Private credit – a disaster waiting to happen

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It has been over 10 years since the start of the global financial crisis, which means we are overdue another one.

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Indeed, analysts have been predicting a market correction for two years; now even the bulls are starting to make noises that market momentum will grind to a halt in 2018. Bank of America joined several of its Wall Street peers in November when it announced that it expects an end to the bull market rally in the second half of next year.

So, the rate at which pension fund and institutional investors are piling into private credit funds is alarming. According to Preqin, at the start of the third quarter of 2017, there were more than 300 private debt funds actively raising in excess of $130 billion in capital, with more than 60% of these funds targeting North America.

New funds are being set up by bankers leaving firms such as Deutsche Bank and HSBC in the US, as well as in Asia more recently – such as Tanarra Credit Partners, a group of former Credit Suisse bankers, led by investment banker John Wylie. His firm recently raised more than A$216 million ($165 million) for an Asia-Pacific credit investment fund, including a cornerstone commitment from A$60-billion pension fund UniSuper Management.

Reports also say hedge fund OCP Asia is looking to raise $500 million for a fund lending to small and medium-sized companies in the region.

Growth

In total, private credit funds managed around $600 billion globally at the end of 2016; at the current rate of growth, that could almost double by 2020, says a report from trade bodies the Alternative Credit Council and the Alternative Investment Management Association, with law firm Dechert.

The boom is being driven by lending to small and mid-market firms who are unable to access bank capital, and they are plentiful (with cov-lite deals at higher rates bringing even more borrowers to the table). Preqin says that only one third of money in private credit funds has not yet been allocated – the lowest level since the end of 2013.

For pension funds, private credit offers a promise of yields, particularly in the small to mid-tier market, but it is a risky game if a potential market correction is looming. The returns from private credit funds are volatile. According to Bloomberg data, some funds have lost as much as 17% this year, while others have risen by around the same figure.

Gambling retirement money on the skill of a manager as we approach the end of a cycle, when leverage is back up to 2008 levels, could be evidence that things are getting out of hand.