One thing that Chris highlights is bank lending to private credit. This cannot be emphasized enough. This is a characteristic of the current market that is not understood by a lot of people. And to me it is the greatest risk in the market today.
So what do banks do? Its simple.
A private credit provider walks into one of the money center banks (JPM, Wells, BofA, Citibank) or large super-regionals (US Bank, PNC, Fifth Third, Regions, etc) with $250MM in equity capital they have raised from investors (primarily pension funds and sovereign wealth funds).
The private credit provider asks the bank for a loan that is a multiple of their equity capital. The intent is that the PCP will lend out both the equity and the levered funds it will borrow from the bank.
I have not touched a deal in this space for awhile. But lets say the bank is willing to lend the PCP 3 times their equity. Now the PCP has $1BN to lend out ($250MM equity plus $750MM in funds from the bank).
The spread the bank charges is lower than what the PCP charges the client. Once again for arguments sake lets say the bank charges the Secured Overnight Funding Rate (SOFR) + 300 bps SOFR today is about 3.5%. So the all in rate the bank charges the PCP is 6.5%.
The PCP’s goal is maximum returns. They lend to clients that are too risky for banks. So the PCP charges SOFR + 700 bps, or 10.5%.
Those of you in the market can fact check my leverage multiples and pricing, but I pretty sure I am directionally correct. With a combination of leverage and pricing spreads, PCPs can make a very tidy profit. They have promised low risk returns above 10% to their equity investors, and for the last decade or so have been able to deliver on those promises.
My question has always been why banks would lend to PCPs. PCPs make loans banks cannot do because they are too risky. Why farm out the credit decision with the bank’s capital to a party that purposely takes on high level of risk?
The banks get comfortable because they look at the equity contribution as their safety margin. The banks should get 100 cents on the dollar back on their loans before equity gets a penny back (on the principal). Equity does get their 10% interest payment on an ongoing basis.
So the $250MM equity cushion, in the bank’s mind, should be sufficient to protect the $750MM in loans.
We will see how this holds. If the loans are only worth 20-40% of par, as has been suggested, the cushion the banks have built in to their model will not suffice to protect them.
We live in interesting times. I look forward to seeing how it plays out.
Curious about the cash flow to the PCP itself and the equity getting their 10% back in your example on an ongoing basis. Are these typically a 2 and 20 set up? Do the managers of the fund get their money/cut from the borrowers ongoing payments first and then the equity gets there payment? Are there principal payments to the bank along the way typically?
But also to bear in mind mom and pop investors are already indirectly invested in private debt through pension funds and insurance companies. This doesn’t end well.
PS… We knew the jig was up about a year ago when Lord Larry Fink issued his generous Proclamation that “ It was High Time that the average Retail Investor had a chance to gain from the Wonders of Private Credit”
"I’m currently batting 0-for-100 on actual apocalypses—but in this field, that still puts me comfortably ahead of the people insisting the smoke is just “seasonal haze.” Great line by QTR, one of the many reasons I subscribe despite his low batting average.
There are some good private equity funds with strong standards (ie. Pimco) but when the tide goes out, it’s shoot first and ask questions later. The ONLY way to invest in private equity/credit is through closed end funds. Like a stock, you can still lose money but you can always sell. Even during the great recession, the default rate was only around 4%.
During the Great Recession (2007–2009), business default rates spiked, with Moody's reporting the speculative-grade default rate rising from 0.9% in 2007 to 4.1% by the end of 2008. Corporate bond defaults increased, with some projections reaching 8% or higher during severe downturns, and 2008 saw record bankruptcy filings by assets.
Corporate Default Rates: The default rate for all Moody's-rated corporate issuers rose from 0.3% at the end of 2007 to 1.9% by the end of 2008.
Speculative-Grade Defaults: The global speculative-grade default rate rose significantly, more than quadrupling 2007's year-end level of 0.9% to end 2008 at 4.1%.
Business Loan Delinquencies: According to [Statista], the delinquency rate on business loans rose from 1.19% in early 2007 to over 4% by late 2009.
Private Equity-Backed Companies: These businesses fared better than peers during the 2008-2009 period, with a default rate of roughly 2.84% compared to 6.17% for comparable companies, as highlighted by a [American Investment Council] study.
The caveat is, as Mark says, the standards were tighter then.
Fox Business had a female guest on with Payne yesterday saying loudly, multiple times this was not a big deal. When they get like that I really pay attention. Usually means there’s about to be a shitstorm.
I think it’s possible Dimon knows the bank has some money sunk here thus his comments. I’d bet behind the scenes there’s a “what do we have where” check going on.
“ Sure, I’m currently batting 0-for-100 on actual apocalypses—but in this field, that still puts me comfortably ahead of the people insisting the smoke is just “seasonal haze.”
You may be already dialled into the photo of the “giant wave” that You shared.
And that, as a metaphor, is about to engulf that coast and the “Giant Financial Wave” that’s about to engulf most of us is both poignant and predictive.
So.. the snap of your photo is of a place called Nazarre’. It’s about in the Middle or just North on the Coast in Portugal.
There’s a 300 mile and 4000 feet deep trench there…off the coast.
It funnels the wave energy from the Storms in the North Atlantic into this most amazing focal point at Nazarre’ ….into waves that are, sort of, 10x the size of the waves 10 or 20 miles North or South.
One thing that Chris highlights is bank lending to private credit. This cannot be emphasized enough. This is a characteristic of the current market that is not understood by a lot of people. And to me it is the greatest risk in the market today.
So what do banks do? Its simple.
A private credit provider walks into one of the money center banks (JPM, Wells, BofA, Citibank) or large super-regionals (US Bank, PNC, Fifth Third, Regions, etc) with $250MM in equity capital they have raised from investors (primarily pension funds and sovereign wealth funds).
The private credit provider asks the bank for a loan that is a multiple of their equity capital. The intent is that the PCP will lend out both the equity and the levered funds it will borrow from the bank.
I have not touched a deal in this space for awhile. But lets say the bank is willing to lend the PCP 3 times their equity. Now the PCP has $1BN to lend out ($250MM equity plus $750MM in funds from the bank).
The spread the bank charges is lower than what the PCP charges the client. Once again for arguments sake lets say the bank charges the Secured Overnight Funding Rate (SOFR) + 300 bps SOFR today is about 3.5%. So the all in rate the bank charges the PCP is 6.5%.
The PCP’s goal is maximum returns. They lend to clients that are too risky for banks. So the PCP charges SOFR + 700 bps, or 10.5%.
Those of you in the market can fact check my leverage multiples and pricing, but I pretty sure I am directionally correct. With a combination of leverage and pricing spreads, PCPs can make a very tidy profit. They have promised low risk returns above 10% to their equity investors, and for the last decade or so have been able to deliver on those promises.
My question has always been why banks would lend to PCPs. PCPs make loans banks cannot do because they are too risky. Why farm out the credit decision with the bank’s capital to a party that purposely takes on high level of risk?
The banks get comfortable because they look at the equity contribution as their safety margin. The banks should get 100 cents on the dollar back on their loans before equity gets a penny back (on the principal). Equity does get their 10% interest payment on an ongoing basis.
So the $250MM equity cushion, in the bank’s mind, should be sufficient to protect the $750MM in loans.
We will see how this holds. If the loans are only worth 20-40% of par, as has been suggested, the cushion the banks have built in to their model will not suffice to protect them.
We live in interesting times. I look forward to seeing how it plays out.
That was a nice summary. Thank you.
Curious about the cash flow to the PCP itself and the equity getting their 10% back in your example on an ongoing basis. Are these typically a 2 and 20 set up? Do the managers of the fund get their money/cut from the borrowers ongoing payments first and then the equity gets there payment? Are there principal payments to the bank along the way typically?
But also to bear in mind mom and pop investors are already indirectly invested in private debt through pension funds and insurance companies. This doesn’t end well.
PS… We knew the jig was up about a year ago when Lord Larry Fink issued his generous Proclamation that “ It was High Time that the average Retail Investor had a chance to gain from the Wonders of Private Credit”
Tick, Tick, Tick…..
Well if Fink says it - it must be true! Isn’t that how the playbook reads?
Boom!!!!!!!!!!!!!!
Great article Chris, I will also start watching for more of Marks' work.
"I’m currently batting 0-for-100 on actual apocalypses—but in this field, that still puts me comfortably ahead of the people insisting the smoke is just “seasonal haze.” Great line by QTR, one of the many reasons I subscribe despite his low batting average.
There are some good private equity funds with strong standards (ie. Pimco) but when the tide goes out, it’s shoot first and ask questions later. The ONLY way to invest in private equity/credit is through closed end funds. Like a stock, you can still lose money but you can always sell. Even during the great recession, the default rate was only around 4%.
During the Great Recession (2007–2009), business default rates spiked, with Moody's reporting the speculative-grade default rate rising from 0.9% in 2007 to 4.1% by the end of 2008. Corporate bond defaults increased, with some projections reaching 8% or higher during severe downturns, and 2008 saw record bankruptcy filings by assets.
Corporate Default Rates: The default rate for all Moody's-rated corporate issuers rose from 0.3% at the end of 2007 to 1.9% by the end of 2008.
Speculative-Grade Defaults: The global speculative-grade default rate rose significantly, more than quadrupling 2007's year-end level of 0.9% to end 2008 at 4.1%.
Business Loan Delinquencies: According to [Statista], the delinquency rate on business loans rose from 1.19% in early 2007 to over 4% by late 2009.
Private Equity-Backed Companies: These businesses fared better than peers during the 2008-2009 period, with a default rate of roughly 2.84% compared to 6.17% for comparable companies, as highlighted by a [American Investment Council] study.
The caveat is, as Mark says, the standards were tighter then.
One day the "experts" might realize the difference between being early and being wrong.
I prefer Trophy Wife’s description of me as “cranky libertarian,” but paranoid prepper isn’t wrong either.
Fox Business had a female guest on with Payne yesterday saying loudly, multiple times this was not a big deal. When they get like that I really pay attention. Usually means there’s about to be a shitstorm.
I think it’s possible Dimon knows the bank has some money sunk here thus his comments. I’d bet behind the scenes there’s a “what do we have where” check going on.
Oh, and I’m 0 for about 1000 on the pockylips.😂
Commodore64? damn!
“ Sure, I’m currently batting 0-for-100 on actual apocalypses—but in this field, that still puts me comfortably ahead of the people insisting the smoke is just “seasonal haze.”
Both Funny and Deeply Insightful
Keep Going!
If only that wave would come crashing down on the Fed and Congress…
Chris..
You may be already dialled into the photo of the “giant wave” that You shared.
And that, as a metaphor, is about to engulf that coast and the “Giant Financial Wave” that’s about to engulf most of us is both poignant and predictive.
So.. the snap of your photo is of a place called Nazarre’. It’s about in the Middle or just North on the Coast in Portugal.
There’s a 300 mile and 4000 feet deep trench there…off the coast.
It funnels the wave energy from the Storms in the North Atlantic into this most amazing focal point at Nazarre’ ….into waves that are, sort of, 10x the size of the waves 10 or 20 miles North or South.
It made me think of Private Credit…..
There is Always a Focal Point.
Godspeed Mate.
Brian
"Most of the Industry was built after 2008." Uh-Oh...
NEW "Dogshit wrapped in Catshit." ....Nice shot of Nazare surf break!....
Are there any good shorts left here? Heavily exposed to bad debt and have not already slumped in price.
Blue Owl dropped 50% in last 3 months and c.70% since ATH.
For the bigger names its unclear how much exposure the parent ticker has to bad debt PC.