Hello, and welcome to The Credit Edge, a weekly markets podcast. My name is James Crumbie. I'm a senior editor at Bloomberg. This week, we're very pleased to welcome Anna Arsof, global head of private credit at Moody's Ratings. How are you, Anna, great?
Thank you, super excited to be here.
Thank you so much for joining us today. Were very excited to have you on the show and also delighted to have us our guest, David Haven's with Bloomberg Intelligence.
Hello David, James, excellent to be with you as always, and you two, Anna.
So We're here to discuss private credit, a hot topic. Everybody's talking about it. Just to set the scene a bit. Private debt has experienced a meteoric rise over the last few years. It still has plenty of fans. I don't think it's going away, but there are plenty of risks
building in this one point seven trillion dollar market. Last week's rate cut from the They're kicked off what could be a significant easing cycle, which would undermine the appeal to investors in loans which are floating so they pay less when rates go down. Regulators also have the industry in their sites amid growing concerns about how any big blow up in private credit would hit banks, which tend
to lend to private credit managers. Fundraising is meanwhile slowing as falling oil prices effect flows from the Middle East and new US measures may make it harder for insurers to invest. And there's still a risk in the US economy that it may tip into recession, which could mean more distress broadly in debt markets, including private credit. We're already seeing signs of private credit stress in the form of amendments, extensions and increasing number of loans being repaid
with more debt and arise in defaults. Some fear a big reckoning as too much money chases too few deals. So let's start there, and is this still a golden age or time now to curb all that enthusiasm about private credit?
Well, golden in it's from a credit person. It's very hard for me to say that. You know, if I was an equity investor, I would have been a little bit too excited. But as we try and tend to say in credit, there is no upside to paying a principle back, so I have to be a little bit more tained in my response. So where are we look, this market got its real i would say golden age period between twenty twenty one and twenty twenty two, and
probably half of twenty twenty three. And why that was the case, Well, at that time we had an extraordinary influx of liquidity. Twenty twenty one was the biggest market in originating leverage finance loans, both in the private and in the public syndicated market. And then we got something extraordinary rate hikes and we got to have a base rate in order five percent, which we haven't had in
a long time. So what that meants is that seal investors were the largest purchasers of really syndicated owns, got scared basically, you know, issuance and claws got really tempered, and the bordly syndicated law market pretty much died, if you will, for two years. So this was the golden moment of the folks out they're the large asset managers and others who had BDC's already set up, who had raised capital, permanent capital ready do we deployed? So yeah.
So that was the period that between twenty twenty one and twenty three was the golden age, and then the market opened this year in twenty twenty four in the borodly syndicated lawn market, it's around three hundred billion dollars that have been already executed, so it became quite competitive, and I'm sure we're going to touch about that.
What do you think, David golden Age?
Still, I think I tend to side with Anna on this one. It seems like we've probably moved through the Golden Age, although we have seen a pretty significant uptakeing growth over the past year in asset loan formation, at least on the balance sheets of BDC's sort of focusing on that. That's up about twenty percent on a year over year base. So they did take a pause and growth as rates began to rise and as there were all sorts of questions about the economy. Seem to have
moved through that. So there's still a lot of dry powder being put to work in private credit and private equity. The two go hand in hand together. So I think that we're going to see a lot of opportunity to add assets. But the question is is this's the right time to be adding these assets? You know, have spreads spreads have come in, have they come in too much?
There's a lot of competitions on a noted and it seems as though the possibility of accidents, which I think we've largely missed over the past couple of years, might be on the rise now.
If I may just to add to some numbers, our estimates show that around one hundred billion dollars of worth of transactions order of three hundred million dollars to executed in the private credit market here to date, from which seventy billion were notorder for a billion dollars. Why mentioning this is because that was the sweet spot of the broadly syndicated loan market and everybody thought, well, the BSL market is going to open, so that's the debt for private credit.
The show is over. But obviously that did not happen. There is a significant number of transactions that you know, in two, three, four years ago would have gone to the BSL market, particularly these ones that I mentioned a billion dollars and above. But private credit, I guess showed it's worth over the last few years. And what I mean by that is, you know, they're much more flexible
in execution. Therefore the rating process that's one and then also can can attend to much more flexible terms like picking. For example, you know, the whole concept of default is not the same. So a lot of that B three credits that traditionally would have been originated and placed in clo clos became more conservative seal information. Also, although his pick top was you know, his slow still was very slow in the first quarter, so they were looking for
better quality credits like B two. So anything that's a B three or would have been basically originated in the private credit market and more definitely more flexible around this. So what's interesting for us is thinking about what's the new norm. Is this an an normally or this year still part of the anomally of twenty twenty one twenty three cycle, or truly private credit is here to stay and going to share the stage would be asl forever.
Yeah, I mean I think that there's a a you mentioned the word flexibility. I think that word flexibility is something that's pretty attractive to the to that sort of private private capital. I wouldn't just limit it to private credit, but I think it's attractive to the private capital ecosystem where private equity providers you know, are often you know, kickstarting some of the transactions that are going on private
credit steps in provides funding. Uh, they do provide ease of execute shan as opposed to the BSL market, You're dealing with one or a small club of lenders, very easy to sort of make changes and amendments and you know, sort of shift gears on the fly in a debt transaction given that limited number of lenders, as opposed to the BSL market or structured market where you've got far less flexibility and you're dealing with more people and have
more hurdles to cross. So that's pretty attractive to the borrowers.
Yeah, and then if I am a d I was looking actually at FED research paper and private credit yesterday preparing for this discussion and just to kind of mention this whole point of typically it was a one lender market. Actually, the FED shows that what traditionally was a one lender typical private credit market has increased to two point eight
on medium for most of private credit deals. And we know that this particular transactions nord of a billion or so, they really become very much a club of six an aid sometimes private credit lenders. So there is quite a convergence for sure in terms of the structure convergency in pricing. You know, the private credit loans used to you know, generate like a six hundred and fifty bases points spread
just a year ago, and now that has shrinked. In some latest deals, we're looking at around five point fifty, which is pretty much within the norm of the broadly syndicate in law market. So we step back and say, okay, so it's very clubbish, meaning more banks are participating. So that's similar to the broadly syndicated lawmarket. Spreads have compressed.
So what makes the secret sauce? And I think it goes back to the terms and the flexibility that if a loan ends up being in trouble, it doesn't have to exit a CLO structure immediately because as the rating
agencies will claim that as a default. Even you know, infusion by a sponsor capital, which was a norm in private credit over the last two years, they would have been potentially a trigger to call it a default and downgrade to C DOUBLEA, which immediately becomes disadvantaged from asset quality in a colo versus in the private credit market, that's a performing loan that luckily got a sponsor in fusion.
So I'm glad you know, we're we're kind of comparing contrasting, but I think we will also discuss how we compare those default straight shortly as well.
What are your expectations for growth of this market? I mean, it's sort of doubled over the last couple of years in size, But what you were saying is it kind of grew very quickly at the expense of broady syndicated loans, which kind of shut down. Now that those are back, Does that mean that the pace of growth of private credit just slows or stops altogether.
Well, we you know, back many people out there, pundits have estimated various numbers out there have been a two point eight to three trillion over next three to five years. We look at it a little bit more simple than that.
If today's one point seve and trillion, and we have a three trillion dollars of private equity dry powder, and we looked at statistically, depending on the rate cycle, equity versus debt on media, and let's say it's around fifty percent equity versus dead which means that that three trillion dollars of private equity capital will need to be invested with the equivalent of the three trillion dollars of debt.
So now exactly the conversation we just had is where this new norm is private created is going to be thirty fifty percent of all leverage trainians credit provisions. Let's assume, you know, for sake of simplicity, fifty percent fifty split up the market share with BSL. You end up basically with need of roughly three or and a half of CREAD provision over the next five to seven years to
deploy that private equity dry powder. So you know, again it's all about timing and how long horizon you want to have, but certainly, based on this very simplisticalcualation, you can get to three trillion market you know, by of the decade.
And in terms of deal size on a single deal level, you know, we've seen some very big deals in a five billion plus. It is going to continue to get bigger in private credit, do you think.
Yeah, exactly, as I said, I mean, seventy of the one hundred billion a year to DAT has been executed. That's our estimates. Point two seventy billion has been these transactions nord of a billion, with a few obviously exceeding even two and a half billion kind of medium size. So for sure it becomes what we are hearing from the banks, from the private credit managers is pretty much every deal nord of a billion actually now goes through a dual process. Private credit almost like arrived and it's
not leaving. And the banks are like, you know, are obviously not liking it. But the private equity managers and sponsors are you know, indulging in it.
Yeah, and the you know, and a lot of those sponsors are advising the private credit lenders, so you know, there is that sort of ecosystem of private capital out there that they cross over from private debt to private equity and keeping everything you know, within the ecosystem I think is pretty attractive to certainly to the advisors.
You mentioned the banks, though I know you cover the banks, you have a very broad mandate moodies, which is is interesting to me.
How are the.
Traditional banks affected by this big boom in direct lending. On the one hand, they were competing, as you say, you know, they lost out on business in the broadly syndicated market, but now they seem to be lending more to the private credit managers, you know, sort of doubling the leverage in some cases in some of the fundraising, how much risk is building on the bank side because of this market growth?
No, absolutely great question and yeah when we set up the private Credit Analytical franchise, said Moodies. And why it lended with me leading it is because I've covered it was the quota of all being creatings globally responsible for capital markets being seem particular the ones who are the largest in in this space and provisioning credit to to
private credit and sponsors. And it became evident as part of our diligence into the banks and or risk meetings that the line that was growing the fastest in addition to the commercial real estate for for a number of years, was the exposure to non bank financials. And when we tried to dig in into that particular exposure, because that can be anything from origination of mortgage stray to be
securitized or traditional COLO or auto loans, et cetera. Really the most significant subcomponent of that exposure to non bank financials was indeed exposure to private credit and private AQ with you. And as a matter of fact, there are two particular business lines within that segment that had the fastest growth. One was the subscription line of credit that obviously had both to private equit but also increasingly over
the last few years, to private credit funds. And the second line was something called asset bak finance or asset back lending, which ultimately is what you just mentioned is the leverage provisioning into the BDCs and other similar funds.
So how do the BDCs, maybe just let devistify this for our audience here, The BDCs typically fund themselves in when they start, when they're kind of a smaller entity, into the secured market solely as they basically typically you know, let's say cross five hundred million dollar size, they issue private placements and anord of a billion, they actually seek usually a public rating, and issue senior and secure dead So in addition to the senior and secure debt, they
actually also still maintain a secure debt that's provided by the banks. And we estimate that that size of that exposure and banks balance is around four hundred plus billion dollars,
which is quite significant. But the change is really the most significant, and what our data shows is that the growth of the bank's exposure in that particular asset by clending to private credit, has outpaced the fundraising of the alternative acet managers private credit lenders, so they have increased the exposure higher than what the capital raising activity it is.
So that might be simply a ketch up, but it's a severy lucrative business, an attractive business for the banks, and we think this is going to be this is going to continue growing because there's always going to be a secured component as part of the banks, as part of the private credit funds originating these kind of loans.
Yeah, and it sort of goes back to, you know, changes and regulations that have been going on since the since the financial crisis, where banks had to de risk you know, vast ways of their of their lending portfolios. So they did draw back from from lower quality corporate credit middle market lending. Uh. And it's easier for them to go in from a regulatory perspective and make a secured loan to an investment grade or near investment grade rated entity than it is to a B three C
doa A one rated entity. And you know, you should probably cueue the foreboding background music now because we are talking about the specter of shadow banking. And you know, if you look through the report, for example, that the IMF did earlier this year, taking I think they dedicated twenty to thirty pages on private credit in their Global Financial Stability Report. One of their you know, sort of key recommendations is stepping up regulation and disclosure around private credit,
particularly within the banking system. So well, I'm sure everybody's going to love that, but we'll see how that goes.
No, absolutely, you know, we we have quite all significant engagement with variety of regulators globally. Everybody's trying to understand what does this disruption, if you will, will mean for the banks, both from a of course competitive perspective, but also from a risk perspective, and you know, you know, there's just a few arguments on that side, on both
sides of the argument, if you will. So for example, you know, if you think about a leveraged loan and that has six seven times leverage, a lot of the private asset manager, private asset managers, alternative asset managers will originate this private credit loans would say, isn't that better that risky loan to be funded with a permanent capital at one to one leverage versus set a bank that has nine to ten times leverage and funded with you
know forty you know, media for US banks and particularly large banks, you know anywhere from thirty to sixty percent of deposits, which have proven, particularly in the last years regional bank crisis, to be quite flighty. So yes, there is an argument to that. And however, you know, with the loans moving into the private credit ecosystem and funded only on banks balance sheets or or in the dark, if you will, because we don't know on what terms.
Every banks has its own risk management standards that are proprietary to a bank, and there's very little disclosures as it is set to day about the breakout of that particular non bank financial exposure line that has been growing. It certainly creates concerns about on what terms are those loans being made and what's the ultimate leverage in the system.
And so definitely we've been calling as well for better transparency, particularly from the bank's perspective, about their exposure because you know this in the larger scheme of things. So four hundred billion, let's say, which is our current estimate based on a survey that we are executing, and we'll be
writing more about it. It's it's not significant. We take a twenty seven trillion US assets banking systems and this was by the way global banks number so but the pace and again the terms and is there not a hidden leverage behind it is what concerns regulators.
But it's just basically fair of the unknown. Again with you, David Sinister, music playing in the background. I mean, you know what we can't see. We worry about you sumbly can see more than a lot of other people because you know you have the access. Is there anything that you're worried about right now?
Not particularly today, because it gives us comfort that a lot of that exposure is in these two particular business lines, as I said, and the particularly asset back finance line is a super senior protection for the banks, whereby they have quite a lot of coverage. Typical the loan to values around sixty percent. And these are all senior loans that have been mostly senior loans that have been supporting
as a collateral. And therefore it has to have a major correction first and foremost, and the value of both the private equity kind of enterprise value of the companies that senior loans support, and think about these are senior loans that even if private equity is necessarily losing their value. The senior loans should be first to pay, and again the bank will be the first one to pay if there is an issue with that loan. So it has to be a major correction in the asset value of
senior loans today. If you think about history, recoveries for senior loans of leverage finance companies have been around seventy percent. We think in this cycle for the broadly syndicated low market that may go down as low as sixty And what we really are focused on is we haven't had a significant default cycle into the private credit loans today. And we will talk in a second maybe why that's
the case, but we haven't. It's the argument of the private credit managers that they will manage this asset better than the banks or the broadly syne killaw market who are here just to originate and distribute versus only to balance. It is something that we are watching to see and we see how they really perform ultimately relative to BSL market. There is a lot of arguments why private credit managers will do it better because they have their own They
have first of all, the benefit of time. At the end of the day, they can because they have permanent capital funding it that don't have overnight liquidity risks, at least the funds that we rate, which is the bulk of the BDCs and around ninety percent of the assets and investment create Because of the low leverage and no immediate funding risks, they can withstand let's at temporary shock into the liquidity market and manage that loan for ultimate
recovery two three, four years from now. And also they've been building a lot of the large funds have been actually building their own resolution teams, hiring structuring teams, being ready for such a cycle. So I think this will be This is probably the biggest unknown is is that fundraising premise, if you will, of the funds that they're going to perform better will come true.
So I think that sort of gets back to the word that I've sort of thrown out there a couple of times, is this whole ecosystem idea that you've got private capital, not just private debt, not just private equity, but sort of private debt and equity working together along with the sponsors too, who have that ability to throw good money after good if you get to a troubled situation, they've got the flexibility to make changes to terms and conditions and amendments in a fairly flexible manner that may
not exist elsewhere. There are people that that view, you know, amendments and things of that nature is sweeping problems under the rug, which may be true. But again, if you can throw good money after good or make an amendment for a loan that you think will be good, it makes sense rather than being forced to do something you
don't want to do. Just and on. One of the things which I think is kind of interesting and I get asset all the time, is why has private credit been as or credit generally, I guess, but private credit been as resilient as it's been. Like if I go back and look at some of the research that you guys did, I look back about a year ago, I think that we were looking at a trailing default rate of about three percent in BA in B three debt. I think you and others were forecasting that that was
going to put perhaps double over the next year. That hasn't happened. And so what what do you think is going on? I've got my own theories, but curious.
We'd love to debate that one. Maybe maybe we agree, So let me just kind of provide little statistics. You know, we were actually close to five percent you know default rate that we project is going to be down to three point five percent this year and going into next year. And that's on the broadly syndicated high yield you know,
senior loans. If you look at now of the private credit loans universe that we rate in the business development companies or BDC sector, actually none acrules went from just fifty basis points two years ago to nord of one
percent today. So again this is like comparing apples and oranges, which is the big issue of the market because as I said earlier, as sponsor can infuse a capital, which happened in you know, at least you know, thirty forty percent of transactions over the last couple of years in the private credit universe, and that is not a default versus a non accrule really means that they're not paying interest.
So the couple of dynamics, there was definitely an ability to move transactions from the broadly syndicated loan market when they crossed that potential risk of default into the private
credit market. So in my view, it's very hard statistically to prove this is we're trying to actually research it at this moment, is how much of that those number of loans that actually moved from be a sell into private credit And if assumed that big part of that maybe would have hit a default, would actually have increased the measured default rate. And obviously that is very hard to point. There was just an avenue of capital that existed in private credit did not exist in prior cycles.
So that's a big reason of why that happened. Secondly, we did have quite a constructive economy. Yes, inflation was high as the rate increased, but we did have historic very low unemployment. The economy was doing well, which means that if you think about the US economy being driven by the consumer, two thirds of the US GDP's driven by consumer spending, and which means it's highly correlated to the unemployment rate more than inflation rate or any other
or even interest rate. Has proven to be the case. So therefore, and you know, we can debate these two tails of the consumer and all of that, but generally the consumer was had extra liquidity, had jobs, which means that was supportive to the economy. So therefore you have two factors again influx of capital for private credit that basically a lot of firms who could have defaulted in a public market went and refinance, so they did not
default in the official statistic. And then secondly, we had a relatively strong economy booming despite the inflation and the high rates.
Yeah, I tend to think that the trillions of helicopter dollars of helicopter money that were pushed into the economy during the pandemic are having a pretty big influence on what we're seeing in individual you know, sort of credit trends and in in corporate credit trends. But one area which which I think is is drawing greater scrutiny right now is the amount of payment and kind income PICK income,
which is flowing through at least BDC balance sheets. I did some research that was published over the past couple of days where we go back about five or six years look at PICK income as a percentage of total investment income, and I think it's gone from less than five percent back in twenty eighteen or twenty nineteen to just about ten percent now for BDC's And I think that you know, a lot of people that I talked
to are wondering, well, this is it. This is showing that there really is stress building up in these private credit portfolios, and all it's going to take is a little spark for that to sort of explode. I don't think that there's going to be explosion, but I do think that that's something too to keep an eye on. And where where you guys.
Absolutely, as a matter of fact, we we deep dive into this issue quite significantly. Maybe I'll just share some of the statistics. Our median picking come as percentage of total investment is around actually six and a half percent, but there is a big discrepancy around that median.
You got to make more of this free.
So yeah, I'll definitely share that. But if you look at some some BDCs here are really you know, nord of twenty percent, like I'm looking for example at Prospect Capital and you know, you know, close to twenty percent. So and then we have some that are really well performing, you know that you know, have you know less than
less than three percent. So how we analyze this? What was unique feature of the prior crede market was that loans can be originated as a peak from beginning, and that was for a lot of these state companies who wanted to reserve capital for investment, and therefore that simply was not you know, both the sponsor and the lenders had agreed from origination that it's better for the company to invest in cash than pay interest. And there's been
priced from the beginning of the transaction. So we consider that still, you know, not a perfect from a credit quality perspective, but something that has been captured and hopefully priced for what we look at when you sit in created comedian, we evaluate the ratings for a number of these BDCs. We actually look at the delta of how much of the picks have actually moved from non picks into pik loans, and that numbers has basically increased significantly over the last year, and we think of that as
a precursor of increase of non accrules. So hence we as we skeptically look at that one point percent non acrul medium for the industry, and we look at more the delta of Okay, it went from three and a half four percent to six percent of the industry in picks, So that means that there's a number of transactions that potentially are tittering into becoming nonocruals.
Pick might be a leading indicator, non accruals a lagging indicator. Correct, And then maybe one of the reasons we've probably seen a significant increase in PICK is because we had a five hundred and twenty five basis point increase in base rates. Those base rates are going to start to hopefully decline after the fifty basis point decline that we've seen or cut that we saw on interest rates, maybe that'll mitigate some of the increase in PICK activity.
It felt like we're all ladies in waiting here to see that not a cruel increase and transfer that peak into non a crules. Not that I'm wishing for the industry, is just that we're obviously protecting the interest of creat investors, and it just looked like a quite a dramatic change of five hundred basis points of interest in the last two and a half years would have had a more
meaningful credit issue for these highly levered companies. But I think that's flexibility, as you said, of capital coming from the sponsor's ability to peak transfer terms in the more invisible part of the credit universe allowed for firms to potentially buy time and now the fifty basis points, and just to kind of give you our baseline is additional one hundred two hundred and twenty five basis points between
now and the end of next year. So this will alleviate interest expands quite significantly and also open the avenue for other strategic investors into these companies. As we know, the M and A market, the sponsor M and A market was pretty much dead over the last two years because sponsors simply could not agree on price of their companies in a rate environment that is quite elevated. I think this will definitely accelerate, particularly towards the end of
this year. Now we have an election cycle which might put people a little bit still in a pause, but certainly for next year, we're expecting M and A to accelerate and therefore open various avenues of one, first, lower interest expense costs. A second coming to an agreement of enterprise value for these companies, which can allow firms to potentially restructure through to REMNA.
Were also seeing things like synthetic pick. Do you see more of that in private credit?
You know, we haven't necessarily as much. I think it does exist. It's hard in the public domain to be honest to distinguish that, and that those are kind of the things that we worry about, like is there and when we diligence the banks, particularly who provide potentially a derivative form for this for these type of activities, how much of their exposure is in derillity form has increased versus like a total return swap policias or versus a
traditional you know lending. And we haven't seen significant pick up activity with some but not it's not prevalent yet in this cycle, like we saw of a synthetic bed term in the two thousand and seven six precursor of thousand eight crisis, and so.
You really need to cue that fore voting music for terms like synthetic pick.
And maybe this is too early to see this, but we are seeing a lot more in the broadly syndicated and public markets more of this credit around credited violence, and you know, there's a fear that it will spread to private credit as lenders and borrowers clash and borrows get more creative about how they do these deals. Are you worried about that as a as a phenomenon in private credit at all?
No?
Absolutely, Actually, Now, our regular diligence with the funds that we read. We have this discussion and I will kind of quote what one fund who said, like, look, we are probably more careful than ever who we get into a club with. It's almost like a marriage agreement, and the divorce can be very expensive. So it became I think that the awareness is a good thing. Actually, you know, folks say, well, would never do underwrite another transaction with
somebody who would do this to us? For example, we and we distinguish which partners are civilized in this market, which are not. And again it goes back to this ecosystem point David is making. A lot of these firms are on Park Avenue or out They all worked at at some point at credits fees or Deutsche Bank or Goldman Sachs or originating leverage finance loans. It's a relatively small universe. We're talking about some funds that have thirty
forty underwriters to maybe one hundred. These are not major couple hundred thousand people investment banks. So yes, there is this clubish element that the funds claim that folks will be behaving in the market, but certainly people are wary and watchful more than ever.
I mean, it is it is clubbish. But there's also this massive increase in demand chasing not that many deals city in the US, which kind of leads to, you know, everyone who comes on this show who's a private credit manager says they only do the good deals. Assumely that means someone else is out there hanging on to the bad deals and they may suffer for it. Is there not a risk that you know, we'll just get, you know, similar situation as we are in the public markets.
Absolutely, you know, we kind of when we analyze the balance sheets of the private lenders, we are very wary about stressing the twenty twenty one vintage we call it, which was the year of exuberance at zero rates or about, and both markets were very open. Not as concerned about twenty twenty two, and definitely the first half of twenty
twenty three. But this year we are quite concerned with the influx of capital, as I said, three hundred billion or so executed in the broadly syndicated one hundred plus in the private credit market, spreads coming down, terms coming down. We actually did analysis of covenants in both markets, and private cred always has argued, well, we get covenants and the BSL market doesn't hence why we have better investment.
That's been their pitch to investors, among other reasons. And we actually did the analysis and it's absolutely true that the private credit market for transactions that are out of three hundred million dollars still has kept both the pricing and
also of the covenants. However, nor of you know, four hundred, particularly the billion dollar plus transactions, those covenant kind of light deals are quite converging, and that's what worries us, particularly about this exuberance of twenty twenty four.
Another manager we had earlier this year talked about tourists in private credit and also this concept of democratization of private credit, you know, bringing more people in. One of the ways that the markets traditionally do this is through ETFs, and you know we are seeing ETFs, and I know you've done some work on it, so I did want to ask you about potential problems with that, you know, purely, you know, really basic terms. ETFs are supposed to be liquid. Private credit isn't.
Yeah. I mean, if you look at the most recent announcement from a Poe, etcetera. And we kind of wrote a piece of that, is that the inequidity piece is actually relatively small. The bucket is I think fifteen percent, no more than that. So yes, it increases risks to even have greater than zero percent liquid assets in ATF. But this is I think what was advertised out there
that this is the private creative. It's not quite. At the end of the day, It's going to be mostly public classes with a small bucket of private that's the beginning, because Paul will commit to market make if you will, and provide bids for that for those products, which means that hopefully there will be more transparency in the market building that. But investors need to be wary that potentially, you know, you can have your capital locked in and you have to stress this for what does that mean
for that particular bucket. And of course, look, I cannot envision an ETF with much greater let's say, fifty percent liquid assets simply that kind of asset ability mismatch. I
don't think that will work. So but broadly, stepping back, even outside of dtfs, you know what has worried us about democratization point is the retail focus of the BDCs, and not only actually the BDCs, but I'm just coming back from Europe from IPM, which is the largest private capital conference in Europe, and there was a new regulation now of called Elative, which will allow for retail investors as low as ten thousand dollars to invest in private
credit there as well. So on one hand, we understand very well the macroeconomic premise of allowing retail investors to benefit from the growth of private markets and the returns the historic turns that have been more favorable, not over the last two years, but historically more favorable to the public market. So you want to allow folks to get access to that building of wealth. But on the other hand, education to investors and understanding the risks of capital being locked.
This is not something that can trade overnight. The whole point of private credit is they said, the benefit of time and waiting on for better markets to mark your transactions if you will. That's something that needs to be very well absorbed. And I do worry when majority of the BDC is actually fundraising that has happened over the last few years has actually come from retail and retail non non publicly traded b deses.
Yeah, I mean, if if you if you really want to get a significant amount of regulation foisted on you very quickly. A great way to do that is to is to overmarket to retail investors have some sort of unexpected situation blow up where things didn't quite work out is as you'd hoped, and all of a sudden you're going to have some pretty onerous regulations. So, you know, it just seems like the funds and the marketers in particular, I think, have to be very careful about the way
that they roll out these products to UH to retail investors. Now, when you when you talk to a number of the sort of large white schee advisors, you know, they're talking about sort of a private wealth market where you're talking about individuals with more than one million dollars of liquid
assets to invest. That scenario where you're going to have a little bit more you know, leeway going into you know, quote unquote retail, but when you're you know, sort of getting into UH masters distributed ETFs, it's an area where I think caution is warranted.
Agreed.
You've made the point Dave in the past that you know, you made these skiing analogy that you know some some of these slopes are just too steep for the for the you know, the tourists, and you know it should be only professionals getting involved. I mean, we're not all heading into a world of trouble with with everyone piling into private credit right.
Now, right right, yeah. I mean the way sort of that that ski ski analogy is at the I mean there, you know, there's a risk everywhere on the on the ski slopes, even on on on the the green circles where I've dislocated my left shoulder with a with a
caught edge. But you know that if you come prepared, if you've got the right equipment, if you know your way around the mountain, if you you know know the slope, you know where the rocks are, where the trees are, where the cliffs are, then you know you've taken adequate precautions and you know, game on, go have some fun. If you don't have all of that in your in your in your backpack, then you might want all look elsewhere.
You talked and recently about how pick just go back to that point is a kind of a bridge for some of these struggling borrowers to you know, get to a point where we have lower rates. You talked about your outlook for rates to come down and Obviously, the FED is embarking on quite an aggressive easing campaign right now, but is it enough do you think to avoid further distress? I mean there still must be some unsustainable capital stretches out.
There, right absolutely. I mean when we actually stressed as for a rating purpose our BDCs to qualify for the investment Great status, we actually use the two thousand and seven two thousand and eighty fault cycle, so which means that we assume that we're going to get into at least you know, you know, eighty percent kind of price of the broadly syndicated the leveraginal market defaults increasing to at least five and a half percent kind of on
the crules. And that's how we test the capital cushion for the disease. We you know, nobody can really uh uh predict where the market can go. What what we are doing in our analysis is ensuring that our ratings can withstand the test of time and test of what the history has shown of where our kind of worst case scenarios have been in leverage loans. And I'm talking
about a market back in two thousand and eight. We use a scenario when there was a three hundred billion dollars of Hong transactions for a year and a half on banks balance sheets. So I think that it's a solid test. Of course, things can always get worse geopolitics, things that we cannot predict. Think about the COVID market, et cetera. How much extra liquidity it can really come from FED balance sheet. That's quite leverage we know today. But we do believe that what we're seeing today is
is probably not the worst case scenario. We do believe that our base case is avoiding orthorization scenario. However, the downside case, when some of this downside risks materialize, make the default rate in the leverage finance cycle jumps significantly from LESSI three and a half too close to seven eight percent. So again, every investor should always do a scenario analysis and test their risk appetite based on that, and we're trying to do that for benefit or ratings and investors.
So maybe switch gears a little bit. Yesterday you did the not you, Moody's did the unthinkable. You upgraded a couple of BDCs. You also have done a nice job, I think, and I think investors agree, have done a nice job of differentiating amongst BDCs You've got some that had positive outlooks and some that had negative outlooks, and
that I think is quite helpful for people to see. What, in your view is the ceiling of where a BDC rating can go, and how do you think about the interplay between Let's use Blackstone as an example because they were upgraded yesterday. There are two funds, Blackstone Private Credit and Blackstone Secured Lending, one notch to BAA two they're associated with. I don't think Moody's rates Blackstone, but it is rated A by some of your friendly competitors. Obviously
A plus a well rated company. Ceiling for BDCs, where could it go as kind of monoliine type entities that are wholesale funded, And how do you think about the interplay between these large white chew advisors and those that don't have them.
Great question. Yes, So we read around the nord of thirty BDCs in the public domain, from which we placed six on positive outlook while ago and we have three your negative outlook and we took an action on three, as you noted, two Blackstone entities and one Eras Capital. So first a question on ceiling. Look, we have a full rating spectrum C A two three ple a. So celink in theory does not exist. But maybe I'll try to answer that question through the median bank creating today.
The medium bank creating or what we called baseline create assessment without additional support in the US is B double A one. So, and we talk about kind of a normal regional cohor without significant concentration in commercial real estate, A highly in a more concentrated regional bank we have with a commercial real estate book would be BA A two B doua A three equivalent, if you will. So what you can see is a convergence. But there are
two different factors. One is the low leverage. We just talked about the banks on average being levered nine times. We're talking here medium leverage on one point one times today for the BBCs we just mentioned so significantly. What the difference is. It's low leverage, Yes, it's a monoligne. But the diverse we're looking at difversification of portfolio across sectors. And then key differentiation and with the banks relative to the BDCs is the funding aspect. There's no overnight funding.
The only like two parts of risky if you will, funding more risky funding is the secure funding from the banks, which is subject to quarterly evaluation. But I know that that those margining loans really in order to be effectively margined for additional collateral, we have to have a major correction talking on average values of sixty percent loan to value, which means that a lot of these loans have to
lose forty percent of their value. So again that's quite a tail scenario for a significant margin risk on the secured book unsecured credles which is a dominant funding for this investment. Greate BDCs a domain basically cannot really withdraw their money if you will, and then you have pervonent equity. So the funding risk, one can argue is pretty is
pretty muted. Where the funding risk comes true is indeed the in the retail on the BDCs liking BI cred But for us, where we spend a lot of time with entity like b credit to be to be eligible for upgrade was actually differensification of funding on their secured basis. So and also how the provision for that maximum withdrawal of liquidity of like twenty percent a year from the retail book, and it's about what availability of lines of
credit for example from number of banks. If an entity like this had high leverage or one or two banks only providing that liquidity support, that definitely would not have been a reason for upgrade up or even investment grade rating.
But somebody like Blackstone, who has absolutely one of the leading relationships with the global banks, we're talking about numerous bank clients existing out there to support that liquidity and also significant liquid acid bucket to provision for that, and in peril with the lowest non a cruel statistic in the BDC cocor we read tipped us over that additional line of investment grade.
Just to go back to where we started, and we're almost had a time unfortunately, but a lot of people still worry about private credit. Our last guest said it was the one thing that concerned him. There was an insurance company from Asia this week saying that there was going to be a reckoning. It's not the first time we've heard that from the market, and we're hearing it from regulators, We're hearing it from from multilaterals and all
sorts of people are they is this concern misplaced? They just don't understand what it is that we're talking about here, or are there really some concerns that we should we should be talking about.
Again, it goes back to the pace of growth and where the funding comes from. It's it's going to be very important to get more transparency from the banks about is there some kind of, as you said, synthetic leverage, additional leverage coming to this market and it's not visible
to us. We're talking about trillion point seven market from which you know we moved is very roughly three hundred billion of assets through the BDC cohort in the US, So there's still lots and the dark and I definitely welcome and all of us who are in the industry analyzing it, welcome more transparency about what's the leverage outside of the BDC coord out there. How much of these funds indeed use a leverage that's secured that's potentially more
margin driven. So in order to answer that question, we really need more transparency, particularly from the banks who are funding this market.
Yeah, but I don't think that you've got people are going to go back and think about what happened during the Financial crisis, where you essentially had unlimited leverage built into the system through through CDOs, derivatives and derivatives that aren't used in the at least in the same way or the same degree in this area part of the world. So I think that makes a big difference. It doesn't strike me, and I lived through the financial crisis as
a desk analyst at a large Swiss bank. It just doesn't seem like the risk transmission mechanism is nearly as potent in the way that private credit is structured today as it has been in maybe some other areas that have caused systemic problems in the past.
I tend to agree with that, and as I noted, a lot of this is permanent capital by pension funds originally who are the largest first investors, insurance companies, sovereign wealth funds, and only most recently this more flight confident of fuel investors came into the space like the retail investors. So hence why we are really looking for those pokts and we want to ensure from a systemic stability that there is indeed attention about disclosures and particularly for those
type of investors. But for you know, I would agree David that we haven't seen those that kind of exuberance of innovative structures that probably exists, but not to that level or you know, as I said, overnight risk derivatives, leverage and leverage synthetic structures that compare to two thousand and seven thousand and eight, Which doesn't mean that will not happen, but that's something that we number of eyes are still watching and continue to watch, and we will be part of that as well.
Yeah, that whole issue of demand liability seems much more contained here, which is a great's that's generally what causes a financial institution or sector to get into trouble. You know, you saw it with Silicon Valley Bank a year and a half ago. It's it's that demand liability issue seems to be pretty well stitched up here.
That's probably what worries me. I've been doing this way too long, and I worry about complacency and things that we can't see. But if you have to pick one thing, and what's the one thing that worries the most about private credit right now?
You know what worries me is that everybody wants to be a poll and I'll explain that. You know, in the back in the financial crisis also where I worked for one of the investment banks, and there was a Chase to become Goldman Sachs because Goldman had a premier let's say structured credit franchise or deriality franchise, et cetera. And then we know that the banks who were trying
to be Goldman always do not exist these days. And there were international n US banks and these days a Poll and some of the other in a large asset manager just like Blackstone, are leading the way they have. They're quite institutionalized, with a lot of capital and a
lot of great talent. And it only requires, as you say, the tourists and and here I'm not referring to the retail investors, but you know, everybody wants to raise capital to be part of the six y you know, new acid class of private credit, and does it in a wrong way, and then it vines a shock to the system just because it was done in a very inappropriate way, either from a leverage or or type of investment, and then can create an issue of either overreaction from a
regular or reaction from retail investors. So that's something to watch where the capital is coming from, formation of new funds talent. That's how there's limited talent, I would say more than limited capital these days, so for sure the investors should be watching where it plays their money.
Great stuff and ours off global head of Private Credit at Moody's Ratings. It has been a pleasure having you on the Credit Edge and David Havens with Bloomberg Intelligence, thank you for so much for joining us today.
Let's do it again for.
Even more analysis. Read all of David's great work on the Bloomberg Terminal. Bloomberg Intelligence is part of our research department, with five hundred analysts and strategists working across all markets. Coverage includes over two thousand equities and credits and outlooks on more than ninety industries and one hundred market indices, currencies and commodities. And please do subscribe to the Credit
Edge wherever you get your podcasts. We're on Apple, Spotify and all other good podcast providers including b Podgo on the Bloomberg Terminal, give us a review, tell your friends, or email me directly at Jcrumby eight at Bloomberg dot net. I'm James Crumby's been a pleasure having you join us again next week on the Credit Edge.