Author: Ariston

The discussion around Private Credit is very loud, but few have clearly explained it. Traditionally, private credit has always been a B2B model. In other words, large institutions lend money to companies to support their growth under controlled risks. For lenders, this has been a very profitable business model. Where there is money to be made, funds will flow there.

1) Similar to private equity firms, private credit institutions are also non-bank lenders that provide debt financing to companies. The terms private credit and direct lending are often used interchangeably, but in fact, direct lending is merely a sub-sector within the broader private credit market. Private credit has explosively expanded to a size of $1.8 trillion. Ten years ago, this market was only $300 billion, and now it has reached $1.8 trillion. Therefore, its growth rate is quite remarkable.

2) So, why is there an alarm now? Mainly because some private credit institutions have begun raising funds from retail investors to support their lending business. At the same time, private credit funds typically provide a certain degree of quarterly liquidity.

3) Specifically, what strategies does private credit have? The first type is direct lending, which serves as an alternative to the broad syndicated loan market. It involves lending directly to businesses. Borrowing companies can be sponsored, meaning they have private equity support, or non-sponsored.

In the U.S. direct lending, 80% flows to companies with private equity backing. In other words, direct lending is largely financing private equity acquisition companies. Many private equity firms also own private credit platforms themselves.

The second type is asset-backed finance lending, which uses contractual cash flows and related assets as collateral. The underlying assets can be very diverse, including mortgage loans, auto loans, lease assets, or accounts receivable.

The last type is opportunistic distressed credit, which is to lend to distressed companies or finance around corporate actions like spin-offs, or to serve those companies that are not suitable for the direct lending market or the private equity market.

4) So, who is the lender? The lenders are private credit funds, and most private credit funds are owned and operated by business development corporations, or BDCs. BDCs are essentially specialized lending institutions. Some BDCs are publicly traded, while others are private.

And many private credit funds are actually run by BDCs that are controlled by private equity firms. For instance, the largest private credit lender currently is the Blackstone Private Credit Fund, also known as BCRED. It is a private BDC wholly owned by the publicly traded private equity firm Blackstone.

Thus, in one part of the business, private equity buys companies; and in another part of the business, private equity also lends money to itself through its private credit platform to buy these companies. If you think there’s a kind of circular structure in this, you are right, because that’s how it is.

5) Now, private credit faces two major core issues. First, should private credit funds be sold to retail investors? Second, is a credit cycle forming? These two issues are interconnected but not the same.

The so-called credit cycle means that loan losses are increasing. There are very bad versions of the credit cycle, such as the global financial crisis; and there are less severe versions, such as the recession of 2001.

Since the global financial crisis, the U.S. has not really experienced any credit cycle, which is why many commentators believe we are now on the eve of a credit cycle.

6) Of course, the current issues in private credit are still in their early stages. This is an unfolding story, and it’s still too early to judge how bad it will ultimately get.

7) Since these private credit loans are not publicly traded, they are by definition illiquid. There is nothing wrong with that. Historically, the investors in private credit funds have always been large, mature institutions. There is nothing wrong with that either. They know what they are buying: a product with higher yields but illiquidity.

But once private credit funds have basically raised funds from the institutional world, they began turning to retail investors, including but not limited to brokerage clients, 401(k) plans, and so on. And this is where the problems begin.

These loans themselves are illiquid. To create an appearance of "liquidity" for retail investors, funds allow redemptions, but typically set limits at about 5% to 7% of assets per quarter, depending on the fund. I believe this information has already been disclosed to retail investors. But I also believe that many retail investors do not truly understand the full implications of it.

Now, due to redemption demands continuously breaching the 5% to 7% threshold, private credit funds have to think of various ways, or simply restrict redemptions.

8) Another important detail: private credit has excessive exposure to software companies, and due to the impact of AI on traditional software business models, valuations of software companies have experienced significant downward adjustments.

Returning to the issue of credit cycles, one point is worth emphasizing: 80% of direct lending loans are providing financing for private equity acquisitions. This is also why the direct lending industry has excessive exposure to software companies. 25% of direct lending loans are directed towards software companies, many of which were acquired by private equity from 2018 to 2022. And the market is worried (despite the intense debate surrounding this concern) that AI could enter the software industry at much lower price points and disrupt the business models of existing software giants.

9) Another issue is that it's estimated that 11% of these software loans will need to be refinanced in 2027, and another 20% will need refinancing in 2028. These loans were initially issued at very low rates because they emerged in a low interest rate era. When they are refinanced, if they can be refinanced, the interest rates will be much higher. Assuming the turbulence in the software industry continues, who will come to refinance these loans? This is an extremely important question.

10) Now, everyone is watching private credit because the growth in lending is primarily happening here. Historically, when a credit cycle unfolds, the problem loans often appear first in the asset class that previously experienced the fastest growth. This was the case during the global financial crisis, where subprime mortgage loans experienced the fastest growth and then exploded.

11) This is also why investors are currently concerned about private credit. Because the growth is right here. Since the global financial crisis, the banking system has generated very little loan growth. Almost all loan growth that has occurred has happened in private credit, which was only $300 billion ten years ago and has now reached $1.8 trillion.

12) Executives from several of the largest private credit funds are working to downplay the redemption issues and the risk of the unfolding credit cycle. But John Zito, Co-President of Apollo's Asset Management Division, candidly pointed out this issue during a discussion organized by UBS for clients.

Zito was originally speaking off the record, but somehow his comments were reported by The Wall Street Journal. When discussing private credit's excessive exposure to the software industry, Zito said: "Most software companies acquired between 2018 and 2022 are of lesser quality compared to those larger companies, and the acquisition valuations were much higher, so I am concerned about many of those privatized companies."

From his statement, it is clear he expects loan losses in the software sector. In fact, Apollo's exposure to software is only 2%, while the overall industry average is about 25%. Therefore, Zito can comfortably criticize competitors. It is a very comfortable position.

He also expects high redemptions to continue for several quarters. He pointed out a contradiction: there is still significant demand in the market to purchase secondary stakes in private equity, that is, to buy a limited partner's stake in a private equity fund. But at the same time, investors who are optimistic about private equity and willing to buy these secondary stakes feel nervous about private credit, even though private credit has financed 80% of private equity firms.

免责声明：本文章仅代表作者个人观点，不代表本平台的立场和观点。本文章仅供信息分享，不构成对任何人的任何投资建议。用户与作者之间的任何争议，与本平台无关。如网页中刊载的文章或图片涉及侵权，请提供相关的权利证明和身份证明发送邮件到support@aicoin.com，本平台相关工作人员将会进行核查。