Taking action: Kelleher in an interview at Bloomberg House in Switzerland. The UBS chairman’s warning has led to the SEC rushing in rules to force private fund advisers to allow external audits as an ‘important check’ on asset values. — Bloomberg
NEW YORK: Colm Kelleher whipped up a storm at the end of last year when the UBS Group AG chairman warned of a dangerous bubble in private credit.
As investors dive headfirst into this booming asset class, the more urgent question for regulators is how anybody could even know for sure what it’s really worth.
The meteoric rise of private credit funds has been powered by a simple pitch to the insurers and pensions who manage people’s money over decades: Invest in our loans and avoid the price gyrations of rival types of corporate finance.
The loans will trade so rarely – in many cases, never – that their value will stay steady, letting backers enjoy bountiful and stress-free returns. This irresistible proposal has transformed a Wall Street backwater into a US$1.7 trillion market.
Now, though, cracks in that edifice are starting to appear.
Central bankers’ rapid-fire rate hikes over the past two years have strained the finances of corporate borrowers, making it hard for many of them to keep up with interest payments.
Suddenly, a prime virtue of private credit – letting these funds decide themselves what their loans are worth rather than exposing them to public markets – is looking like one of its greatest potential flaws.
Data compiled by Bloomberg and fixed-income specialist Solve, as well as conversations with dozens of market participants, highlight how some private fund managers have barely budged on where they “mark” certain loans even as rivals who own the same debt have slashed its value.
In one loan to Magenta Buyer, the issuing vehicle of a cybersecurity company, the highest mark from a private lender at the end of September was 79 US cents, showing how much it would expect to recoup for each dollar lent.
The lowest mark was 46 US cents, deep in distressed territory.
HDT, an aerospace supplier, was valued on the same date between 85 US cents and 49 US cents.
This lack of clarity on what an asset’s worth is a regular complaint in private markets, and that’s spooking regulators.
While nobody cared too much when central bank interest rates were close to zero, today financial watchdogs are fretting that the absence of consensus may be hiding more loans in trouble.
“In private markets, because no one knows the true valuation there’s a tendency to leak information into prices slowly,” said Peter Hecht, managing director at US investment firm AQR Capital Management. “It dampens volatility, giving this false perception of low risk.”
The private lending funds and companies mentioned in this story all declined to comment, or didn’t respond to requests for a comment.
Private credit was embraced at first for shifting risky company loans away from systemically important Wall Street banks and into specialist firms, but the ardor’s cooling in some quarters.
Regulators are doubly nervous because of the economy’s febrile state. These funds charge interest pegged to base rates, which has handed them bumper profits – and made their borrowers vulnerable.
“As interest rates have risen, so has the riskiness of borrowers,” Lee Foulger, the Bank of England’s director of financial stability, strategy and risk, said recently.
“Lagged or opaque valuations could increase the chance of an abrupt reassessment of risks or to sharp and correlated falls in value, particularly if further shocks materialize.”
Values are especially cloudy outside the United States, because of poor transparency. And it’s the same for loans made by funds that don’t publish quarterly updates or where there’s a single lender with no one to judge them against.
Tyler Gellasch, head of the Healthy Markets Association, a trade group that includes pension funds and other asset managers, said policymakers have been caught napping.
“This is simply a regulatory failure,” said Gellasch, who helped draft part of the Dodd-Frank Wall Street reforms after the financial crisis.
“If private funds had to comply with the same fair value rules as mutual funds, investors could have a lot more confidence.”
The Securities and Exchange Commission has nevertheless begun to pay closer attention, rushing in rules to force private fund advisers to allow external audits as an “important check” on asset values.
Some market participants wonder, however, whether the fog around pricing suits investors just fine.
Several fund managers, who requested anonymity when speaking for fear of endangering client relationships, said rather than wanting more disclosure, many backers share the desire to keep marks steady.
This has prompted concerns about a code of silence between lenders and the insurers, sovereign wealth funds and pensions who’ve piled into the asset class.
One executive at a top European insurer said investors could face a nasty reckoning at the end of a loan’s term, when they can’t avoid booking any value shortfall.
A fund manager who worked at one of the world’s biggest pension schemes, and who also wanted to remain anonymous, said valuations of private loan investments were tied to his team’s bonuses, and outside evaluators were given inconsistent access to information.
The thinly traded nature of this market may make it nigh-on impossible for most outsiders to get a clear picture of what these assets are worth, but red flags are easier to spot.
Take the recent spike in so-called “payment in kind” (PIK) deals, where a company chooses to defer interest payments to its direct lender and promises to make up for it in its final loan settlement.
This option of kicking the can down the road is often used by lower-rated borrowers and while it doesn’t necessarily signal distress, it does cause anxiety about what it might be obscuring.
“People underestimate how dangerous PIK products are,” said Benoit Soler, a senior portfolio manager at Keren Finance in Paris.
He pointed out the sometimes enormous cost of deferring interest: “It can embed a huge forward risk for the company.”
And yet the value of loans even after these deals is strikingly generous.
According to Solve, about three-quarters of PIK loans were valued at more than 95 US cents on the dollar at the end of September.
“This raises questions about how portfolio companies struggling with interest servicing are valued so high,” said Eugene Grinberg, its cofounder. — Bloomberg
