The private-credit revolution

 

 

“No dead institution looms larger over the financial system than Drexel Burnham Lambert. The investment bank, which collapsed in 1990, is to today’s Wall Street what PayPal was to present-day Silicon Valley: an incubator for young hot shots who went on to shape an industry. Whereas those from the payments firm would start SpaceX, LinkedIn and YouTube, Drexel alumni founded Apollo, Ares and Cerberus, and firms that later became the credit divisions of Bain Capital and Blackstone.

 

Drexel’s great innovation under Michael Milken was introducing risky borrowers to bond markets; its junk bonds [A] fuelled private equity’s leveraged-buy-out boom during the 1980s. The ambitions of its descendants, and Apollo in particular, are even more radical. They, too, have grown by funding buy-outs, but now court many more types of borrowers, from blue-chip companies to households, with the promise of being quicker, more flexible and more reliable than banks. They simultaneously pitch investors higher returns than on other types of debt without an increase in risk.

 

Much like Mr Milken before them, the private-credit kings believe they are injecting vitality into a sclerotic system. Marc Rowan, the boss of Apollo, sees private credit as the solution to the fragility of banks and a boon for the economy. KKR, a rival investment firm, likened the present innovation in credit to the launch of the iPhone in 2007—an historic disruptor.

 

Irrational exuberance?

 

Regulators and some bankers are sceptical. They see private debt as an exuberant and dangerous form of regulatory arbitrage, bound to blow up when defaults rise—as they surely would during a recession. Expanding private credit to include new sorts of assets and investors will only compound the folly, they assume, with potentially systemic consequences.

 

The stakes are massive. The five biggest private-credit managers have amassed $1.9trn of debt assets. But they view all of the $40trn borrowed by American households and businesses as fair game, particularly the $13trn of loans sitting on the balance-sheets of banks. McKinsey, a consultancy, says private credit’s addressable market is $34trn. Apollo, around $40trn.

 

So far private credit has mostly consisted of private-equity firms lending to companies owned by other private-equity firms. It represents the third wave of innovation in borrowing by such highly indebted outfits. After junk bonds in the 1980s—the first wave—came leveraged loans, which are made by investment banks before being securitised (pooled and sliced up) by asset managers as collateralised loan obligations. The resulting tranches, varying in risk, are sold to investors, including insurers and banks. The share of corporate debt classified as bank loans fell from a third in the 1960s to a tenth in 2009 due to these innovations.

 

The trouble is banks can be left holding unwanted debt when investor demand dries up, as when central banks began raising interest rates in 2022 (some loans which financed Elon Musk’s takeover of Twitter in October 2022 were sold only in April). Private-credit funds, lenders often managed by firms with big private-equity businesses, stepped in and thrived in this turmoil. They now fund the majority of new buy-out deals—including some of the biggest.

 

But this is nothing compared with the empire of debt private credit plans to build. To understand it—and just how radical it is—consider the ways in which they are raising capital and finding borrowers.

 

First, the capital. Some funds have already grown massive on the back of courting individual investors. Assets held by business-development companies (BDCs), funds which invest in private credit and are generally open to individual investors, have quadrupled to $440bn since 2019. Blackstone started BCRED, the biggest, which is pitched at wealthy individuals, in 2021. The fund now manages $70bn of loans. Were it a bank, BCRED would be America’s 37th-largest.

 

They just wanna have funds

 

To broaden their appeal to retail investors, the architects of these investment products have become rather creative. Apollo and State Street, an asset manager, launched an exchange-traded fund (ETF) in February which holds a portfolio including private loans.

 

Apollo has also started “tokenising” ACRED, a private-credit fund, to give investors access to its wares on the blockchain.

 

KKR has launched products which mix public and private debt for retail investors through its partnership with Capital Group, another asset manager. In April Blackstone said it was working on something similar with Vanguard and Wellington Management.

 

Private-credit firms are also turning to life insurance for capital. Unlike bank deposits, which can be withdrawn instantly on a smartphone during a panic, life-insurance policyholders typically incur penalties for withdrawing their capital early. Private-markets firms argue that this comparatively stable funding makes insurers ideal buyers of less liquid and more complex assets with higher yields, including private credit. The sleepy life-insurance industry can be marshalled to fund long-term projects and lending, to the benefit of America’s economy and its growing number of retirees. They also benefit from lax regulation, including by way of offshore reinsurance arrangements in Bermuda and the Cayman Islands.

 

Apollo started Athene, its insurance arm, in 2009—a decade before many of its rivals cottoned on to the idea. Athene now sells more annuities, a type of retirement product, than any other insurer in America. Last year KKR completed its acquisition of Global Atlantic, another big insurer. Blackstone has taken minority stakes in insurers in exchange for managing their assets, rather than buying a firm outright; it now has $237bn of insurance assets under its watch. Brookfield and Carlyle, two more investment firms, both manage insurance assets. And in April Bain Capital said it would buy 9.9% of Lincoln Financial, another life insurer, in exchange for managing its assets.

 

This scramble for new assets has been matched by an aggressive search for places and ways to lend them. That includes stalwart firms with stronger credit ratings which in the past have borrowed from America’s investment-grade-rated bond market. And it extends to markets like mortgages, credit cards and other types of asset-based lending. Goldman Sachs reckons private-credit firms might capture $11.5trn of such debt—much of it currently lent by banks.

 

Banks are falling over themselves to supply them with debt. They are striking partnerships with asset managers, shifting debt from heavily regulated balance-sheets to insurers and funds. According to PitchBook, a data provider, eight such partnerships were announced between October and March (there were four in 2023). Barclays agreed last year to offload to Blackstone a portfolio of credit-card debt against which it would have had to hold more capital. In September Citigroup made the biggest such deal so far, agreeing to arrange $25bn of corporate loans before funnelling them to various funds at Apollo.

 

The speedy courtship between banks and asset managers has surprised many. In 2023 the chairman of UBS, a Swiss bank, told a conference that there was “clearly an asset bubble” in private credit; in May the bank agreed to partner with General Atlantic to give the banks’ clients access to the option of borrowing from the private-markets asset manager. One investor likens the new partnerships to asset-rich old men finding racier young brides. Such May-December couples include Oaktree, a 30-year-old California fund, and Lloyds, a 260-year-old British bank.

 

But the biggest firms are doing more to supplant banks than siphoning off their loans; they are increasingly generating their own loans. Blackstone originated $35bn in investment-grade lending last year, destined for the insurance balance-sheets it manages. Apollo did $220bn across its businesses. Nearly half came from a stable of 16 lending firms owned by Apollo, Athene and other affiliated funds. They include a former division of GE Capital, the ill-fated financing arm of the legendary American industrial conglomerate, and Atlas, the legendary securitisation business of Credit Suisse, the ill-fated Swiss bank.

 

Apollo reckons it will surpass $275bn annually by the end of the decade. That includes big-name clients. Since the firm struck a deal to finance AB InBev, a giant brewer, in 2020, demand for its services has risen from corporate bosses hoping to benefit from the firm’s unrivalled capacity for financial engineering. Last June Apollo supplied $11bn to the Irish manufacturing facility of Intel. For the purpose of the challenged chipmaker’s credit rating the transaction was classified as an equity investment. Yet the deal was structured to furnish $4.7bn of pristinely graded debt for Athene’s balance-sheet, equivalent to 15% of the insurer’s capital. (Intel has since been downgraded by rating agencies, and its share price has fallen by almost a third.) Blackstone announced a similar transaction with EQT Corporation in November, allowing the natural-gas producer to retain its credit rating while furnishing the insurers advised by Blackstone with debt.

 

A revolution has unfolded in debt markets. But can this rewired system cope with a recession? BDCs provide a window on their investments each quarter. Even before President Donald Trump instituted new tariffs on April 2nd, borrowers were deferring interest payments in an attempt to stave off defaults. Almost half of borrowers have negative free operating cashflows, compared with a quarter at the end of 2021. The concentration of private-credit loans in technology and business-services sectors is of particular concern.

 

Default is in our pars

 

There is also surely hidden stress in a system where assets change hands less frequently than in public markets. Take Pluralsight, a tech company bought by Vista, a private-equity firm, in 2021. Private loans to Pluralsight were marked at close to par before seeing their value slashed in a restructuring last year. In January the keys to Alacrity, another software company, were handed to lenders who until recently had valued its debt at similarly high levels. Private-equity funds spent years paying top prices for assets before 2022. A recession would undoubtedly reveal more instances of shoddy lending and valuation.

 

The risks of private-credit funds could pose some dangers to the banks they have been keen to dislodge. Private-credit lending usually augments, rather than fully replaces, the role of banks. For every dollar a BDC raises from investors, it typically borrows one more from banks. Close to half of BCRED’s $30bn of borrowing is from big banks. David Scharfstein of Harvard and co-authors argue in a paper that capital requirements have incentivised banks to lend to BDCs rather than make the loans directly to companies. That would make a recession worse if private-credit firms pull back from lending more sharply than banks would have. But banks in turn would have more security given investors in BDCs would take the hit first.

 

Greater dangers lie in the novel sources of private credit’s capital, retail investors and insurance schemes. One is that investment firms promise too much liquidity to retail investors, who assume that their investments will be as easy to exit as stocks, resulting in a run for the exit and politically unpalatable losses. Experimenting with ETFs indicates that firms are underestimating these risks.

 

Life insurance is a more complex beast. Insurers are highly leveraged, and have taken on more debt in recent years. Their borrowing from Federal Home Loan Banks—privately owned but government-sponsored banks—has risen to $160bn, a record. The market for funding-agreement-backed notes, another type of debt, is growing rapidly. If the assets of life insurers go bad, institutional investors will run for the exit. The failure of a large life insurer would be severe; the simultaneous failure of a large asset manager would compound the effect. The lack of transparency in private markets means regulators and investors might not see a problem coming until the very last moment.”  [B]

 

A. Junk bonds, also known as high-yield bonds, are debt securities issued by companies that have a lower credit rating than investment-grade bonds. This lower rating signifies a higher risk that the issuer might default on their debt obligations (e.g., miss interest payments or fail to return the principal).

Why the higher risk?

 

    Issuers of junk bonds are often companies in less stable financial situations, such as those with high debt ratios, young companies with unproven operating histories, or companies experiencing financial difficulties.

 

Why do investors buy them?

 

    Higher Yields: To compensate for the increased risk, junk bonds offer higher interest rates (or yields) than investment-grade bonds. This makes them attractive to investors seeking higher returns.

    Potential for Price Appreciation: If the issuing company's financial situation improves, their credit rating can increase, leading to an increase in the value of their bonds.

    Diversification: Adding junk bonds to a portfolio can offer diversification benefits, as they may perform differently than other asset classes like stocks.

 

Risks of Investing in Junk Bonds:

 

    Default Risk: The primary risk is that the issuer will default, meaning they may not be able to make interest payments or repay the principal at maturity.

    Price Volatility: Junk bonds are subject to greater price fluctuations due to uncertainty about the issuer's financial performance.

    Liquidity: Junk bonds may have lower trading volumes, making it potentially harder to sell them quickly or at a desired price.

    Interest Rate Sensitivity: While less sensitive to short-term interest rates than some bonds, junk bonds can still be affected by changes in long-term interest rates and overall economic conditions.

 

How to Invest:

 

    Investors can buy individual junk bonds through a brokerage firm.

    Alternatively, they can invest in diversified portfolios through mutual funds or exchange-traded funds (ETFs) that specialize in high-yield bonds.

 

Credit Rating Agencies:

 

    Credit rating agencies like Standard & Poor's (S&P), Moody's, and Fitch evaluate bonds and assign ratings based on the issuer's creditworthiness. Junk bonds are rated below investment-grade, typically below BBB- (S&P/Fitch) or Baa3 (Moody's). 

 

In Summary:

Junk bonds offer the potential for higher returns but come with increased risk due to the higher likelihood of default. They are best suited for investors with a higher risk tolerance and as part of a diversified portfolio.

 

B. The private-credit revolution. The Economist; London Vol. 455, Iss. 9450,  (May 31, 2025): 10, 7, 8, 9.