Private Credit Reckoning is Coming Executives Are Mistaking Luck For Genius The Weekly Wrap

President Trump asserted there has been a regime change suggesting the war is ending. I still find it hard to believe that President Trump will end the war with the strait closed because that would be viewed as defeat. We now know that private credit understates its software exposure, that the industry wants to massage the data to make it seem smaller. The lesson here is that an entire generation of private credit executives have mistaken a lack of a credit cycle for genius. When private credit eventually blows up, it's going to be a shock to the industry's executives, just like the GFC was a shock to Wall Street executives. It's not going to be pretty. Hi, this is Steve Eisman and welcome to another edition of The Weekly Wrap. Because of Good Friday, this is a shortened week. So this wrap is for the week ending Thursday, April 2nd, but recorded Wednesday, April 1. The first quarter is over and it was a tough one. The market started the year with a nice January. The market was up a bit over 1% by the end of January. However, largely because of the war, but also because of fears about the impact of AI and private credit, the quarter ended with the S&P down 4.6% for the year and Nasdaq down 7.1%. I will have more to say about the quarter and the performance of all the sectors and important subsectors on next week's wrap. But on this wrap, we will discuss the following. One. While the war in Iran continues to grab headlines, we need to keep focusing on the underlying economic issues at play. Two. More bad news about private credit. Three. The psychology and herd mentality of hedge funds. Four. The psychology of the executives of private credit funds and how similar that is to the psychology of Wall Street executives pre the Great Financial Crisis. And finally, five. I answer two questions from viewers. So let's get started. We have now entered the fifth week of the war. Over the weekend, President Trump threatened to destroy Iran's energy infrastructure and Karg Island unless the Iranians negotiate and reopen the Strait of Hormuz. Like I have said before, we are now in an environment where there is only one variable that matters. The war. On Monday, the market attempted to rally but ended down on day after the publication of certain negative headlines. But on Tuesday, the market was up strong on a Wall Street Journal article which stated that President Trump told aides that he is willing to end the war without reopening the Strait of Hormuz. After our interview with Stephen Cook of the Council of Foreign Relations, which we posted on Monday of this week, I must say that that headline does not sound right. On the other hand, on the same Tuesday morning, President Trump put out a scathing statement on Truth Social. He said, All of those countries that can't get jet fuel because of the Strait of Hormuz, like the United Kingdom, which refuse to get involved in the decapitation of Iran, I have a suggestion for you. Number one, buy from the US. We have plenty. And number two, build up some delayed courage. Go to the Strait and just take it. You'll have to start learning how to fight for yourself. The USA won't be there to help you anymore. Just like you weren't there for us. Iran has been essentially decimated. The hard part is done. Go get your own oil, unquote. By Tuesday morning, after the market soared almost 3%, President Trump asserted there has been a regime change, suggesting the war is ending. Even given this and the Truth Social statement, I still find it hard to believe that President Trump will end the war with the Strait closed because that would be viewed as defeat. But that's just my opinion. Clearly, making any investment decisions right now is very difficult, given that the markets are literally trading headlines. Moving on. More bad news on private credit. Shocking, I know. Monday morning, the Wall Street Journal published a very interesting article about private credit's exposure to the software sector, pointing out that the actual level of exposure is considerably higher than the 25% that has been estimated. By looking through the filings of scores of private credit funds, some commentators have reached that 25% estimate number. They say 25% of all direct lending loans are to software companies, specifically to software companies bought out by private equity from 2018 to 2022. The journal article suggests that there is leeway in how private credit classifies a company as being or not being in the software sector. I call this data massaging. Private credit funds classify software companies that service other sectors, such as healthcare, as being in those sectors as opposed to software. Tomato, tomato. If that isn't data massaging, I don't know what is. The journal looked at four private credit funds, four major private credit funds, and found the following. One, the Blue Owl Credit Income Fund, a $34.8 billion fund, reported 11.6% of its portfolio in software, but the journal found its software exposure at around 21%. 11.6% versus 21%, it's quite a discrepancy. The Blackstone Private Credit Fund, aka BCRED, an $82.5 billion fund, reported 25.7% in software, but the journal found 33% exposure. Three, Ares Capital Corp., a $29.5 billion fund, reported 23.8% exposure, but the journal found nearly 30% exposure. And finally, Apollo Debt Solution Fund, a $25.1 billion fund, reported 13.6% software exposure, but the journal found 16% exposure. What conclusion should we draw from this? It's pretty simple. Private credit's exposure to software is so large that the industry wants to massage the data to make it seem smaller. If and when the software industry suffers massive problems because of AI, this will have a huge and negative impact on private credit. Losses could be ugly. Now, do we care if a few private credit funds suffer huge losses? Yes, if it impacts the banks, who may or may not be involved in financing either the equity or the credit behind these deals, take huge write-downs, and if pension funds across the country are invested and take a large hit, and if other entities with retail exposure like life insurance companies are invested and take a large hit as well. The impact will be felt, but more importantly, any sense of trust, safety, and security will be seriously eroded. Once the trust is broken, it's hard to restore. One more point. This software classification story is one more aspect of the opaqueness of private credit. We now know that private credit understates its software exposure. Also, the marks on its portfolio, the value of the loans, is priced by the private credit funds themselves. Now, how reliable is that? There is opaqueness in this industry everywhere you look, and that is part of the problem. Investors always fear what they don't know, and here, we don't know a lot. The role of psychology is a topic that does not get enough examination. The most you hear about it is when business news reports panic selling or sometimes panic buying of stocks. However, psychology plays a much larger role if you know where to look. We're going to discuss first the occasional herd mentality of hedge funds, and then the role of arrogance in the realm of private credit. Let's first look at the herd mentality of hedge funds. The hedge fund industry likes to think of themselves as the smartest people in the room, the independent thinkers, the risk takers, and that is sometimes true. Here's what is also true. Hedge fund managers and analysts know each other. They see each other at conferences. They go to idea dinners where they share long and short ideas. It can create a herd mentality in certain trades, and we can see that in the strange price movements of certain asset classes since the war in Iran began. Since the beginning of the war, oil prices and interest rates are up, but gold prices are down. Now, oil prices rising makes perfect sense. Interest rates rising is less intuitive. Normally in a crisis, investors will flock to U.S. treasuries, thereby driving yields lower. This time, however, rates are up because higher oil prices have tapped into investor fears about inflation. Fair enough. Gold going down makes no sense. Gold is viewed as a hedge against the demise of fear currencies, rising inflation, and an increase in overall risk. So normally, gold prices go up during a war. The combination of a war with rising inflation expectations should cause gold to skyrocket. Here we have a war and fears of inflation, and yet gold has declined about 10% since the war began. What explains this negative move in gold? Answer, herd mentality. Apparently, a bunch of major hedge funds from Caxin to PIMCO to Citadel to Millennium and Balyazni all had similar trades where they were betting on lower interest rates and higher commodity prices, including gold. When the war began, their interest rate bets went badly against them. All of the funds in these trades have suffered fairly significant losses since the war began. And I'm guessing that the risk managers of these firms ordered all the portfolio managers with these trades on to reduce risk. That meant selling bonds and gold, and that's why gold prices are down when they should be up. It also could explain why interest rates have gone up so quickly. Now let's turn to the world of private credit. When I watch business news and see interviews of the executives of private credit, I'm struck by how almost universally they defend the industry. The defense is not surprising, but the tone somewhat is. Most of these executives are arguing that there is nothing wrong, just bad publicity. Since there is obviously something wrong, the question is whether they actually believe what they are saying. I'm convinced that they do. They actually believe that there is nothing wrong. There is an arrogance to their presentation, and that arrogance feels like the same arrogance Wall Street executives displayed before the great financial crisis. History does not necessarily repeat, but it sure can rhyme. And here's the rhyme. Prior to the great financial crisis, Wall Street executives suffered from one of the worst cases of arrogance in business history, and that requires an explanation. I'm creating a master class on how to analyze banks and lending companies, and I'll go into all of this in much more detail there. But here's a quick version. Banks make money with leverage. As long as they are making money, the more leverage, the more they make. The formula to understand is that return on equity equals return on assets times leverage. Imagine two banks each with a 1% return on assets. If Bank 1 is levered 10 times, its ROE is 10%. If Bank 2 is levered 40 times, its ROE is 40%. From an economic perspective, both banks are equally profitable because they have the same exact return on assets. The only difference is the leverage. Historical footnote, between 1997 and 2007, leverage in the banks more than tripled, but the ROEs stayed flat. It was the leverage that caused Wall Street profits to explode. And you don't need to be a genius to take on more leverage. You just have to borrow, and anybody can do that. Wall Street executives are compensated not on return on assets, but on a combination of net income and return on equity. Wall Street executives got paid tens of millions, largely because they took on more leverage. An entire generation of Wall Street executives mistook leverage for genius. And the resulting arrogance was on full display pre-crisis, as executive after executive got on business news and claimed nothing was wrong when, in fact, everything was wrong. Something similar has happened in the world of private credit, but the arrogance is not from leverage. Most private credit funds can only be leveraged two to one. The thing to focus on here is the lack of a credit cycle. Since the GFC, the level of losses in virtually all asset classes has been consistently low, almost subterranean. It's been a great time to be a lender. What makes lending a unique business is that the cost of goods sold is unknown at point of sale. In the case of lending, the cost of goods sold is losses, and those losses always occur sometime in the future. When the lender makes loans, they underwrite those loans with a level of losses in mind. If losses come in lower, that creates excess profits. It's been 17 years since there has been losses in the United States, and private credit, as a result, has generated excess returns throughout. The lesson here is that an entire generation of private credit executives have mistaken a lack of a credit cycle for genius, and that's why private executives believe that nothing is wrong. Why? Because times have been good for so long that they have forgotten what it's like to experience serious levels of losses. It's been so long that it seems unimaginable. When private credit eventually blows up, it's going to be a shock to the industry's executives. Just like the GFC was a shock to Wall Street executives. It's not going to be pretty. Now I'm going to address two questions from viewers. First question is from Cormac, who says, Hi Steve, massive fan of the show and the way that you conduct interviews breaking down extremely complex information into something that even someone from a non-finance background can digest. I, however, have probably one of the dumbest questions you will receive. Is GameStop, symbol G-E-M-E, at its current price, which is around $22, a value stock? I am not one of the people that would invest looking for short squeezes or other nonsense, but in this current environment where private credit is threatening the U.S. economy, I see a stock with a massive stockpile of cash and wonder if it would be worth investing in. I know that Michael Burry has mentioned that he sees some value in the stock, particularly if they use their cash to acquire other businesses with more upside in revenue. Thanks again for doing this show and being open to receiving questions. My response? Without question, this is not a dumb question at all. Let's review a little history. GameStop operates a declining business. It sells video games in retail stores, but the entire business has moved online. In 2021, GME was a heavily, heavily shorted stock, but then became a meme stock. Leaders of Reddit boards told their followers to engineer a short squeeze by buying GME, and the stock soared multiple times and wiped out the hedge funds who were short. Literally wiped them out. That's the danger of being involved in a heavily shorted stock. Believe me, I know. You can be right on the fundamentals and still lose money. Top line fundamentals at GameStop have not gotten better, but the company has cut costs and so is profitable. Also, the company was very smart and used the price surge to raise capital. Currently, GME has $6.3 billion in cash and cash equivalents, but $4.1 billion in long-term debt, so it has net cash of $2.2 billion. The market cap is $10 billion. In a recent substack, Michael Burry argued that GME has value because they could use their cash to acquire other businesses. I do not find this argument compelling at all. It sounds like a pipe dream to me. Buy a stock because they could buy something worthwhile at a good price? Good luck with that. Maybe they buy something good, and maybe they buy something not so good. Maybe they buy something at a good price, and maybe not. Too many maybes for me. Second question is from Malwin, who says, Hi Steve, thank you for the great coverage of what is happening in the private credit markets over the last few weeks. It is my understanding that within the private lending space, broadly speaking, there are two types of lending entities. A closed-end fund that is publicly listed, and retail investors can buy and sell at the prevailing price. It provides liquidity to retail investors, and the issuing company is insulated from redemption pressure. I am talking about companies like OCSL, which is a public company. The second vehicle is like BCRED, the Blackstone Fund, where there is no day-to-day price, and limited 5% or so redemption volume can be liquidated. However, their portfolio size is huge compared to listed BDCs. From the issuer's perspective, what is the attraction for BCRED-type non-listed vehicles? Is there more fee income in it? Why is the entire market not made up of companies like OCSL or OBDC? There's a whole list of companies. Great question. The answer is all about who is investing in the private credit fund. Private credit funds, the ones that are not public, restrict investors to wealthy individuals and institutions by operating under exemptions from Investment Company Act registration. To qualify, they must restrict investors to accredited investors or qualified purchasers and limit marketing. In other words, to very rich people or institutions. This exemption allows them to avoid SEC registration as investment companies, which means no public reporting, no leverage limits under the 40 Act, and no liquidity requirements. The public entities that Mylan referenced are all public BDCs, Business Development Corporations. BDCs are a structure Congress created in 1980 to let retail investors access private credit. But in exchange, BDCs must register with the SEC, file public financials, and operate under leverage limits that private funds don't face. So BDCs are permitted to use leverage, but only up to 2 to 1. The non-public private credit funds do not face these leverage restrictions. Also, BDCs must distribute at least 90% of income. This last Monday, March 30th, we posted an interview with Stephen Cook of the Council of Foreign Relations, who was a Mideast expert with deep contacts in the region. We discussed the war and how it will potentially change the region. We also discussed what his contacts are telling him about what is really going on. So check it out. This coming Monday, we will post an interview with Steve Leisman, Chief Economics Reporter at CNBC. Steve is a recurring guest. We discuss the impact of the war on the economy, the Fed, private credit, and a bunch of other topics. So I hope you tune in. Be sure to check out our website, realeismanplaybook.com. If you're enjoying these weekly wraps in our podcast, we kindly ask that you support the channel by subscribing to our YouTube channel and to our audio channels as well. The Real Eisman Playbook. Subscribing is the best way to help us expand this community to more like-minded individuals such as yourselves, and we greatly appreciate your support. And that's the wrap. See you real soon. This podcast is for informational purposes only and does not constitute investment advice. The hosts and guests may hold positions in stocks discussed. Opinions expressed are their own and not recommendations. Please do your own due diligence and consult a licensed financial advisor before making any investment decisions.