As public SEC filings show, I have been buying shares of New Mountain’s private credit arm for my own account, even as the recent press and political commentary about private credit as an asset class has been exceptionally negative. Without commenting on any specific private credit firm by name, let me explain why I believe the private credit sector has been “oversold.”
Private credit, as an asset class, began to flourish following the 2008 financial crisis, when the traditional banking system was under tremendous stress. As the banks were forced to pull back from lending, new funds with longer-term capital stepped in to fill the breach. Private credit has been a counter-cyclical support for the financial system as a whole.
Today, the traditional banking system seems generally safe and well-managed. However, private credit continues to have major structural advantages over traditional bank lending in terms of financial safety. If private credit did not exist, policymakers would want to invent it.
First, traditional banks are levered with about $9 of debt for every dollar of equity, while private credit firms are often levered with just $1.00 to $1.50 of debt per dollar of equity.
Second, traditional banks are inherently subject to bank runs, and most private credit firms are not. Banks “borrow short and lend long,” relying on demand deposits and other short-term money sources to make multi-year loans. This mismatch caused the collapse of many banks during the Great Depression, and the demise of Silicon Valley Bank and others in recent years.
Private credit funds are generally designed specifically to avoid the risk of a run on the bank. Many private credit firms are built on permanent shareholder capital. In hard times, the price of the shareholder’s stock may trade down, but their original investment stays in the private lender, untouched. The shareholders are free to sell their shares to the other buyers in the public markets.
Other private credit strategies are “semi-liquid.” They allow capital to be withdrawn on set terms, but they offer a higher interest rate to investors than bank deposits in return for longer potential lock-ups on the investor’s money.
For example, the investor group as a whole may be able to demand repayment of up to 20% of total investor capital each year (i.e., 5% each quarter). Therefore, even under the worst panic conditions, private credit withdrawals can be managed smoothly over a period of years. In normal times, when fewer than 20% of investors want to withdraw, individual investors can have full liquidity on their own piece.
This withdrawal structure (or “gate” system) is not some improvised answer or surprise. Rather, it is a fundamental term of the strategy, compensated for by the higher interest rate paid. For individual investors, it is analogous to receiving a higher rate on a five-year certificate of deposit than on overnight demand deposits, but having some restrictions or penalties on fully redeeming the five-year CD on day one.
Private credit lenders generally have other positive features as well. Often, they can afford to have higher paid, more sophisticated teams of analysts making the credit decisions. Often, the teams have major personal investments in their own funds. Private lenders can focus on borrowers that are too small to gain the attention of the giant Wall Street banks, and offer them service, flexibility, and certainty that the big banks can’t. The private lenders can then receive covenants and other safety protections in return.
The private credit loans are also often safeguarded by a low “loan-to-value” ratio. Typical loan-to-value ratios may now be around 50%, and – in my experience – closer to 30% for the software loans being debated now. This means, for example, that if a software company was acquired for $100 per share, the private credit firm may be lending just $30 of the $100 price, with $70 of the acquirer’s equity junior to them. All of this $70 has to be wiped out before the lender experiences even $1 of loss. Furthermore, the acquirer who put in the original $70 may feel compelled to put additional money into the company rather than lose the capital they have already committed.
The fears that have recently arisen about private credit were not really linked to mainstream private credit at all. JPMorgan Chase CEO Jamie Dimon’s widely repeated line about “cockroach” loans referred to two loans that were chiefly held by banks, not by private credit firms. And the banks were fooled, it seems, by fraudulent documents, not by general weakness in credit conditions.
Indeed, one of the safest and smartest ways for banks to invest in credit is exactly what they do now: lending to private credit firms, backstopped by the full diversified pool of loans, and positioning themselves as the most senior third or so of the private credit loan stack. To simplify, this means that when the private credit firm makes a $30 loan to the $100 software company, the bank provides the most senior $10 or so of that $30 loan. All the company borrowers in the diversified pool would have to lose roughly $90 of their original $100 value before the banks take any loss. This seems exceptionally unlikely to happen in a widespread way, since private credit loans are extremely diversified across thousands of individual credits. Furthermore, even in the worst-case scenario, the private credit sector is roughly just 2% of the total U.S. credit market – not nearly large enough to cause systemic risk.
There is a social risk in unreasoning panic against private credit, however. It is the risk that the entire private credit sector gets strangled and killed through irrational fears, thereby depriving thousands of Main Street companies of the capital they need to prosper and grow. The accounting firm EY has estimated that private credit financing now supports 2.5 million jobs, earning $217 billion of wages and benefits, generating $370 billion of GDP. Hopefully, sound regulatory and market judgment will prevail in time, and the facts will speak for themselves.
