Hello, 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 have on the show Cat Hidalgo, who covers private credit for Bloomberg News in London. How are you, Kat, I'm well.
Thanks so much for having me on, James.
We're very excited to get your take on the markets. Thanks very much for joining. We're also delighted to see Andrew Chan, a credit analyst with Bloomberg Intelligence in Hong Kong. We'll be coming back to Andrew a bit later in the show to talk about the brewing mess in Chinese debt markets. So do stay with us. But first, Cat Hidalgo with bloom Bloomberg News, You've been all over the private debt story. The deals are getting bigger and bigger,
breaking all records. There's a five point three billion dollar loan package in the market right now. At the same time, fundraising is ramping up. Oak Tree looking to raise eighteen billion dollars for a single private debt fund, which would make it the largest ever, and pensions are being urged to allocate more to the strategy, which is enjoying what Blackstone has called a golden moment. However, we're starting to see evidence of growing risk, similar to the signals we've
been getting from the public bond and loan markets. There are risky companies obviously involved in this private credit market, and they're borrowing a lot of money where there's a lot a lot of transparency or regulation. Rates of sword earnings are slowing as recession looms. Some of those borrows just can't keep up. What's the situation, cap How bad is it out there? When we look at private credit defaults.
Well, it's a really interesting situation. The problem is that we don't really know. It really is a very opaque and private market. So we can rely on some surveys and a bit of data here and there. For example, pros Goauer, which is a law firm, releases a private credit default index, and their Q two.
Iteration, which came out recently.
Shows that there was actually a decrease in the number of defaults, and that's amongst US companies. But that was after two consecutive quarters of an increasing rate. Right now their default rate is at one point six y four sent and so that's in the US, and that is
still considered quite low. But other than that, we really just have to rely on the anecdotes and things like the general default rate, which you mentioned is kind of ticking up, and these things do indicate that there is more stress in the market, but not by an overwhelming sum. And there's also a difference between loss rates and default
so there's a lot of different things happening. What I can say is that what we're gathering from the people that we speak to, from fund managers and investors in those funds, is that there has been a noticeable increase in stress, but it's not dramatic or worse than other parts in the market. The kind of the typical thing that you'll hear from a fund manager is that they'll say they're hearing other portfolio struggling, but that their portfolio is doing great.
Right.
As you mentioned, we just don't know in some cases, so it's very difficult to actually measure this stuff, and that from markets is problematic. Usually, is there something you think that that's you know, we're just not able to track that that you know could be worrying. Is there something blowing up somewhere that we just can't see.
I think it's again I mean, it's really difficult to say there's a there's a possibility of that, but one hopes that most of these funds are small enough and the allocations that pension funds and insurance companies have to these funds are small enough that if there was to be a major blow up, we wouldn't see too much systemic risk.
But you know, we're keeping our eyes out for it.
And and I don't I don't want to call out and say that I'm sure there's nothing nothing huge or wrong in the market. It's something that we're following very closely.
So based on what we can see and what we can measure, what kinds of companies are struggling at the moment, and why are they struggling now.
So I think one interesting area is actually that businesses that suffered in COVID are falling out of favor. Of course, they just can't handle the amount of stress that they've had over such a long period of time, but also that businesses that might have done really well in COVID, that kind of really enjoyed those tailwinds that they saw out of COVID are now no longer enjoying them and
struggling as a result. I think also the other trend to watch out for is that you're also more likely to see assets that have been held onto for a long time by their private equity firm that probably should have been sold off previously and been able to refinance their debt, but because of the slowdown in M and A and refinancing, because of higher interest rates, they no longer have access to those lifelines. So it's those kind of older businesses.
Are they in any particular sector and are they particularly kinds of businesses that we've we're more focused on, are they I mean the ones that did well in COVID are the ones that we were using because we were all locked in our house and we couldn't get out. But what kinds of When we talk about the kinds of company, what sectors are they and what kind of businesses are they?
So there's the usual suspects. We've retail businesses, the obvious ones, things like casual dining. But what's interesting about private credit is that they really don't focus on those on those sectors. You know, we've got the odd specialized fund and the odd investment in most funds, but typically a private credit fund will focus on things like technology and healthcare, which is why I thought that this one example that we tracked down of a business being taken over by its lender.
It's called Enva, it's a care home or operator in Germany. I thought this one was really interesting because people have written ad nauseum about how bets in the healthcare space could go billy up, But it would be actually really detrimental to see a whole sale shift in the credit quality of healthcare businesses on the private credit industry, just because they're so exposed.
After technology.
It's the biggest area of focus for private credit funds, and we know that sector is getting squeezed by labor inflation and regulation. We've just got to see what happens there and see if it becomes a wider vider trend, because we've really only seen of this one example, maybe a couple of others in the past, but it would have a very interesting impact if that became more serious.
I guess the country to focus on is that we've noticed the larger concentration of depth F equity swaps in Germany, but we haven't yet been able to discern if that's because the situation is generally worse out there, or there are specific dynamics there, or if it has to do with technical factors in the market, kind of surrounding reporting that allow us to actually pick them up more more
easily than we could elsewhere. Obviously, PMI came out yesterday with really bad numbers for the sector in manufacturing sector in Germany, and there was a recession recently there, So it kind of could be either factor.
One thing that jumps out there when you're talking debt for equity swaps, what is that? Why are we talking about that in this context?
So debt for equity stops is a kind of a method of last resort for a private credit fund. They've got all of these leaders that they can pull when a portfolio company is under stress. But the final thing that they'll do is they'll have a conversation with the private equity sponsor.
The sponsor will.
Say, we're not willing to put any more money into this business, so we're going to hand over the keys to you, and you can exchange all of the debt that you're owed into equity and now you private credit fund are the sole of this business. And we wrote my colleague and I Silas Brown wrote a piece about seeing a couple a few more examples of this happening, and it's an indicator of serious stress in the market.
So that's why we're talking about this.
So the debt side, that's when a private lender will give money to a private company in a bilateral sense, almost like privately negotiated deal that is alone, but because this company can't pay the money, but they end up just owning the company exactly.
Yeah, it doesn't necessarily happen on a bilateral basis every time. Sometimes you've got maybe three lenders, which is what happened in a case called Unza in Germany recently. But yeah, that's pretty much the principle.
That's the idea a bank or a lender, they don't generally want to own a business. They don't want to operate a healthcare company or a retail company or a fine dining establishment. What happens in this case, I mean, do they just suddenly shift their business model or what do they do with the assets?
It's a really interesting area.
Can I give you a bit of context on this actually, just to kind of flesh out my answer, So we could do a whole podcast just on the.
Dynamics of these arrangements.
But what's interesting to me is that there's this narrative emerging when we speak to direct lenders and private credit for managers that it's not necessarily bad to have a debt for equity swap. That because you know, the fund is now the equity owners of a business that has no debt because it's all been shifted into equity. There's huge potential for upside, much more so than when you were just debt holders with an expected yeald. The flip side of that, of course, is that you know, this
is not what private debt funds were created for. Kind of to answer your question, many of them aren't equipped to deal with a large number of restructuring And while there is that potential for upside that's being talked about more and more, there is huge potential for downside. They could lose their entire investment, and most funds wouldn't be able to make a profit if they had even two
or three situations where they couldn't recover their money. The entire fund would not make a profit if that happened. But you know, it depends on the fund, and there's a huge amount of variation on this topic. Typically larger funds have a more substantial restructuring or workout department. We've definitely seen some major funds hiring more and more in this field recently. I can't speak to whether they actively want to own these funds. No one's ever said that
to me. You know, I actively want to own these portfolio companies, but we sorry not funds portfolio companies. But we do know that some of these larger funds have taken over the keys to more and more businesses, and they are this idea about their being potential for upside is is kind of on their radar. Smaller funds would
struggle more in the area. But I think what the final thing that I'll say on this is that at the end of the day, big or small, these funds were not made to own and operate the companies that they lend to. That's not what was pitched to investors, and it offers a completely different risk profile, much closer to something like a special situation sund But.
It's interesting in that, you know, they're on the one side, they're lending this money at very high rates, they're making a good return there, and then when things go bad, they're actually you know, potentially making even more money because they're becoming equity owners. So so sort of win win situation. But at the same time, I mean I do worry because you know, we see this all the time in
the public markets. There is a you know, the risk of complete wipeout in some of these firms, right, I mean, you must have to risk losing all your money.
Absolutely, that's that's that's completely the case. And I think we're in private equity funds, you've got the potential for huge upside on every one of your investments, and you only need a couple of winners, of big winners to make the whole fund profit overall. But that's just not the case in private credit funds. That's not the way
that the dynamics work. And so if you do, if you do not recover any of your money on a few investments, it can be really detrimental to the returns of the entire fund.
So looking back to where we started this conversation, you know, there are more defaults, We are seeing more problems in private credit. What is the outlook for more of this? You know, do we expect a big default wave to happen?
Right, So that we've mentioned we've mentioned that the bulk of these deals are done the laterally. I think you said that, but you know so, So a direct lending fund might be the only lender to a company. So when we talk about a big wave of defaults, we have to contextualize that in the relationship aspect of these funds, they really kind of focus on their relationship based culture. They talk about how that's very much in place, and so what this means is that they pride themselves on
their ability to negotiate and provide flexibility to borrowers. So a wave of defaults will always be tempered by the funds trying to manage these situations more so.
Than a bankuard, for example.
So market participants have told us that this could be a factor and why we've seen so few defaults in the space so far. But just to give you an idea of what these funds can do there, they can wave covenants, they can extend maturity, they can negotiate with sponsors to provide more equity. As we said, they can take keys to the business without it being public or calling it a default. So the possibility for a huge
wave of defaults is definitely tempered by that. What would really trigger wave would be a shift in risk appetite for these funds where they were no longer willing to kind of provide that flexibility. They were more keen to kind of crack the whip and be more stringent about terms and conditions. And then, of course these companies, we can't forget are in the real economy, and if we had an overall macroeconomic decline, that could push many of these businesses over the edge.
So it's more like getting a loan from my friend rather than having to go and beg the manager of Buckley's Bank to better terms and a few more days to pay my loan.
Is that right?
They might not be quite as nice as your friend, but that's definitely kind of the idea that they're going for.
Yeah.
Interesting, Okay, So it's still fairly new market though private crediting. It's seen such a boom, as we've discussed over the last few years, but it's still fairly new. How does the current default situation compare to history in terms of the level of worry out there right now?
It's interesting. Again, we do have very little data to go off.
We really can only talk about what we see in surveys and anecdotes. Another prosaur report from April showed that one hundred and fourteen out of one hundred and fifty private credit executive surveyed they expected the faults to rise in their portfolios in the next year, which is the highest level in the past five years from the survey. But that's kind of what makes this phenomenon so interesting is that private credit has never been for a proper
recession before. This is this is uncharted territory. We can't we can't really say. I mean, we definitely know that we're seeing more defrequity swaps than ever before, more defaults than ever before. So and certainly it feels like people are worried. This is something that most people that you speak to bring up, and it's it's something that people watching closely.
So before we talk to Andrew Chann at Bloomberg Intelligence, how do we reconcile that with all the fundraising, all of the billions in dry powder being raised for the strategy, and the ever increasing scale of some of the loans that are getting done.
Yeah, that's a really interesting question.
Does feel like a paradox, doesn't it, But the two aren't actually mutually exclusive. So yes, private credit is raking in records terms of dry powder, especially in Europe. But the data shows that more money is going to fewer funds, So that kind of implies that investors are plowing money into a select few of.
The largest funds. So this would show that.
There is a fear among these investors, these pension funds, these insurance companies that invest in private debt, but that they are they do believe in the asset class, they're just a bit more wary of it now, so they're more wary of the smaller firms that they would suspect would be more susceptible to the fullests that had smaller restructuring teams that are less equipped to deal with stress. And I think the larger loans are a symptom of
the same trend. The funds are fearful of stress and are relying on larger companies investing more in them because they see those as as safer option. So that's kind of how I see it in my head. Does that make sense, James to you?
Absolutely yes, We'll look forward to reading more of your analysis and coverage. Thank you so much. Kat Hidelgo from Bloomberg News and of course to listeners read all of Kat's scoops on the Bloomberg terminal and at Bloomberg dot com.
So you're going soon, Kat, Thank you, James.
Moving on to another big topic. As I mentioned earlier, we're very fortunate to have with us Andrew Chan, who covers credit for Bloomberg Intelligence based in Hong Kong. How's it going over there, Andrew.
Great, Well, I guess like exciting for a SOLS.
So there's a ton of anxiety right now in markets about the state of China's economy, which has a significant repercussion for everyone else in the world. The eighteen trillion dollar economy is decelerating, the property crisis is deepening, consumers seem very beat, exports as struggling, and more than one
in five young people are out of work. And as we talked about last week on this show, Country Garden, a company with about three thousand pending property projects up and down China, is on the cusp of default on its debt. And also at the same time, protesters gathered at one of the biggest shadow banks demanding their money back as payments were halted. So a lot of issues
you know across China right now. You know great to have you on the show, as you know, as an expert based there, and we've we've we've been looking at this from different angles on this podcast. But but we want to drill down a little bit now into what we're calling local government financing vehicles, which is another part of this sprawling debt mess you know in China. Can you start, Andrew by telling us what these entities are? You know, what is what we're calling an lg FV and how do they work?
Yeah? So, right now, the LGFE definition is pretty blurred because a lot of these entities they used to provide some sort of public service or build some type of infrastructure for the local government. But once that purpose was finished, I mean, its existence was in doubt, and many evolved by foraying into like other businesses, some profit orient mostly profit oriented, but they largely still remain in an extension of the local government.
So just but in basic terms, they are entities that are phoned to fund infrastructure, schools, that sort of thing in China, Is that right?
Yes, that's correct, not necessarily a school, but definitely like public services.
Okay, so why do they have to set these vehicles up? Like don't they just borrow money directly.
Ah, So say, for example, like I want to build a subway, and so they would set up like a subway LGFE, so to say, And so it's like somewhat run like more on co marcial terms rather than being built say by the local government.
Okay, but who is responsible for that debt?
Then?
If you if you're burrowing through through a special purpose vehicle like this is, does that mean that you're you know, kind of distancing yourself from the ultimately from repaying that debt.
So the debt is definitely belongs to the LGF, which again is an extension of the government, and a lot of the lenders that lend to the LGF, whether it's like say through offshore notes, on shore notes, or through bank lending, they understand that there's some sort of implicit government support to this SPV so so to say, or LGFF.
Okay, And by government you're meaning you're meaning the federal government, not not the local or the state government, right, Oh no, the local government okay. Okay, So it doesn't necessarily roll up to the federal level.
No, not to the central government level.
Okay.
So just to like put this in perspective, I mean, it's a we're hearing huge numbers. How much debt do they actually have?
Okay, So using the termino, we actually use the bottom up approach to estimate this China LGF debt, which could be around like nine point eight trillion US dollars based on the latest available financial data of more than three thousand lgfs.
So to put that in perspective, Andrew, how much debt are we talking about here?
Yeah, So using the terminal, we use a bottom up approach to estimate China's LGFF debt which could be around nine point eight trillion US dollars based on the latest available financial data for more than three thousand lgfs and
local soees. Now, looking at the overall financing structure, around seventy percent of this is funded by financing other than bonds, such as bank loans, while around twenty nine percent is onshore bonds and another one percent are offshore bonds of around one hundred billion US dollars.
So this is a lot of it is actually sitting with foreign investments, is that right?
Not as much so one percent of their total loans or so? Okay, And so the remaining ninety nine percent is on shore bank loans or onshore bonds.
Okay, so mostly held by should I mean is it mostly Chinese banks that are that are holding this debt? Yes, it is, and then most of those banks actually stay owned a majority okay, yes, interesting, So the anxiety has been around a default by one of these local government financing vehicles. What other chances of that happening and what would what would that mean for China?
Yeah, so I think your question can be rephrased to like, what type of debt are we talking about that is to be defaulted?
Now?
In our view, no LGF wants to be the first to default on its offshore or on shore notes. I mean, considering the relatively small offshore amount and small proportion in their total death structure. I mean, there could be very low incentive for lgf's to default because should there be a default of a high profile LGF, I mean, investors would likely reassess China's SOE and LGF issuing universe on
a standalone basis without state support. I mean that could create a lot of unintended consequences, mainly because there would be substance a huge, substantial repricing in risk and subsequent refining refinancing risks for not only offshore but likely onshore too. I mean, that could lead to a lot of rating downgrades, which could transpire to, in a worst case scenario, systemic
risk for the financial system. I mean, right now we calculate around twenty trillion US dollars equivalent of outstanding bonds could suffer from some form of repricing risks because a lot of investors really when they price these state owned bonds or state affiliated bonds, they factor in a form of state support.
Okay, and what right now do you think is the probability of one of those government financing vehicles defaulting?
Is it?
Is it a high likelihood or is it very very small?
Do you think?
Uh, very small for the time being. And it goes back to the point that no one wants to be the first one because obviously these local governments they have, they operate independently, and so if say one province defaults, then that pretty much spills over to a read across to all the all the other provinces as well because of the reassessment of state support. That's why in the past actually earlier this year, we saw one example. It was called Junyi Road and Bridge Construction in Gueijo Province,
which is one of the poorest provinces in China. I mean they abruptly restructured, and a lot of the debt was actually restructured on the bank loan side. But if you look at say they're onshore bonds and their offshore bonds, they remain close to par.
Okay okay.
And of course if we look at say some of the old if you've been following the sector, you might recall some names such as chun Ching Energy, Beijing, High End State owned Assets, Investment in UNN, Health and Culture. I mean all of them had offshore dollar notes, and despite all of the tight liquidity and the very volatile bond prices, a lot of them, I mean all of them actually repaid their offshore dollar debt without issuing new
dollar debts. So the local government came out step, stepped up and helped them, and in particular, one notable example is chum Ching Energy, which actually repaid all outstanding on shore and offshore bonds before filing for bankruptcy.
Okay.
So that shows you, like the importance of any local government to not be the first to default on a public note.
Obviously that it want to, but they might ultimately be forced to because of maturity walls or you know, lack of liquidity or whatever. I mean, what can the actually what can the government to prevent this happening? How can they help out here?
Yes, and so I think the key backstop will be the state owned banks, and so they've done most of the lending for it, and so, of course the exact answer to this question like how much bad loan losses can China's banking system absorb, that's for another podcast and for the banking team. But again, if we look at say the overall picture, the total assets of FI in China according to the China Banking and Insurance Commission, I mean, is around fifty seven trillion US dollars, with shareholder funds
of close to five trillion dollars. So again, depending on your own NPL assumption, I mean, there appears to be a decent capital buffer. Now, of course, the banks would likely need to raise additional capital somewhere somehow, but again that's another question for the banking experts. But the key point remains, and that is the banks can act as
a temporary backstop. Should lgfs need to urgentily structure their loans, of course, such actions will need to be coordinated by the local and central government.
Do we expect losses to those banks? I mean, is there going to be a haircut on that debt?
There will likely be a haircut for that. And so it depends on how the banks classified these loans. And so say, for example, the Jini example I just gave out, it's been restructured, and the principle everything has been extended by another twenty years now that can be may not necessarily be considered a bad loan in Chinese accounting, so to say. And so as long as the LGFE continues to pay their interests, I mean, it's considered a performing loan.
What analogies can we drove between this and the property crisis in the sense that, you know, the Chinese government right now doesn't seem to be doing much to support the property developers, and in fact, it seems that the company's party doesn't really you know, want to support them to the extent that they want to, you know, bail out. You know, there's a moral hazard issue. They didn't want to bail out excesses that have gone on in the
in the real estate market. Is it the similar situation for the local government financing vehicles?
Is it a similar situation? I guess that question is
more is more interconnected? And now why I say that is because if the central government is not helping out the property developers and they end up defaulting, I mean, I think that sends the wrong message to the entire sector, and so pretty much all the home buyers will will likely shun future home purchases of state owned developers and non state owned developers, and so that will have a trickle down effect, which is the property developers they won't
be buying land from the local government. The local government won't have any money to provide support to the lgfs. So I mean a lot of this is really hinged upon the central government's decision to allow a big player like Country Garden to default, And to me, I think it just really sends the wrong message because this vicious cycle will just not be broken until something substantial comes out from the central government. So again, home buyers aren't buying,
developers aren't buying land. Local governments become poor, they can't support their local government lgfe's and again that's the house of cards there we're talking about.
So ultimately, do you think this ends with government bailing everyone else and everything just you know, coming back to normal again.
It will be very difficult. And now I say that is mainly because looking at Evergraham, which defaulted two years ago already, I mean, this messis continues to drag on.
So I think they're in my opinion, there may have been some bureaucratic miss and hopefully the Chinese government can try to reverse this, so to say, because the property sector has just been dragging everything down, and if you look at say the second order, third order effect coming from it, I mean, property accounts for a quarter of GDP and if that's dropping, you can't meet your five
percent target. You're starting to see rising unemployment in the sector, not only on the terties on the property level, but
all the ancillary sectors as well. So it can be your cement, your white goods, electronics, and so a lot of bad debt will start to pile on the supplier side, construction companies with razor razor thin margins, and of course you have the declining housing prices which will lead to negative wealth effect again, which isn't good, and so everything is really hinged upon the central government's actions.
Now, okay, obviously there's going to be many different parts of this and it's going to be, you know, a long drama to come. But right now, what are the key takeaways for investors?
Do you think? Andrew?
The key takeaway for investors. I think the first one is that the China high yield sector is unfortunately close to uninvestable, as we've seen with the property crisis saga, because I don't think we've ever seen a sector be decimated in such a way that there are over one hundred billion US dollars in investor losses and over two hundred something bonds are below ten cents, which pretty much
assumes very very pessimistic recovery expectations. That's one, and then I guess on the second front is that if there are r V opportunities on the LGF side, and it goes back to our our thinking is that the lgffs, no matter what, needs to be saved because one, the toll I'm not outstanding on the offshore notes is very
small in the grand picture. And second of all is that a lot of these lgfes are pricing to be rather distressed as somewhat over fifteen percent, and so on that front over there, there could be r V opportunities over there if our thesis is correct that the lgfe's will be saved.
V as in relative value. Yes, okay, So just to wrap things up, what's the next big thing to watch? I mean, we're looking right now at the country God and Grace period everyone's worried about to fill. There are there any sort of triggers or any events that you think we should be looking out for in terms of, you know, the calendar coming up.
Two things, I guess the first thing would be definitely like how the Chinese government is plans to deal with this, because obviously there's a spillover effect not just domestically but internationally as well. Their demand for commodities will likely be adversely affected. All your geopolitical goals such as China's One Belt, One Road initiative may definitely slow down on that front. That's more of the macro picture on the company and
sector wise basis. I think a lot of investors will start to focus on the remaining survivors and even the SOOE developers because again with the country Garden debaco, I mean, it seems like no one is safe. And so those state owned developers, a lot of them still have bond prices in the eighty cents ninety cents levels, and so if one of them starts to become a bit shaky, I think that would really put the nail in the coffin for the entire sector.
Thanks very much, Andrew Chan of Bloomberg Intelligence. You can read all of his great analysis on the Bloomberg Terminal. Do check it out and hope see you soon on the show again, Andrew.
Thank you very much, James, and thanks.
Again to Cat Hidelgo from Bloomberg. Yous read all of her great credit scoops on the Terminal and at Bloomberg dot com. I'm James Crombie. It's been a pleasure having you join us again next week on the Credit Edge.