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.
00:12And 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,
00:21with 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.
00:46I 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.
01:11I mean, that's kind of the sleep at night, treasuries, agencies, investment grade corporate portfolio.
01:16Portfolio. Private 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,
01:36which 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, it should invite closer scrutiny.
02:21It doesn't mean it's necessarily problematic.
02:24Dan Tarullo served as a member of the Federal Reserve Board from 2009 to 2017, with particular responsibility for bank
02:31oversight.
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, is that it's filled in a
02:48gap that banks either never quite worked in traditionally,
02:53which is providing funding of certain sorts in leveraged buyouts, private equity transactions, but also kind of moving into some
03:03other areas because of some of the advantages that they have and 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, banks aren't in
03:16some of these spaces, private credit moves in.
03:20It's not as though the banks are now totally out of the exposure because banks have been providing and do
03:26provide a substantial amount of backup credit, credit lines for private credit funds.
03:34And thus the exposure of banks is indirect rather than direct, but indirect exposure can be just as damaging as
03:43direct 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, a point Apollo's Mark
03:56Rowan knows all too well.
03:58And it's de-risking for individuals because people are not funding their investments in these BDCs with their treasury portfolio.
04:05They're selling their equities.
04:07Last I looked, First Lean Debt is senior to equity.
04:11They are making an intelligent decision that they can earn equity-like returns without equity-like risk and take money
04:17off the table.
04:18I mentioned that public equity is about 32% of our portfolio and that private credit had moved up or
04:24credit 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, something that's difficult to do with assets
04:51like private credit that, by their very nature, don't change hands regularly.
04:56But something Apollo Global Management just announced it was moving toward.
05:00It's illiquid.
05:02I mean, it's illiquid for good reasons.
05:03If you're financing, you know, lending somebody $200 million on something and you want to sell 10% of it,
05:12who's going to do the credit work on such a small piece and you just don't have the liquidity to
05:17see it?
05:17And I would say a lot of these people, a lot of the people who are doing this, running these
05:21portfolios, will 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.
05:31But he also has other concerns.
05:33One of the things that worries me here is that the information gaps we have aren't being plugged to the
05:44best of the ability of the regulators.
05:46And, you know, if they if they did that work, we might all be somewhat reassured, I suspect, would probably
05:53find 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, because, you know, there's no price discovery
06:04for for these illiquid loans.
06:07And the fact that the regulators are not helping the rest of us pope through that opacity and figure out
06:16exactly what is going on.
06:17While concerns about the risk profile for private credit are on the rise, others point to its strengths in spite
06:23of the recent market turmoil.
06:25Obviously, some companies have some credit issues and and either they get refinanced or in some cases they get reorganized.
06:33But 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 who's doing the investing as
06:52it does on the nature of the credit being extended.
06:54What may make sense as part of a large portfolio for an institutional investor may be wrong for retail investors
07:01saving 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, but it also means that the private credit fund has a very
07:18good sense of when it's going to face redemptions and how much capital it has available.
07:24As the private credit people have moved, have tried to move more and more into retail, we've seen this liquidity.
07:32This is the liquidity issue that's blowing up that you referred to earlier.
07:37Retail investors just don't think in terms of long term investments and they can't get their money out no matter
07:44how 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 and money
07:54market funds and ETFs.
07:57It'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 at the retail level
08:05right now.
08:06We have the potential for individual investor behavior to create some mismatch between the structure and the underlying investments in
08:18the 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, in many cases, panicked and de
08:29-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, when prices are down, I
08:40think that could create some challenges for 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.
08:54But the consequences of it being wrong and being bad from a political, sociological sort of way are much worse
09:02because the political sector can watch with interest, but not much action.
09:09If big institutions and very high net worth individuals lose money, but a 401k plan start to lose money, individuals
09:19that were brought in late in the cycle, you know, there's going to be there's going to be a lot.
09:24There'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, but the worst case scenario for private credit might
09:34not be what we are expecting.
09:36What I regard as the bigger risk right now is not so much financial stability.
09:41It's more macroeconomic.
09:43That 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 and you
10:09need to have a sense of what would happen if the investments into the private credit funds dried up so
10:18that 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, but
10:31I don't think they'd be able to fill the hole entirely.
10:34And so you'd have the same kind of problem of concern that you have when banks are encumbered because of
10:41losses.
10:41They can't make more loans and they are denying credit to credit worthy households and businesses.
10:48So as we sit here today, I'm actually somewhat more concerned about the macroeconomic impact of private credit than the
10:58financial stability or macro prudential impact of private credit.
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