Private Credit Isn't Going to Kill Us. Probably.

Go look at how many folks in DC front-ran the government response to COVID and got their faces ripped off when the market soared. 

What about Private Credit? First of all, private credit is the same as public credit… just… private. That means it’s junk by definition. Unless you embrace the industry marketing term “high yield.” Yeah, no kidding - lower credit quality means higher yield. That's the deal.

If you want a higher yield than investment grade, you are going to take more risk. The average default rate in private credit historically is 2%. There are somewhere between 10,000-12,000 middle market borrowers in the asset class. That means about 250 defaults per year. A default almost every day is normal. But, everyone is yelling like defaults are rare. You’re buying junk! Know what you own.

What could take this down? Leverage. It almost always comes down to a lack of liquidity that turns an orderly selloff into a rout. If it’s an orderly market of buyers and sellers, prices will move in a digestible fashion. If someone gets margin called or can’t meet redemptions, things are going to move fast. But, are these funds broadly leveraged? I suppose we may find out, but it doesn’t look like it. The max leverage a BDC can use is 2:1. A third of all private credit funds employ no leverage. The average is going to fall somewhere between 0.5x-1.0x. Unless the underlying holdings are massively leveraged and the marks are almost fraudulently bad across the board, that’s not really a lot of leverage. 

And here's the part nobody wants to say out loud: the illiquidity is a feature, not a bug. If there's stress in the private credit markets and investors are trying to panic sell, they might just get gated on redemptions. I'm sure that'll piss them off, but it might actually protect them. If the fund just flat out says "no" for long enough for the market to rebalance and sort itself out, it places a floor under the bid. Or maybe they have the manager has properly risk-managed the fund and has enough cash reserves to meet redemption requests. You can see this for any fund alongside their leverage ratios - the good ones typically carry well above 5% in cash reserves or have access to a credit facility.

But, what if they are right? Private credit is a risk asset. Anyone that buys it thinking it is a safe asset I don’t feel sorry for you (unless they had someone give them bad "professional advice”). Ok, tell me how deep the market decline is. How long. What are the safe havens? You can’t. What you can do is determine when things get a little ridiculous and take it as an opportunity. 

You could’ve bought Bank of America for about 3 bucks post GFC. That was paying 25 cents on the dollar for their book value. It’s only gone up 16x since then. Apple was $11 (split-adjusted). It’s $260 today. Amazon $35 now $230. JP Morgan $15 now $270. It was a fish-in-a-barrel situation where everything was historically cheap. It was priced like the world was ending. In which case, none of this matters anyway.

Not every recession or market decline gives you that kind of opportunity, but every market decline in history has given you SOME opportunity. That is unless you are already positioned over your skis and leveraged to the hills. Patience and a long term view is rewarded in the markets. Let all the apes and degens make the mistakes and buy from them if they panic sell.

I don’t have a position in Private Credit, but if someone is going to sell me some for 60 cents on the dollar I might…