Private Credit On The Zombie Treadmill To Meltdown – Forbes

When you suddenly hear about a boom in a financial instrument in the mainstream media, you can be pretty sure trouble is on its way. At the very least, you can speculate that a peak market level – whether in volume or price – has been, or is about to be, reached.

There are a number of reasons for this. It could be because so much money has been made that the nouveau riche of this endeavor are boasting about it, setting off a wave of FOMO that hits the media. Or it might simply mean that, at the top of the market, holders of that asset want – and start to need – ‘exit liquidity,’ and are out promoting what they want to sell in order to pull in the final bag holders.

Either way, it’s a signal to me that something wicked this way comes.

So, the phrase “private credit markets” is popping up more and more, and the narrative is that they have been booming. To me, this says they have boomed. “Private credit” sounds like a long-established concept, but it’s relatively new – a term dating back to just after the global financial crisis. The private credit market is barely a market at all, since the financial instruments it generates are not publicly traded. Private credit is lending to companies at high interest rates by non-banks. A cynic might typify it as loan sharking to shaky companies by shady outfits, but that would be harsh – even for such a lucrative business.

So let’s go digging. Where can I get some of this private credit? It doesn’t seem to be exactly front and center in rustling up business, and yet there are $2 trillion of private credit loans out there. That is a systemically important amount of money.

Let’s keep it simple:

Q: Who raises this private credit?
A: Private equity outfits.

Q: So who do they lend it to?
A: Private equity-backed companies.

Q: Why do they lend it to private equity-backed companies?
A: To keep private equity-backed companies afloat and/or pay out dividends to private equity participants.

Q: Who do the private equity companies sell the private credit debt to?
A: Institutions like your pension scheme, sovereign wealth funds, university endowments – the same kinds of operations that got stuffed with mortgage derivatives that blew up the world.

Q: Who invests in private equity outfits?
A: Institutions like your pension scheme, sovereign wealth funds, university endowments… you get the idea.

Q: Why do those institutions invest in PE and private credit?
Official A: Because the returns are great.
Cynical A: Because the value of these illiquid investments is marked in private, not in public markets that trade daily, so the results are ‘smooth.’ Bad news can be delayed until the bitter end – and by then, the initial buyers or sellers are long gone.

In summary: PE buys companies with investors’ money, levers up the companies or keeps them afloat with high-interest loans sourced from similar investor groups, and makes lots of money along the way.

Q: Isn’t this the kind of circular, opaque, conflicted dynamic that caused the global financial crisis?
A: Yes, but thankfully the numbers are not as big. (Assuming $2 trillion doesn’t scare you.)

Let’s wave some red flags. The acronym of the day: WCGR!

• The market has grown 400% in 10 years.
• Really high-interest rate loans – up to 15%.
• Returns to repay these high-rate loans have to come from successfully running complex businesses that were either distressed or being eagerly offloaded.
• Circular transactions of opaque, illiquid, and non-mark-to-market assets are classic causes of financial meltdowns.
• The customers for these instruments are classic Wall Street victims – see the S&L crisis, the credit crunch/GFC, and a never-ending stream of scandals.

Well, it might never happen, but what might the impact be if trouble hits this never-blossoming financial juggernaut?

Just like the mortgage market during the GFC, it depends on the quality of the assets generated by this financial process. The lower the average quality of the debt, the more likely things could go belly-up and send hundreds of billions to money heaven. The seeds of a vicious circle are all there. If the private credit market freezes, then companies that can’t roll their barely sustainable debt fail. This devalues even the good paper, which can trigger forced/panic selling – deepening the freeze and causing further failures. Contagion spreads.

The interconnectivity of this market within the financial system is not fully known, but hundreds of billions in credit assets going up in smoke would certainly have ramifications.

However, here’s the thing: this is all built on cheap, near-free money created by the history of recent bailouts and QEs. This, in turn, is ultimately driven by U.S. fiscal deficits, which create a constant need for liquidity to cycle money back into government coffers via taxes or debt. It’s a high-wire act – and the circus has never been bigger.

Ironically, this might be good news in the short term: a crisis in private credit will likely be bailed out, and that means money printing. This would probably mean QE – or some version of it – which is already on the way. Now it might just arrive sooner.

The ratcheting of instability has no end in sight. This potential crisis is yet another indicator that the direction of travel for the dollar is toward weakness, inflation above the legacy 2–3% target, and chronically heightened volatility.

Meanwhile, the zombie treadmill will grind on as the private credit industry moves from back rooms to front pages. Another financial crisis in the making? Ultimately, there’s always another one on its way – but this could very well be the next.

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