Panic at the Disco!
By: Vivaan Shah – Co-Head of Energy Industry
Contributing Editors: Nathan Li, Caden Warner
The private credit industry is not as strong as it seems.
For the last decade, private credit has been the fastest growing financial industry. The market has quintupled in scale since 2009, achieving a 14.5% CAGR that dwarfs traditional industries such as corporate borrowing and leveraged loans. But, this boom was not an accident. After the 2008 Financial Crisis, Basel III regulations restricted high risk bank loans, and suddenly, private equity firms lost their main source of credit. As a result, non-bank institutions filled in the gap, providing bespoke financing solutions at an interest rate premium. However, the last six months have revealed a silver lining, as three events have demonstrated that the private credit field is not as stalwart as it may seem.
Last September, First Brands filed for Chapter 11 bankruptcy. On the surface, it seemed to be a retold story, as an auto parts supplier succumbed to its high debt-load caused by an overconfident roll-up strategy. But, the truth soon emerged. Firstly, to secure leverage, the firm pledged the same outstanding invoices as collateral within debt agreements. In one instance, a General Motors invoice sold to one lender for $17,826 was re-offered three days later to another lender for $463,735, a staggering 26X inflation in value. Secondly, First Brands altered invoice amounts to be artificially higher, with one invoice changing from $179.84 to $9,271.25, an astounding 52X increase. Finally, the firm created special purpose vehicles (SPVs) off-balance sheet to store the illegal debt, which was unknown to lenders at the time. However, during restructuring meetings, nearly $10 to $50 billion of hidden leverage was revealed, which had no attached cash to pay them off. The result was the severe injury of numerous private credit lenders, seen through 25% of Jefferies’ Point Bonita Capital fund being exposed and UBS’s O’Conner fund closing with a $116 million loss. This highlights a structural rot, as private credit operates beyond the public scrutiny of GAAP standards and subsequently relies on self-reported data that is easily manipulated. Famously, Jamie Dimon responded to the incident that, “[w]hen you see one cockroach, there are probably more,” inciting fears that there may still be companies like First Brands lurking in the corners of private credit portfolios.
Last November, Blue Owl Capital faced a crisis. The First Brands debacle had created worry among investors in the privately traded Blue Owl Capital Corporation II (OBDC II) credit fund, with redemption requests doubling to 6% of NAV, well above the 5% legal limit. So, Blue Owl Capital proposed a merger with its publicly traded OBDC credit fund to offer instant liquidity. But, investors soon realized they would incur a 20% loss, as the market had already priced in uncertainty into the OBDC fund, while the OBDC II fund lagged behind due to its private valuation. What emerged was absolute chaos, as the Blue Owl Capital stock plummeted 5% in just two days, and the firm quickly scrapped the merger. However, the damage was done, as investors realized that private credit funds could force losses at any time, which built more anxiety.
This February, UBS reported that private credit defaults could balloon to 15% in a worst-case scenario, 2% higher than previous estimates. This is because it was recently revealed that approximately 40% of sponsor-backed private credit loans are in the enterprise software industry, which has contracted as legacy businesses become increasingly threatened with obsolescence by artificial intelligence. As a result, companies are relying on PIK loans, utilizing debt to pay interest, because they do not have sufficient cash flows. However, this only delays the inevitable, as 46% of technology loans mature in less than four years. This realization caused a massive sell-off in stocks like Ares, Blackstone, and Apollo, which all dropped close to 4% following the report. This is the last straw.
For private credit investors, they have seen three red flags arise in funds during the last six months: fraudulent “cockroach” companies, forced investment losses, and artificial intelligence unease. Ultimately, what we are seeing now is panic at the disco, an end to the party that has lasted more than a decade and possibly an emerging reckoning that could shape the financial markets for years to come.