Private credit suffers from distrust of managers – 04/01/2024 – Market

Investor confidence in private market asset values ​​has reached such low levels that some are taking action on their own.

More managers are hiring investigators to obtain information that helps them learn more about the companies they are lending or investing resources to, as well as to assess underlying collateral risks, according to Jason Wright, senior managing director at the crime consulting firm financial, risks and regulation K2 Integrity.

Private credit has become one of Wall Street’s fastest-growing sectors, more than tripling in size over the past decade to $1.7 trillion as managers turned to investments that promised high returns as well as a protection against mark-to-market losses.

Historically celebrated for providing stability even when government bonds were wavering, this attribute is increasingly being seen as a liability as investors worry that stable valuations may not be accurately reflecting true risks.

“There’s a lot of discretion used by managers of these portfolios, and the biggest questions we’re facing right now are about recoveries in these assets more broadly, and how much can be recovered,” Wright said in an interview. “What is the true amount of debt here?”

In February, Bloomberg News reported that in some cases, the same loans were being valued very differently depending on which portfolio they were in. The huge price swings are also spooking regulators, who are worried that the lack of consensus could be masking more problems beneath the surface.

A growing trend in private markets has been the emergence of so-called business development companies, which are essentially closed-end funds that invest in small and medium-sized private companies and are often publicly traded.

Demand for non-traded private BDCs (investment funds in small and medium-sized companies), as well as other private vehicles, where money changes hands in amounts that managers decide, has also skyrocketed in recent years.

Business development companies hold approximately 40% of all private credit deployed in North America, according to a January research article published by Barclays. That represents assets under management of about $315 billion, according to Corry Short, a strategist at Barclays who was involved in preparing the report.

“Interest in private markets more broadly and how business development companies value their assets has been a key interest of clients lately,” Wright said. “Now we have large funds asking whether these valuations in private markets and credit portfolios have been tested, and how we can test them”

BDCs also invest in distressed companies. They are open to retail investors and are becoming increasingly popular with pension funds, insurance companies and family offices, as well as other international institutions.

To be sure, a growing number of lenders pay third-party valuation experts to review their valuations, and funds are routinely audited.

However, recent fundraising data shows that some of the upside has been taken away from skyrocketing private credit growth, leading some BDCs to start cutting rates to help keep capital coming in.

Some investors are going further and betting directly against BDCs to capitalize on any future losses.

There was $439 million of new year-over-year short selling activity against the funds, a 37% increase, according to data from S3 Partners, a financial analytics firm. The total short interest in BDCs is $1.32 billion, representing 3.85% of the floating short interest.

“In some extreme cases, we are seeing instances of loan terms being too good to be true,” Wright said. “When investigated, it is discovered that collateral promised to investors for loans was actually promised to others. Multiple times.”