Magellan Financial Group (ASX: MFG) co-founder Chris Mackay has joined a growing chorus of objection to the way private credit has been able to flourish unchecked. Within a recent client note, Mackay flagged concerns over perceived regulatory failures, plus unfettered investor euphoria.
Based on Reserve Bank (RBA) data, Australia’s private credit currently totals $40 billion - around 2.5% of total business debt – while private credit funds are (by some measures) on track to manage $200 billion in capital.
While private credit can complement traditional fixed income strategies, Mackay, like David Di Pilla’s at HMC Capital and Phil King at Regal Partners – who have both vocalised their objection to private credit - accuses (some) providers of looking to cash in on the rush of capital to the sector.
It’s unfortunate, adds Mackay, that many of those “championing” private credit are reminiscent of the junk bond brigade from years' past.
“Some of the best storytellers reprise the waves of junk bonds, derivatives and similar past ‘successes’ and now narrate that their fees super-charged illiquid non transparent investments are superior,” he said.
Regulatory failure
Mackay also argues that lack of visibility over leverage and regulatory failures and have allowed the private credit market to thrive outside the scrutiny of public markets. He attributes a bubble in non-public markets to a clear sign of regulatory failure.
“Still nascent regulatory failure have allowed accelerating multiplication of private credit formats raised with fees and artificially low bad debts inflating ‘performance data’, outside the heavily regulated excess capital holding traditional banking system,” Mackay told investors.
Adding to Mackay’s concerns is unprecedented growth in global private credit globally - now said to worth more than US$1 trillion - as an alternative source of financing for businesses.
Too few investors, adds Mackay, really know what goes on under the bonnet of these underlying loans.
He believes evidence that some funds are reluctant to disclosure their unwillingness to write off badly performing loans, disproportionate fees, and loans to companies about to go broke, raises questions about the thoroughness of due diligence.
“Bubbles are becoming greater and more risky/damaging in non-public markets as money chases money and derivative trades are already multiplying to create ‘products’ blessed by the sages gaming the ratings agency rules and processes – as occurred prior crises,” he said.
“The story tellers absolutely tap into and create their legendary zeitgeist necessary for the grand scale with suspended belief that this time is unique and past examples have limited precedent value.”
Concerns overstated
However, despite the steady drip of negative headlines in the private credit space, JP Morgan in a note to clients last year suggested that concerns investors may misjudge the balance of risk and reward within this fast-growing sector have been overstated.
While JP Morgan recognises the risk of default, and that direct lending may not be appropriate for all investors, the private banker continues to have a constructive view on direct lending. In exchange for less liquidity; JP Morgan believes direct lending offers investors 250 basis points of yield, per annum, above leveraged loans.
While some investors worry growth is out of control, and that companies of questionable quality are taking on too much debt, JP Morgan also thinks the facts say otherwise.
“If we just focus on the United States and remove dry powder, we estimate outstanding direct loans in the United States to $475 billion, compared to total principal value of $925 billion for domestic high yield and $1.4 trillion for the USD Leveraged Loan Index (as of 2Q23),” the private banker noted.
Similarly, while lending standards have loosened a bit recently (suggesting lenders are not receiving as much compensation for a unit of risk), JP Morgan believes those standards remain solid overall.
Overall, while defaults may rise further, JP Morgan thinks investors may be well compensated for the risk. “Following the spike in borrowing rates over the past two years, defaults rose in public markets,” the private banker noted.
“However, they did so from extremely low levels. The increase only brought default rates back to their long-term median.”
Within a recent note, Goldman Sachs also reminded clients that over the past decade, the asset class has generated higher yield than most other asset classes, while maintaining loss ratios that are lower than those of high-yield fixed income instruments.
