00:00In recent days, the shine on private credit has come off after some people have had trouble getting their money
00:05out.
00:07Shares of KKR and Blue Owl were down as much as 10% yesterday.
00:11And I think we're seeing the first sign of stress around these funds.
00:15Although the lending is private, concerns about the industry have made their way into public markets,
00:20with shares of Blue Owl, Apollo, and others under pressure.
00:24I get nervous any time any particular strategy gets a little bit crowded.
00:28Andrew Junkin invests in private credit as chief investment officer for the Virginia Retirement System.
00:35He oversees pension assets for 230,000 Virginia public employees
00:40and allocates about 16% of their $130 billion to private credit.
00:45I think the capacity for the private credit markets to absorb the growth that has happened
00:53and that is forecasted to continue to happen is probably pretty solid.
00:58It's not the highest expected return asset class that we have.
01:04That would probably be private equity, but it is higher than public fixed income,
01:09which for us is really investment grade.
01:10I mean, that's kind of the sleep at night, treasuries, agencies, investment grade corporate portfolio.
01:17Private credit has a little bit more credit risk in it, of course, but the yield is higher.
01:23And we're expecting returns kind of in the 7, 8, 9% over the long term.
01:29Right now, we do think that private credit has expected returns that are a little bit higher,
01:35which is one of the reasons in the short term we've been sort of increasing our allocation.
01:39Marcy Frost is CEO of CalPERS, the largest public pension fund in the United States.
01:45On the private credit side, we've been very specialized and working only with high-quality managers.
01:51We had an 8% allocation to private credit, and I think we're hovering around 4%.
01:56And we believe that that book is diversified enough that the team is really not too concerned about the software
02:02exposure.
02:03For regulators, dramatic, rapid growth in any asset class often raises questions.
02:09Any time an asset class grows very quickly in absolute amounts but also profitability,
02:17it should invite closer scrutiny.
02:20It doesn't mean it's necessarily problematic.
02:23Dan Tarullo served as a member of the Federal Reserve Board from 2009 to 2017,
02:28with particular responsibility for bank oversight.
02:31He's now a professor of law at Harvard.
02:34Well, there are certainly risks, David.
02:36I mean, the way I put things now is we should be on yellow alert, you know, not red alert.
02:42The story about private credit, which is to a considerable extent the right story,
02:46is that it's filled in a gap that banks either never quite worked in traditionally,
02:53which is providing funding of certain sorts in leveraged buyouts, private equity transactions,
03:00but also kind of moving into some other areas because of some of the advantages that they have
03:07and also because of capital requirements for banks.
03:10So if we take that as a starting point and say, okay, for regulatory and business reasons,
03:15banks aren't in some of these spaces, private credit moves in.
03:19It's not as though the banks are now totally out of the exposure because banks have been providing
03:26and do provide a substantial amount of backup credit, credit lines for private credit funds.
03:34And thus the exposure of banks is indirect rather than direct,
03:39but indirect exposure can be just as damaging as direct exposure.
03:44J.P. Morgan just this week decided to limit its indirect exposure by restricting lending to some funds.
03:50The degree of risk in private credit depends, of course, on what you're comparing it to,
03:55a point Apollo's Mark Rowan knows all too well.
03:58And it's de-risking for individuals because people are not funding their investments in these BDCs
04:04with their treasury portfolio.
04:05They're selling their equities.
04:07Last I looked, first lien debt is senior to equity.
04:10They are making an intelligent decision that they can earn equity-like returns without equity-like risk
04:16and take money off the table.
04:18I mentioned that public equity is about 32% of our portfolio and that private credit had moved up
04:24or credit strategies had moved up.
04:26Actually, the funding source for that had been largely public equity.
04:30So for us, it was kind of a relative value trade.
04:33Whatever the comparison, managing the risk in private credit is critical, as in any investment.
04:38That's a major theme of Lloyd Blankfein's new book, Streetwise, about his career at Goldman Sachs.
04:44He describes Goldman's risk management system based on marking assets to market daily,
04:49something that's difficult to do with assets like private credit that, by their very nature,
04:54don't change hands regularly.
04:56But something Apollo Global Management just announced it was moving toward.
05:00It's illiquid.
05:01I mean, it's illiquid for good reasons.
05:03If you're financing, you know, lending somebody $200 million on something
05:09and you want to sell 10% of it, who's going to do the credit work on such a small
05:14piece
05:14and you just don't have the liquidity to see it?
05:17And I would say a lot of these people, a lot of the people who are doing this, running these
05:21portfolios,
05:22will say they are marking them.
05:24But how do you mark it?
05:25Tarullo agrees that the illiquidity of private credit makes it more difficult to keep valuations current.
05:30But he also has other concerns.
05:33One of the things that worries me here is that the information gaps we have
05:39aren't being plugged to the best of the ability of the regulators.
05:46And, you know, if they did that work, we might all be somewhat reassured.
05:52I suspect we'd probably find some issues and problems that need to be dealt with.
05:56But it's both the opaqueness of the valuations of many of these investments
06:02because, you know, there's no price discovery for these illiquid loans
06:07and the fact that the regulators are not helping the rest of us
06:12poke through that opacity and figure out exactly what is going on.
06:17While concerns about the risk profile for private credit are on the rise,
06:21others point to its strengths in spite of the recent market turmoil.
06:25Obviously, some companies have some credit issues and either they get refinanced
06:31or in some cases they get reorganized.
06:34But by and large, I would say the default rate has been lower than has been expected historically.
06:41And so the returns have commensurately been probably a little bit higher.
06:46Making sure that private credit is the right investment depends every bit as much on
06:50who's doing the investing as it does on the nature of the credit being extended.
06:54What may make sense as part of a large portfolio for an institutional investor
06:58may be wrong for retail investors saving for retirement.
07:02One of the biggest advantages of private credit has been that the capital is tied up.
07:10That means there's not liquidity for the investors,
07:13but it also means that the private credit fund has a very good sense of when it's going to face
07:20redemptions
07:21and how much capital it has available.
07:24As the private credit people have moved, have tried to move more and more into retail,
07:30we've seen this liquidity.
07:32This is the liquidity issue that's blowing up that you referred to earlier.
07:36Retail investors just don't think in terms of long-term investments
07:42and they can't get their money out no matter how badly the underlying investment is doing.
07:47But a little bit of liquidity is not the way people who are used to investing in stocks
07:54and money market funds and ETFs, it's not the way they think about it.
07:58And that limitation on liquidity, I think, is a lot of what's putting the pressure on
08:04at the retail level right now.
08:06We have the potential for individual investor behavior to create some mismatch
08:13between the structure and the underlying investments in the structure.
08:19So think back to the global financial crisis.
08:21I think a number of academic studies afterwards showed that individual investors in 401ks,
08:27in many cases, panicked and de-risked kind of right at the bottom of the market.
08:32And if there's a big run to sell, whether it's private credit or private equity,
08:37when prices are down, I think that could create some challenges
08:42for that market to function efficiently and effectively.
08:45It's not any more likely that a security will be good or bad in the hands of a retail person
08:51versus an institution.
08:53But the consequences of it being wrong and being bad from a political, sociological sort of way
09:01are much worse because the political sector can watch with interest but not much action
09:09if big institutions and very high net worth individuals lose money.
09:14But if 401k plans start to lose money, individuals that were brought in late in the cycle,
09:22you know, there's going to be an inquiry or an inquisition that will follow this.
09:27As Tarullo says, it's not time for a red alert yet.
09:31But the worst case scenario for private credit might not be what we are expecting.
09:36What I regard as the bigger risk right now is not so much financial stability,
09:40it's more macroeconomic, that is, how much leverage is there totally in this system?
09:47We know there's leverage by the companies that are borrowing from the private credit funds.
09:52But are the investor, to what degree are the investors in the private credit funds also borrowing?
09:57To what degree are the private credit funds themselves borrowing?
10:02And once you, you know, you really need to have that sense of how much leverage is there
10:07and you need to have a sense of what would happen if the investments into the private credit funds dried
10:17up
10:17so that they could no longer make the kinds of loans that they've been making.
10:22Under those circumstances, I would expect that banks and other providers of credit could step in to some degree.
10:30But I don't think they'd be able to fill the hole entirely.
10:34And so you'd have the same kind of problem, a concern that you have when banks are encumbered because of
10:41losses.
10:41They can't make more loans and that you're denying credit to credit-worthy households and businesses.
10:49So as we sit here today, I'm actually somewhat more concerned about the macroeconomic impact of private credit
10:57than the financial stability or macroprudential impact of private credit.
11:02All right.
11:02All right.
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