Investors are Waking Up to the Private Credit Crisis

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. That man there is Steve Eisman. You may not have heard his name before, but you've probably seen his character from The Big Short. Steve is one of the few investors that predicted the collapse of the global banking system back in 2008. He is an exceptionally smart and rational investor. I had the great privilege of interviewing him last year. But one of the things that's caught my attention recently is that Steve is currently sounding the alarm on private credit and the risks that it poses to the market over the next few years. So, in this video, I want to break down everything Steve has been saying. You know, what is private credit? What's the problem? And just how bad is it? It's been a very, very long time that we've had a financial story that has news flow like this, so consistently and so consistently bad. So, let's get into it. Private credit, what is it? That's really where we do need to start. In its simplest form, private credit is simply lending that happens outside the traditional banking system. So, instead of a company borrowing money from a big bank, it borrows money from a private fund or non-bank lender instead. Why does this happen? Well, remember the global financial crisis of 2008? I was in eighth grade at the time, so I don't particularly remember it the way that others do. But what happened in the aftermath was that banks were hit with much tighter regulations. So, that made sense. The financial system had just blown up. We don't want that to happen again. But one side effect was that banks became more restricted in the kinds of loans they could make. So, what ended up happening is the demand for borrowing didn't disappear. It just moved. So, companies that still needed financing increasingly turned to non-bank lenders, and that's where private credit really took off. But this is the main criticism of this development. The increased banking regulations post-2008 didn't stop the riskier lending. It just shifted it from somewhere that we could see to somewhere that we can't. That's the private in private credit, right? And what this ultimately means is we don't really know the extent of the problems in private credit until we're actually in it. This was Steve talking to me about this point last September. There's really no systemic risk. I don't see systemic risk in the banks. Is there systemic risk in private equity? Could be, but I don't have enough data to know. And right now, as we'll discuss, we're kind of finding out that maybe it isn't okay. So, that's the primer on private credit. But you might be asking, well, who are these big-name non-bank lenders? Who even are the players in this story? Well, interestingly, many of the biggest private credit lenders are actually firms you have already probably heard of just from a different part of the investing world. Companies like Blackstone, Apollo, KKR, Ares, Carlyle. These are giant alternative asset managers that originally made their name in private equity, buying companies, improving them, and then selling them later for a profit. But over the past decade, they've realized something very important. When you buy companies, you also need someone to provide the debt financing. And instead of letting banks earn those interest payments, they decided they could just do it themselves. In one part of the business, private equity buys companies. And in another part of the business, private equity lends money to itself to buy those companies. If that sounds somewhat circular to you, it's only because it is. So today, these firms don't just buy companies, they also lend to them. They raise massive pools of money from pension funds, insurance companies, and more recently, retail investors. And then, they use that money to issue loans to businesses. And because these loans are often to companies that are smaller, more leveraged, or just a little bit riskier than what a traditional bank might prefer, they can charge higher interest rates, which is why private credit has been able to offer very attractive yields that have enticed investors to pile in. But there's another puzzle piece, and this will become important later on in the video. So, I mentioned that to raise the money to lend out, private credit firms will tap pension funds, insurance companies, retail investors, and so on, right? But here's the thing, they also borrow money from the major banks. Yes, all that the regulations have done post-2008 is just add another step in the process. So, instead of the major banks now directly lending to the risky companies, the banks lend to private credit funds who then lend to risky companies. Let's hold that thought for now because next, I want to explain the current problem. The thing that's happening right now that's thrust private credit firms into the spotlight, and that's the SaaSpocalypse. Now, I made a video on this very recently. So, if you want to learn more about this, definitely check that one out. But the SaaSpocalypse refers to the brutal sell-off we've seen across the software industry. But we're not just talking Salesforce, Adobe, Snowflake, Atlassian, Shopify, etc. We're talking all software businesses. These companies are all under pressure because investors are starting to believe that AI will come through and either crush their revenue growth as a lot of these platforms charge per head, or as a worst-case scenario, AI will just render their software useless as Claude or Gemini or ChatGPT or something else will just be able to come and do the same job but better. So, what was a few years ago the hottest trend to be on, just software as a service, was now being completely spat out. Share prices are falling hard and confidence generally is waning. But here's the thing. Actually, I'll just let Steve explain it. Credit is overexposed to software companies and software company valuations have declined en masse due to AI's impact on the traditional business model of software companies. Some commentators estimate that 25% of direct lending loans are to software companies. The company's private equity bought from 2018 through 2022. Yeah, it's not good. And remember how I was saying that because this stuff is private, you kind of don't know how bad it is until you get into it? Well, right now, we're kind of in it. And the truth is, it's looking worse than people first thought. Now, I want to shout out this journalist from the Wall Street Journal who found that many private credit fund managers are actually playing down their exposure to software as fears spread about threats from artificial intelligence. Software is actually the largest industry for most of these private credit funds. And what the journal found was that if the private credit firm funded a software business that's, for example, got something to do with healthcare, they were actually reporting that as exposure to healthcare, not software. So before this investigation, the four funds they investigated, Blue Owl, Blackstone, Ares, and Apollo, had on average 19% of their investments in software. But in truth, their average software exposure is actually around 25%. Blue Owl was the sneakiest of the bunch reporting just half the software exposure than they actually had. 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. So the problem here is this. Between 2018 and 2022, private equity was buying up SaaS companies and in the process, private credit loaned a lot of money to these software companies. But these lenders are now trying to downplay how exposed they are. Not good. The overarching risk here is that if AI does have a disruptive impact on the cash generating abilities of these software companies, and if they have to refinance in the next year or two at higher interest rates, they may struggle to pay back these loans. And if that ends up happening en masse, when one quarter of private credit loans are to software companies, that could be a real problem. So that's the medium term problem. But this also creates a short term issue too, particularly for retail investors. That is that they can't really get out. You see, because these private credit loans aren't publicly traded, they're quite illiquid. And historically, that's what the institutional buyers have been okay with. Low liquidity, higher yield. But since the rise of retail investing in private credit, firms have started to get creative with ways of making themselves look liquid. So these days, private credit firms will usually allow redemptions of 5 to 7% of assets per quarter. And you betcha, now that this exposure to software has been revealed, private credit firms are seeing a massive wave of people trying to get out. One, Blackstone's large $82 billion private credit fund called BCRED received a redemption notice, a quarterly redemption notice of 7.9% of assets. The fund redemption cap is 5%. Two, Cliffwater. Investors put in a 14% redemption notice from the $33 billion Cliffwater Corporate Lending Fund. The fund only honored its 7% cap amount, leaving half of the redemptions unfulfilled. Three, Morgan Stanley. Investors put in a 10.9% redemption notice from the $8 billion Morgan Stanley North Haven Private Income Fund. Morgan Stanley honored only the 5% cap amount. Blackrock. Investors put in a 9.3% redemption notice for the $26 billion Blackrock H Lend Fund. Redemptions were honored only at the 5% cap. So long story short, the market is expecting loan losses from software, and they're running for the exit. Even John Zito, a top executive at Apollo, said recently, I'm not as rosy and I'm not as confident in what will happen with the technology. Anyone who tells you that the earnings last quarter were really good so it's all good, anyone who says that clearly doesn't understand. Most of the businesses that were bought from 2018 to 2022 are lower quality than those companies, smaller than those companies, and were trading at much higher valuations than those companies. So I am concerned about many of those take privates. Okay, so these smaller software companies that private equity bought up in 2018 to 2022 are probably going to struggle. Private credit will probably take losses. But to end the video, I just want to look at whether this will be a systemic risk that the media are now starting to suggest. Because here's the concern. Remember that point I was talking about earlier where private credit gets its money to lend? Sure, it's retail investors. Yes, it's insurance companies. Yes, it's pension funds. But it's also the major banks. AKA, if private credit takes losses, banks also take losses. 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. That's the predicament we're currently in. People are losing faith in private credit quickly because they can't see what's going on. And we know the private credit firms are massaging the data to try and make it not look so bad. And to top it all off, banks are exposed to this. But how bad is it? Is this going to be the big short happening all over again? I can tell you that in the great financial crisis, we thought that they were off laying all the risk out into the market, and we found out it came back to the banks. The idea that the banks are not somehow involved in this... Oh, the banks are involved because they lend. So when you talk about private credit funds, they're levered two to one. That one turn of leverage that they are levered, they get a lot of it from banks. Now, my argument is that, assuming this gets really bad, if you have a scenario where private credit takes huge losses, there probably could be some losses in the banks. This is my personal opinion. The difference between now and pre-great financial crisis is that the leverage is half in the banks. That's what I was going to ask you. I was going to say, Steve, two to one is not seven to one. Where were we in the GFC? How much leverage was out there in these CDOs? The way to think about it is how much leverage was actually in the banks when you put back all the stuff that was, quote unquote, off balance sheet, but was on balance sheet. It probably averaged for the big banks, they were levered 40 to one. And that's the reason why, at least from what we understand today, this probably doesn't pose a GFC level threat. In the GFC, the banks were so levered that it was a house of cards 40 layers high, whereas in private credit, it's two. Well, specifically in BDCs, it's two to one and has been since 2018. So, my conclusion is, it's hard to see the full extent of the software impact on private credit. It doesn't look good that firms are trying to mislead on their exposure. I feel like I agree with Steve that private credit will get crunched hard if these smaller, low quality software companies get heavily affected by AI, have to refinance loans at higher interest rates today, and ultimately can't pay. And yes, investors will lose money if that's the case. But in a worst case scenario, as Steve notes, it currently doesn't look like a big enough problem to really cause havoc in the broader banking system as the media are really playing into at the moment. Again, hard to know. This stuff is private. It's hard to see. But that's my takeaway at this moment in time. Now, before we finish up, I do just want to put the message out to everyone. If you're going to be in Omaha in a few weeks time for the Berkshire Hathaway shareholder meeting, definitely come along to the Berkshire Bonanza that we are hosting. It's going to be myself, Divya Narendra, Phil Town, Matt Peterson, Hamish Hodder, and Nate O'Brien is also going to be there as well. So, come say hi. It'll be a great time, 3.30 to 6.30 p.m. Friday, May 1st at the Diamond Room Omaha. Please check the details in the description, the pinned comment. And if you are yet to pre-order a copy of The New Money Strategy, I would really appreciate it if you did. I've said this so many times but I'll say it again. Pre-orders, these days, I was surprised to learn they really do determine the commercial success of books these days. So, if you would be able to pre-order a copy if you would like to, I would really, really appreciate it. So, you can scan the QR code on screen to check out the details or check out the description and pinned comment. With that said, guys, thank you very, very much for watching and I'll see you all in the next video.