Jeff Meli: Welcome to the Flipside, I’m Jeff Meli, the Head of Research at Barclays. I’m joined today by Brad Rogoff, the Global Head of FICC Research. Who is here to talk about private credit. Thanks for joining me, Brad.
Brad Rogoff: Thanks for having me, Jeff. Very excited to talk about what has become the hottest two words in my markets besides I guess of course Federal Reserve.
Jeff Meli: Well we’ve done plenty of Flipside episode concerning the Fed but this is the first time we’re going to talk about private credit. Now private credit consist of non-bank lending where the debt is not public. So it’s not publically traded and the companies that borrow the money are not required to make public disclosures. It’s basically the private analog of the better known public credit markets which include things like corporate bonds and institutional loans.
Brad Rogoff: It’s really just an alternative version of the institutional loan market in my opinion. So in the loan market, banks originate loans to companies, sell them to a broad base of large asset managers who own the loans on behalf of their investors.
On the private credit market, non-bank lenders go directly to the companies that are looking to borrow money. In fact, another term that – well maybe it’s not exactly the same, is often used synonymously is direct lending.
Jeff Meli: Brad, you already alluded to how popular this topic is with credit investors. And in my experience it seems like almost any conversation with a large investor in the credit market turns to private credit at some point. Everyone is getting involved. And may be more quantitatively the market does appear to be growing very rapidly.
Brad Rogoff: It has, everyone is doing it. We estimate the size of the market is currently $1.2 trillion which is roughly the size of the leverage loan market and approaching the high-yield bond market.
I think it’s growing for good reason. Private credit offers both investors and issuers benefits vis-à-vis the public credit market. Sure there are trade-offs and it’s not for everyone. But in the end, both sides are happy in most cases thus far. And I think the growth has provided a good alternative.
Jeff Meli: Well, Brad, I’m actually much more skeptical of private credit. I think the growth is really the consequence of some well intended regulatory initiatives that have resulted a generic trend of more risk moving out of the public sphere. And I think that will pose its own risks when this cycle eventually turns.
Brad Rogoff: Yes, I don’t know if that’s skeptical or dire, Jeff. But, as I mentioned already, this is not for everyone. But let me start in a more optimistic take. First some history. In the aftermath of the Global Financial Crisis, small and medium sized companies needed financing. The banks they had previously relied on were under significant strain and were reluctant to extend credit.
So these companies went to other lenders. Initially those were BDCs or Business Development Corporations. And these investment vehicles raised money from investors and lend it directly to these smaller companies.
Jeff Meli: Now these BDCs have existed really since the 1980’s. But the issuance definitely picked up in the years following the global financial crisis. That’s where the trend started for private credit but it has a lot of momentum and now there are more investors involved like insurance companies and others. Also a variety of new investment vehicles.
Brad Rogoff: I would say at this point, BDCs, maybe 20 percent of this market. So they matter. But you’re right, they have been eclipsed. The investor base grew rapidly and quickly this became an important channel of financing for these companies.
So given how quickly it’s grown and with such broad interest there must be something attractive about the asset class. What’s interesting though, it that for the market to grow this rapidly it had to be appealing to not just investors but issuers as well.
Jeff Meli: See, Brad that seems hard to believe. How can both investors and issuers preferred this to public credit?
Brad Rogoff: All right, to me and anyone who’s listened to a Flipside knows that there’s no way I ever will get you to believe in a free lunch. But in nascent markets there can be arbitrage opportunities.
So let’s start with the investors where I think the argument’s a little bit easier. First of all, private credit does not trade actively and so it doesn’t get mark-to-market, i.e., it has much lower volatility. It’s a nice feature in environments like we are currently experiencing.
Jeff Meli: Well, Brad, your own research has indicated that the default rates in private credit are quite similar to the default rates in public credit. So this lack of volatility is really more a question of optics than anything real about the value of the assets.
When markets sell off these investments drop in a value in a real sense whether or not there is a price that you could reference to show that they marked down.
Brad Rogoff: Well we do know that sometimes optics matter, Jeff. More importantly, investors get greater yields than they would from public credit. The yield increase, it’s difficult to estimate precisely because of differences in the most common structures between the markets.
But we think the additional yield was in excess 200 basis points for an extended period of time and it’s now closer to 100 basis points higher on a like-for-like basis. In the environment we have been in for the past decade, that extra yield definitely matters to investors.
Jeff Meli: Now, of course, investors are sacrificing liquidity in order to earn this extra yield. Private credit doesn’t trade, so it’s not like public markets where there’s pricing and trading happening all the time, so it is less liquid.
But I get it, at some point there’s a trade-off between liquidity and yield, and depending on the extra yield that trade-off can make sense, particularly for part of a fixed income portfolio. But just to be clear, if private credit generates better returns for investors, then by definition it must be more expensive for issuers, that’s a zero sum game.
Brad Rogoff: Only if you consider coupon for the entire price for issuers. When people ask me the lessons from the global financial crisis, I often say that private equity learned that when they are buying a company the structure of their financing is as important as the company they bought.
Private credit is used primarily to finance private equity or sponsor owned companies. Until the last few years, most of the issuers in this market were smaller companies that don’t have immediate or perhaps any access to public credit. Maybe they gain access but it’s costly in terms of management time, investor education, et cetera.
The private market offers an alternative that requires a relatively small number of lenders and thus gives greater certainty and speed of execution, both of which are valuable to issuers. As I mentioned, bank financing becomes more scarce around the global financial crisis and private credit fills that gap.
Jeff Meli: Look, I understand that issuing debt is more difficult for a small company that only rarely need to come to the market for financing than is the case for say a huge public company that issues corporate bonds all the time. And of course, markets are very volatile right now. So it resonates that speed and certainty matter.
But a lot of the growth in private credit occurred during the period of very low volatility and very easy financing conditions that proceeded this current bout of volatility we’re experiencing. I don’t really get how the certainty and speed arguments made sense then.
Brad Rogoff: I think you’re undervaluing the overall cost associated with issuing debt for a smaller company. Certainty and speed for an issuer is basically a liquidity premium in reverse. You pay the extra premium but lock in financing at a set price when you need the money.
Jeff Meli: Well, Brad, I think there’s more to the story here. So you’ve highlighted the barriers faced by smaller companies when accessing the public credit market which causes them to turn to the private market. But isn’t it the case that we’ve seen larger and larger companies accessing the private credit market?
Brad Rogoff: That is definitely true, and actually a big reason why we’re talking about it right now. The maximum size of available issuers has grown along with the investor base, and some larger companies have raised money through private credit.
We’ve seen some deals in the $3 billion of debt range recently, and I can see where you’re going with this. It’s the case that those sizes are more typical to institutional loans and so you shouldn’t have the same barriers that I just mentioned. I think those deals are actually what’s driving the premium to lower levels, as I mentioned earlier.
Jeff Meli: Well, I think the missing ingredient that we haven’t touched on yet is leverage. Remember that in 2016 the U.S. Federal Reserve began to emphasize their leverage lending guidelines that were intended to stop banks from originating loans to companies where the leverage of the company was too high.
Now, we define a company’s leverage as the ratio of its debt outstanding to it’s profits, or EBITDA. The guidelines effectively cap that ratio at six times. That cap was meant to apply regardless of whether the bank held onto the loan, or sold it to its investors.
Brad Rogoff: I know those guidelines well, Jeff. I also remember that the GAO ruled that the Fed did not follow the correct rulemaking process when issuing them, so they could not enforce them as a rule.
Jeff Meli: Yes, that’s true, but they are still used as a guideline. And I think it’s clear that banks are still reluctant to bring deals to market that significantly exceed that leverage threshold. But there’s no such restriction in the private credit market because banks aren’t involved.
In fact, what we’ve seen is that the percentage of deals with high leverage, even over seven times or eight times has been growing. I actually think that the ability to use such high leverage is a big part of the draw for issuers, particularly the larger ones. Maybe this was at one point in time a lifeline of sorts for smaller companies, but I think the use case has quickly morphed.
Brad Rogoff: I agree. Empirically leverage has been growing, it’s easier to do highly leveraged deals through a non-bank channel. But I have two caveats that once again make the point that we cannot measure tradeoffs through one statistic.
So first, whereas covenant light is the norm for broadly syndicated loans, private credit typically has a better covenant package. So covenants give investors rights to force a renegotiation if the company fails to meet certain financial targets.
When those do exist investors are better protected, even if leverage is slightly higher. Second, I think about leverage just like liquidity. There’s a fair price for more leverage and investors are the ultimate judge of whether they are getting a good deal.
Jeff Meli: Well I agree on the covenant point. To be fair, though, we had started to see some slippage in the covenant packages in private credit, although precise data’s pretty hard to come by in that market.
I suspect that pushing the limits on the covenant package is a goal for the sponsors that own these companies, particularly if they agree with your comment that financial structure is as important as the asset that they're purchasing.
Brad Rogoff: All right, maybe there’s a bit of hyperbole there, and I don't think they’ll tell you they necessarily agree with it, but I stand by the point. If I had to guess, some of the covenants slippage will reverse with the recent surge in volatility.
Still sponsors will argue that despite the presence of covenants it’s worth paying a premium since negotiating with fewer lenders makes getting a deal done much easier. How much easier? It’s open to debate. I see public secured loans getting made even in stressed situations where covenants do not come into play. Once again, a lot of this is based on a market that had low volatility.
Jeff Meli: OK, but I would disagree with you on the leverage issue. It is true that from the perspective of an individual investor or an individual company there's a fair price for increased leverage, but the Fed did not try to limit leverage to protect investors.
They were trying to do that to protect the economy. When too much leverage is widely used you could end up with a large set of companies that all run into trouble at the same time, like if the economy experiences a recession.
Companies that are more levered will likely have to reduce employment by more, reduce investment by more, have less ability to respond to challenging economic conditions, and more likely to sort of do economic harm. This can exacerbate a downturn, and in particular I think what worries the Fed is that it could do more damage to the labor market.
Brad Rogoff: So that’s an interesting interpretation. The guidelines were forced as part of the Fed’s macroprudential regulations, and as you mentioned the guidelines applied even if the banks sold the loans. So clearly there were worries about the overall use of leverage rather than specifically about what was sitting on bank balance sheets, but this was also coming out of a credit crisis and maybe the more general societal costs associated with leverage even during a downturn aren’t typically that high.
Jeff Meli: That’s fair, and I admit I don't really know how to size the social costs of widespread use of high leverage, but I think we can agree that the benefits of high leverage are all private.
Brad Rogoff: I do agree with that statement, but I also think the Fed is trying to have its cake and eat it, too. Interest rates are only just starting to rise despite the economic recovery post COVID being in full swing and inflation reaching 8 percent. Is it really all that hard to imagine why investors were forced to look to alternative investments to generate yield?
Jeff Meli: Well it’s not. I agree with that, Brad, and I think reach for yield definitely has contributed to the demand for private credit, but while we’re on the subject of higher rates, how worried about you – about the effect of the hiking cycle on these borrowers? Private credit is really in the form of loans. They're all floating rate. That means as the Fed starts hiking interest rates the interest payments that these companies owe are going to go up.
Brad Rogoff: I am concerned, and as a credit guy by background I love to look at free cash flow. Even at seven to eight times leverage these companies generated cash to pay down debt because rates were so low, but clearly higher interest bills are going to start eating into free cash flow. But remember, public loans are floating rate, too.
Jeff Meli: Yes, they are, but those borrowers are less levered, and more broadly if I’m right that the ability to utilize more leverage is a major draw, the growth of private credit also shows I think the downside of trying to use banking regulation to affect the broader financial system. What we’re seeing here is that the activities have just migrated away from the banks and, therefore, away from the regulation and here in this case into the private market where the regulators have very little ability to affect the outcomes.
Brad Rogoff: It’s actually a broader point than just banks that you're making, Jeff. So look at the recent SEC proposal to require climate-related disclosures from public companies. Obviously private companies are exempt.
In general, the burden on public companies has been one reason for the growth of private assets, equity and credit, and a decline in public investments. (Retrieval) might be temporary and as you mentioned the Fed is now raising rates, but the cost of being public are only going up. So I don't think we will see the growth of private credit reverse any time soon.
Even if that were the case, remember approximately two-thirds of the broadly syndicated leverage loan market’s private and so is one-third of high yield bond issuers. When the costs go up, all of these options look more attractive.
Jeff Meli: Well Brad, we’re going to have to see how this plays out over the next couple of quarters, particularly now like you say that interest rates are starting to rise.
Clients of Barclays interested in reading more about private credit can see Brad’s recent piece, “Private Credit: Attempting to Redefine Risk Reward”, available on Barclays Live.
