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Private credit funds are having a moment. Once under-the-radar lenders that did deals with riskier clients, the firms have gotten a lot more popular as interest rates have climbed. But private credit funds are also under a lot less oversight than traditional lenders, allowing little transparency into the way they value their loans. And all this new-found attention is starting to come with heightened scrutiny.  

On today’s Big Take podcast, Bloomberg reporter Silas Brown shares what we know — and what we don’t — about how the world of private credit operates, and what new regulatory interest could mean for the $1.7 trillion dollars of assets these funds are managing.

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Here is a lightly edited transcript of the conversation:

Sarah Holder:  There’s a group of lenders who used to be kind of off the radar in the world of finance — but who now seem to be having a real moment. We heard about them from Silas Brown, a Bloomberg reporter based in London.

Silas Brown: You have seen this kind of cascading effect where these kind of figures have suddenly become these industry financial heavyweights. 

Sarah Holder:  The kind of people who might have… 

Silas Brown:  Dinner with Barack Obama, mansions on both US coasts and dazzling modern art collections, from Frank Stella to Jean-Michel Basquiat. These are all solid bragging points when you’re sitting at finance’s top table.

Sarah Holder:  So who are they? They are leaders of what are called — private credit firms. Private credit firms lend money to all kinds of businesses but they don’t have the same level of oversight as banks do.  And it used to be that they didn’t get that much attention. 

Silas Brown:  It was seen as the less glamorous of the two options, investment banking dealing with these kind of  big M&A transactions and powerful deals and private credit would sort of pick up the scraps on the bottom.

But as interest rates have risen the past two years – these firms have suddenly found themselves to be the new darlings of the lending world. 

Silas Brown: You know, everyone seems to have a view on private credit now. Everyone seems to be considering setting up their own private credit firm or, you know, like, being kind of rude about private credit or whatever. Everyone seems to have to have a view on it. 

Sarah Holder: But all this newfound attention is also coming with heightened scrutiny. 

Silas Brown: I think as the market is kind of booming, regulators are cognizant of the fact that they don't know that much about what's going on in this market.

Sarah Holder: Today on the show we go inside the world of private credit to find out what we know — and what we don’t — about how it operates. And what the future might look like for the $1.7 trillion dollars of assets these funds are managing. 

This is The Big Take from Bloomberg News. I am Sarah Holder.

Sarah Holder: So Silas, how did private credit companies get so big? How are they making Basquiat money?

Silas Brown:  Private credit is, at its root, a tool for private equity firms to buy companies. So private equity firms buy companies by using some money of their own and their investors and then also some debt provided traditionally by investment banks. People a while back now, sort of tens of years ago, thought that there might be a new way of doing it, which was that they would provide private credit, which is an alternative to the bank led, bank led markets.

Silas Brown:  What happened two years ago is that as rates rose, banks became much more cautious around underwriting these big deals, and private equity needed to still do some of these deals — they did do much less of the deals, but the deals that they could do — they then thought, oh, well, how about we knock on the door of these lovely mid size lenders who have scaled and who are getting more and more money and perhaps they can satisfy the needs that were once met by, investment banks.

Sarah Holder:  And Silas says because these lenders were willing to lend when others weren’t, they were able to charge higher rates to borrowers. Which meant they could offer relatively higher returns to their investors. All of this made them popular with pension funds and sovereign wealth funds.

But the thing about private credit that now has people nervous is that it’s private. Unlike a lot of traditional bank lending where banks make loans to businesses and then bundle them up and sell them off to other people, private credit continues to be held by the private credit firm. 

And because it is hardly ever traded, the only people who know what it’s worth are the people holding it — the private credit firms. And they have an incentive to say that the loans are worth a lot. 

Silas Brown: One thing that I think is fundamental to private credit is to do with the value of the loans. So in the traditional, lovely, easy to understand world of publicly traded debts, you can look at where the debt is trading versus you know the cents on the dollar. And that gives you a good impression of how likely the debt is to be repaid, so like how risky it is. 

Private credit — it isn't traded. People hold onto the debt for the life of the loan. But they still need to ascribe a value to what those loans are. So, they are kind of basically trying to work out what their assets hold. 

Sarah Holder:  That seems a little like someone checking their own homework, right?

Silas Brown:  Yes. Which is a pretty suboptimal state of affairs for investors but also for regulators who are trying to understand the health of the market. 

Sarah Holder:  So, the whole world of private credit seems, for lack of a better word, a little shady. Or at least in the shadows. Is that how you see it?

Silas Brown: Well, I think that's not how they see it. I think that, much like all private markets, there's much less access to information for outsiders. And the outsiders also include journalists that cover the market as well. And so we have much less data, we have to try to paint as accurate a picture as possible with fewer utensils than our kind of public market peers.

It's not to suggest that there is anything nefarious underneath, necessarily. But private credit has kind of rapidly become much more significant than it once was. And so where an insignificant thing, not knowing much about it, doesn't have much consequence in the eyes of many, now, people are a bit nervous about how little they know about it. And I think what we're trying to establish is, to what extent can we believe the valuations.

Sarah Holder: And the problem with trying to cross-check the private firm's homework — to look closely at how these valuations are being made — is that the details behind the deals are not easy to get.

Silas Brown: In Europe, where I sit, there are no publicly available data points for what the valuation of these assets are. So me as a journalist, will have to find some clever disgruntled fund manager to sort of sit on a park bench with me and go through the marks of their fund.

Sarah Holder: Did you sit on a park bench with a person like that? 

Silas Brown: No I didn’t, perhaps due to my incompetence as a journalist. No one has yet done that for me. But, in the US, there is some visibility over valuations. They publish their valuations on a quarterly basis. So you can see, um, through these things called BDCs, which are effectively kind of lending vehicles for some of the major private credit firms, you can see the valuations that they're ascribing to their deals.

Sarah Holder: Silas and his colleagues wanted to compare the way private credit firms were valuing their loans and how the rest of the market might value them — so they ran a big data analysis. Using data compiled by Bloomberg and fixed-income specialist Solve, and interviews with dozens of market participants, they found some eyebrow-raising discrepancies. One scenario they looked at was...

Silas Brown: Situations where two private credit firms are both lending in the same deal… So they're both holding the same debt but there can be really substantial differences in opinion about where they should value the debt.

Sarah Holder: He gave us an example. 

Silas Brown: If something is priced at 84 cents on the dollar, and something is trading at, um, 59 cents on the dollar that is a different picture that it's painting for an investor. One signals, really deep distress, like, the company's in loads of trouble, and one signals kind of stress, like, the company's in trouble, but, you know, there should be a path forward. And, you know, people invest in these funds, and I think it's reasonable for them to be asking, why there's such a discrepancy.

Sarah Holder: After the break, will the private credit balloon… pop? 

Sarah Holder: Hey! We're back. Before the break, we were talking about the striking rise of private credit funds. And Silas Brown was telling us how these funds essentially check their own homework — they tell the market what the loans they hold are worth. But sometimes what the private credit funds say their loans are worth — doesn’t exactly match up to the way other people value them. He gave us a drastic example:

Silas Brown: This is like a really funny one. I still think quite a lot about it. So when debt is marked at a hundred, it'd be, people say it's marked at par. Par, which basically is, you know, is the most performing metric effectively that you can have. And a few examples that we've found of, of companies that go into file for bankruptcy, um, and then the filing after that event marks the debt at par, if you were in the public markets, there would be no way that after a Chapter 11 bankruptcy filing, which is obviously a very serious thing to happen, that you, that there would be no kind of movement in the price of the debt.

Sarah Holder: Those are the more obvious cases, but concern about the lack of transparency in the private credit market overall is increasingly getting attention. Here’s former FDIC chair Sheila Bair speaking about it on Bloomberg TV. 

Sheila Bair, BTV: There needs to be a more holistic view among the regulatory community about the risks that are going into the non-bank sector. You’re having a lot of credit flowing into these private credit funds now. They’re not subject to the same level of capital regulation. They are not as transparent.

Sarah Holder: Silas said one specific thing that has caught the eye of people watching this industry is the rise of what are called “payment-in-kind” deals.

Silas Brown: If you read our writing, you probably see this kind of annoying acronym, PIK, quite a lot, and it's called payment-in-kind loans. And what that means is that instead of paying, uh, the company paying in cash, uh, they'll stop paying the interest on the debt for now, and let it accrue.

There's very clever arguments for why it isn't necessarily a signal of distress at all, but in some cases it clearly is. By and large, like, if there's an unexpected use of PIK, and a company was paying interest and is now saying they don't want to pay interest, and they're using PIK to not pay interest, that's kind of like, not ideal for a lender.

Sarah Holder: And so, I mean, this growing concern from financial regulators about private credit companies, um, sort of signals a shift in the initial enthusiasm about them, right? You were saying they were seen as an alternative to move the lending away from bigger Wall Street banks and into these specialist firms. What about the economy right now has people changing that stance?

Silas Brown: Yeah so, I mean, I think, um, to play the defender of the private credit market against those dastardly banks… 

Sarah Holder: Please. 

Silas Brown: What I will say is the leverage models that they have in private credit versus, like, investment banks. It does cause a sigh of relief among regulators. The leverage levels are still, by and large, substantially lower than what you would get in an investment bank. So that's a kind of good thing for private credit.

However, I think as the market is, is kind of booming, regulators are cognizant of the fact that they don't know that much about what's going on in this market that it's become this kind of pretty titanic force in leveraged finance. And leveraged finance is among the riskier forms of kind of global finance. And so they are sort of scratching their heads and not quite sure what is happening.

It doesn't necessarily mean that something’s bad happening. It just means that there is an information gap that they're trying to kind of get to. Um, but I think by and large if I was a regulator, I would think it's probably good that a lot of this risky debt is out of the hands of banks. However a lot of the risky debt is in the hands of specialist lenders and the investors of the risky debt are also like pension funds that are, you know, relevant to the everyday lives of people like you and I.

Sarah Holder:  Yeah I mean, so what's the worst case scenario, um, of all this? If these loans are super overvalued, the whole house of cards collapses, how big of a deal is that? 

Silas Brown:  As someone who's covering the market, I'm often very worried about an imminent collapse so I'm thinking about it quite often. I think more likely what will happen is, if the kind of downside scenario, there will be a lot of instances of defaults and debt for equity swaps, there'll be companies crippled by higher interest rates and high debt burdens, and lenders having to kind of cope with potential losses as a result of those companies going into default, and going into kind of insolvency in some situations.

And so, what was once a kind of market that could have been defined by owning a Basquiat becomes a market being defined by, like, owning some random company.

Sarah Holder: We've been talking about a lot of the risks. But what are some of the measures that have been proposed, whether by financial regulators or the private credit fund managers, to prevent these downstream impacts to  investors if these valuations are in fact too high?

Silas Brown: I think they will be increasingly using and listening to third party providers, people like Lincoln International and Houlihan Lokey and Deloitte, places like that, who are, by the way, paid by the lenders, so they're not kind of like totally independent assessors, but they do add this kind of layer of scrutiny over the values of the loans. So I think that's kind of helpful. I think the market will probably benefit from industry bodies trying to kind of create a coherent set of standards for everyone.

Sarah Holder: So the private credit industry kind of came of age in 2008. Does this feel like a full circle moment for it as people start raising concerns about its stability? 

Silas Brown:  I mean, I think, um, it's obviously boomed in a kind of more benign environment and, and now it's having to deal with higher interest rates. But, um, uh, you know, I think most people believe that it will carry on growing just as private equity will carry on growing. I mean, it serves a pretty clear function for private equity firms. But it hasn't really been through a full cycle yet. 

And, you could argue that the next, like, 18 to 24 months are like pretty defining for the market as it is now.

You know in the 2008 situation, the market was kind of like infinitesimally small versus what it is now and there's a lot more players, a lot more deals, a lot more companies that are involved and whether or not the market has like underwritten debt in a kind of efficient and like sensible way is definitely going to be evident over the next like two years.

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