Navigating the trouble with private credit

Everyone is talking about private credit these days, including people who had never particularly cared or followed this relatively immature asset class before. This is a sure sign - if we needed confirmation - that private credit funds are currently facing a serious reputational crisis.   

Although the intensity of the reporting on the story has accelerated in the media in recent weeks – I would recommend listening to the always entertaining Financial Times Unhedged podcast Uncomfortable moments in private credit -  this is nothing new to those who have been following the meteoric rise of the asset class as banks withdrew from mid-market lending following the Great Financial Crisis. There were exciting times back then when private equity firms, including the one I worked for, started building direct lending teams and launching funds as a highly opportunistic move and effective diversification mechanism.  

The strategy was so popular that funds grew very quickly into a $1.8 trillion industry and decided to branch out of their sophisticated institutional investor base to attract retail investors into a mix of private and public vehicles - or BDCs if you enjoy a financial acronym. This is important because, in reputational terms, those retail vehicles are where the greatest risk always lied as the untested involvement of a new more panic-prone class of investors always came with serious potential consequences at times of credit-stress.  

Fast forward to today, the problems of the highly debated and, for some, arguably questionable decision made by private markets firms to sell illiquid assets into semi-liquid vehicles as well as the anticipated misalignment between institutional and retail investors when times get tough are now being very publicly exposed.    

This was predictable and we saw a preview of that scenario unfold with the issues experienced by Blackstone Real Estate Income Trust (Breit) in 2022 when the firm, faced with redemption calls, decided to limit withdrawals. That experience and the sharp recent share price drop must have weighed on their decision to get the firm and some employees to invest $400 million to cover its flagship private credit fund redemption requests in full.  

Whether you believe the optimistic view of many industry insiders that the underlying loans in those direct lending vehicles remain largely sound, that the AI disruption will create positive opportunities including for software businesses, that these structures are diversified, only moderately levered and do not pose any systemic risk, it remains that they were untested in times of real, perceived or anticipated credit-stress. 

As Bloomberg’s Big Take put it recently “Private Credit’s Gate-Crashers Are Forcing Funds Into a Brutal Spot”. That spot is the acute dilemma described by Simon Nixon in his Substack article: “Faced with a wave of redemption requests from anxious investors, private credit funds are confronting an acute dilemma: block exits and risk reputational damage, or sell assets - potentially at firesale prices - to meet withdrawals”. The choice is stark and the reputational damage will have lasting impact whatever the decision made, given the likely consequences on returns of funds selling their best loans at potentially discounted value to meet redemptions requests above the 5% quarterly gate.   

Effective communications, or the lack of it, is central to this dilemma. As Bloomberg puts it, “arguments for gating can ring hollow for investors amid talks of private credit pain that could last up to 18 months. And that’s assuming advisers had fully communicated to retail investors what a cap on redemptions would mean in a period of credit stress”. In other words, when it comes to a retail investor base, you can never over educate on the nature of private assets or over communicate on the exact level of liquidity offered during time of stress. The effort required to keep that audience on side should not be underestimated by private markets firms as the probability that they will publicly turn on the firms that sold them these products is real, very high and will inflict lasting damage on their reputation. 

Another communications implication is that it is the private markets firms that prepared well ahead of the storm and that communicate consistently which will have the best chance of maximising their ability to defend themselves and their performance in such challenging times. Whether you have sympathy for Main Street’s private credit panic or not, it cannot be ignored and is putting significant pressure on the share price of the listed private markets firms and funds. Having a clear response strategy and protocol in place is critical to protect your brand throughout the crisis and licence to operate in the long run.