Does personal credit score have a credit score high quality drawback? | Invesloan.com

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Good morning. The price of Brent crude bounced around between $85 and $90 for most of the day yesterday — except for a brief moment after US energy secretary Chris Wright tweeted, incorrectly, that the US Navy had escorted a tanker safely through the Strait of Hormuz. The oil price dipped below $80 before the tweet was deleted. Never ignore the role of human stupidity in markets. Send your best examples proving this timeless rule to: [email protected].

Private credit again

This newsletter has argued that private credit’s recent problems are fundamentally liquidity problems rather than credit quality problems. A few investors got spooked, mostly about the risks AI posed to software loans. The nervous nellies wanted out of some private credit funds. Their exit requests hit up against redemption limits of some illiquid credit funds, talk of “gating” investors spread into the air, and this led predictably to more redemption requests. It’s a product design problem, really: semi-liquid private credit funds aimed at retail investors are just not a good idea.

However, some people argue big credit-quality skeletons are in the industry’s closet. One of those people, if you want to call it a person, is the stock market.

Business Development Corporations are well-designed retail private credit products. BDCs are closed-end funds that mostly invest in loans to small and midsized businesses, often those owned by private equity — that is, in the same sort of stuff the non-traded private credit funds invest in. Investors can buy and sell shares in the BDCs at a market price at any time, but this does not require that the funds buy or sell assets.

As a result, BDC shares can trade at a premium to the net asset value of the fund, which is disclosed quarterly. And lately many of the funds have traded at big discounts. Here are the premiums or discounts of the 11 largest BDCs by market capitalisation (I have used tickers rather than fund names because otherwise the chart becomes too clunky; you can look the names up):

But that chart doesn’t really tell the whole story. This next chart shows the one-year change in the premium or discount at each of the 11 big BDCs in percentage points:

Investors have decided they are not willing to pay nearly as much for the big BDCs’ assets as they were a year ago. The market may well be valuing the assets incorrectly, of course. But the market’s judgment as of now is clear: this stuff isn’t as good as it thought it was. Here, by the way, are the share prices of the five largest BDCs:

Hedge fund Glendon Capital Management recently made an argument that fits with the stock market’s judgment. It argues private credit loan yields, which average somewhere in the low single digits, are several percentage points higher than their semi-publicly or publicly traded cousins — syndicated loans and high-yield bonds. Glendon asks why borrowers would pay more to BDCs and private credit funds (“direct lending”) than they would pay in the loan or bond markets, unless the borrowers were lower quality. Glendon’s slide:

How is it possible, Glendon asks, that private equity funds and BDCs are reporting lower loss rates than public loan and bond markets, when the yield on their loans suggests that the loss rates should be higher?

Unhedged, loyal readers will remember, has ruminated on this question quite a lot, in our letters about private credit’s special sauce (from three years ago) and the source of its excess returns (two years ago). It is certainly true that some borrowers have reason to avoid public markets — maybe their businesses are unusual and their cash flows uneven, and they prefer a bilateral relationship with a single lender, bound by a custom contract, to the judgment of an anonymous crowd. A core claim of all private credit fans is that good PC funds are better at underwriting complex companies than the public markets.

All that said, I broadly agree with Glendon. There is probably only so much extra yield to be had from smart underwriting and structuring. As I wrote six months ago, “There is no magic in credit markets. If a lender is earning above-average returns, most of the extra return is probably coming from either using more leverage or taking more credit risk — not from special skill or innovative product design.”

But Glendon makes a stronger claim, too: that BDCs put more favourable valuations, or “marks”, than the public markets on the same assets or very closely related ones.

I don’t know how pervasive bad marks are in private credit. But ultimately such marks are not sustainable: at some point, returns have to be delivered, in cash, to investors. BDCs are pass-through vehicles that have to come up with dividend payments. Non-traded funds have to meet redemptions, however irregularly. The big question is whether the industry’s structure creates pervasive incentives for managers to mismark their assets. The stock market, as we have seen, seems to think so. We’d be keen to know if readers agree.

More on this in days to come.

One good read

Dining with Dr John.

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