Private Credit and Liquidity: Are Transparent, Public Markets Really More Rational?

From a Bloomberg article in February 2024:

At the end of last year, UBS Group Chairman Colm Kelleher shook the market by warning that a “dangerous bubble” was forming in private credit. But the more urgent question is: who actually has an accurate grasp of the true value of this market?

The backdrop to the rapid rise of private credit funds is straightforward. They pitched themselves to long-term investors such as insurers and pension funds as follows: “If you invest in our loans, you can avoid the price volatility of traditional corporate bonds or loans. These loans barely trade (some never trade at all), so their prices remain stable. That means you can earn returns without the stress.” Thanks to this seductive proposition, private credit has grown from Wall Street’s fringes into a $1.7 trillion market.

Recently, however, cracks have begun to appear in that foundation.

Over the past two years, rapid rate hikes by central banks have put pressure on corporate balance sheets, and many companies are struggling to meet their interest payments. One of private credit’s core selling points — that funds themselves, not the market, set the value of their loans — is now emerging as its biggest flaw.

According to Bloomberg, bond-data specialist Solve, and interviews with dozens of market participants, some private credit funds are still assigning high values to the same loan assets that other funds have already marked down sharply.

Take Magenta Buyer, a special-purpose vehicle set up to make a loan to a cybersecurity company. As of the end of September 2023, the highest valuation on that loan was 79 cents on the dollar, while the lowest was 46 cents. A loan to aerospace supplier HDT was valued on the same day in a range from 85 cents to 49 cents.

This kind of uncertainty over the “real value” of assets is a chronic problem in private markets, and regulators are worried. When interest rates were near zero, it was not seen as a major issue, but now that same uncertainty is effectively helping to conceal bad loans.

Peter Hecht, a managing director at AQR Capital Management in the US, puts it this way:
“In private markets, no one really knows what assets are truly worth, so information tends to be incorporated into prices slowly. That artificially suppresses volatility and creates the illusion that risk is low.”

Most of the private credit funds and companies mentioned in the article either declined to comment or did not respond to requests.

Private credit initially drew praise because it shifted high-risk corporate lending away from systemically important Wall Street megabanks to specialized private lenders. Today, however, the heat has cooled somewhat, the economic outlook is shaky, and regulators are on higher alert. These funds charge interest rates that float with benchmark rates, which has boosted their returns but also increased the burden on borrowers.

Lee Foulger, director of financial stability at the Bank of England, said in a recent speech:
“As interest rates have risen, the risks faced by lenders have increased as well. If asset valuations are delayed or opaque, the likelihood of sudden, simultaneous repricing events also grows.”

Outside the US, lower data transparency makes the picture even murkier. In particular, when funds do not publish quarterly reports, or when a single fund holds an entire loan, the very basis for valuation becomes ambiguous.

Tyler Gellasch, head of the Healthy Markets Association, a group that includes pension funds and asset managers, says this:

In response, the US Securities and Exchange Commission (SEC) has moved quickly to require private funds to undergo external audits. This is seen as an “important check” on asset valuation.

Some market participants, however, believe that this uncertain valuation framework may actually work in investors’ favor. Several fund managers, speaking on condition of anonymity, said that “many investors actually prefer valuations to remain stable.” That, in turn, has fueled concerns about a “silent cartel” among private funds, pension funds, insurers, and sovereign wealth funds.

An executive at a large European insurer warned that “once loans reach maturity, you can no longer fudge the marks, and losses will crystallize.” Another fund manager, who previously worked at one of the world’s largest pension funds, recalled that “private loan marks were tied to the team’s bonuses, and external valuers sometimes had limited access to information.”

One warning sign drawing attention recently is the rise of payment-in-kind (PIK) loans. These allow companies to defer interest payments and pay them in a lump sum at maturity together with principal. This structure, used mainly by lower-rated borrowers, can also serve as a way to mask liquidity stress.

Benoit Soler, senior portfolio manager at Keren Finance in Paris, warned that “people are underestimating how risky PIK loans are,” adding that “the cost of deferring interest can saddle companies with substantial risks down the road.”

Even so, PIK loans are still valued at surprisingly high levels. According to Solve, as of September 2023 roughly 75 percent of all PIK loans were marked at 95 cents or more on the dollar. “The fact that loans from companies struggling to service their interest are still being valued so highly inevitably raises questions,” said Eugene Greenberg, co-founder of the fintech firm Solve.

Another anomaly is that some publicly traded loans held by private equity funds are marked well above their actual market prices. For example, Carlyle Group provided a second-lien loan to TruGreen, a U.S. lawn-care company, and valued it at 95 cents on the dollar. At the same time, a mutual fund marked the same loan at 70 cents.

BoE’s Foulger noted that “valuations in private credit portfolios are still more generous than in public markets.”

The case of Thrasio, a company that aggregates and distributes products on Amazon, highlights these valuation gaps. For its loans, Vanguard and Oaktree Capital marked them at 65 cents and 79 cents respectively. Two BlackRock funds valued the same debt at 71 cents and 75 cents, while Monroe Capital was the most optimistic at 84 cents. Goldman Sachs, by contrast, marked it at 59 cents.

In the end, Goldman proved closer to the mark. Thrasio recently filed for Chapter 11 bankruptcy, and the loans now trade below 50 cents on the dollar. Oaktree later had to cut its valuation to 60 cents.

“As companies come under stress or move closer to bankruptcy, uncertainty around future cash flows increases and valuation gaps widen,” explained Ethan Kaye, an analyst at Bloomberg Intelligence.

PitchBook data show that when the same loan is held across multiple funds, around 10 percent of cases exhibit a valuation spread of at least 3 percentage points. When three or four funds hold the loan, the gap tends to be even larger.

Another example is Progrexion, a credit services provider. After losing a lawsuit brought by the U.S. Consumer Financial Protection Bureau (CFPB), the company filed for bankruptcy. Court filings indicated that first-lien creditors were expected to recover 89 percent. Prospect Capital, which held the loan, nonetheless marked the asset as fully recoverable at 100 percent at the time.

According to data compiled by Solve, Prospect Capital was among the funds whose marks diverged the most from other valuers. Bloomberg Intelligence noted that “the smaller the fund, the more aggressive its valuations tend to be.”

“There are major differences in how managers approach asset valuation, and there is a lack of transparency and comparability,” said Florian Hofer, a director at German alternative investment firm Golding Capital Partners.

Supporters of private credit argue that such criticism is overblown. Because private loans are typically held by a small group of lenders with significant influence, they say there is no need to mark them down as quickly as in public markets. In their view, the very “flexibility” of private credit is a strength.

“The leveraged loan market is buffeted by technical factors such as ratings downgrades or sector rotations, but private credit is not,” said Karen Simeone, a managing director at HarbourVest Partners. “It is only natural that volatility is lower.”

Private lenders also tend to use less leverage than banks, and much of their investor capital is locked up for longer terms, making them less vulnerable to market shocks. They do not rely on customer deposits and typically secure stronger collateral rights.

Transparency has improved somewhat as external valuation firms such as Houlihan Lokey and Lincoln International have begun to mark loans, but they are paid by the funds for their services and therefore are not fully independent. “We do not have unfettered access to every loan. There are information gaps,” said Timothy Kang, a team head at Houlihan.

In the United States, many private lenders are listed as business development companies (BDCs), which are required to disclose net asset values every quarter. While BDCs are relatively transparent, managers are incentivized to mark assets higher because valuations are directly tied to their compensation.

Finian O’Shea, a BDC analyst at Wells Fargo, put it this way: “The people who ultimately sign off on valuations—BDC boards and external valuation firms—also have incentives to keep marks high. They do not want to take the hit either.”

Echoing the UBS chair’s comments, AQR’s Hecht believes the core issue is not a handful of “outliers” but the very nature of private credit itself.

As I mentioned in The $2 Trillion Private Credit Market: A Hidden Bomb for the U.S. Economy?, the private lending market is characterized by its closed structure, and the key function that emerges from this structure is resilience to volatility. Of course, there is some possibility that systemic risk could spread through the economy as major banks provide leverage to private credit funds. But measured as a proportion of bank equity, the leverage that banks extend to private credit funds is at a low level, and because it is mostly structured as senior debt, the probability of such contagion is very low.

A Bloomberg article from yesterday, JP Morgan Traders Are Getting Shut Out of Private Credit Market, reported that the head of JPMorgan’s private credit division is trying to open up this closed private lending market, but is facing difficulties because incumbent private-credit-focused financial firms are reluctant to provide JPMorgan with up-to-date loan data or sell their existing loan contracts. The key selling point that private credit funds emphasize to their investors—such as pension funds and insurers that commit capital to them—is precisely this resilience to volatility. If funds or loan products were to trade in real time among investors, price-driven volatility would inevitably increase.

Investors who are critical or skeptical of private credit argue that this opacity and closed nature lead to private credit funds’ risks being assessed as lower than they really are, which could ultimately result in investor losses or even morph into systemic risk. As you can see in the Bloomberg article I translated above, in practice you often find cases where private credit funds that hold exactly the same corporate loan assets assign different values to them based on their own internal standards.

That said, it is hard to assert categorically that a highly liquid market with transparent information disclosure necessarily has superior price-discovery capabilities compared with a less transparent, less liquid market. In How to Earn 78% Returns with Listed Real Estate Stocks, I wrote that I was able to generate returns by exploiting an arbitrage opportunity created by the imbalance between the public and private markets in SL Green Realty, a listed REIT. At the time, SL Green Realty’s share price was being valued similarly to other listed REITs that held far inferior asset portfolios, even though it owned a portfolio composed solely of top-tier prime office properties in core Manhattan locations (with virtually no vacancy risk). In contrast, a Korean overseas real estate equity fund that owned a B-grade office building in New York was valued 30–40% below its purchase price at the time of sale; after repaying the debt, there was nothing left over, and most investors in that fund lost their entire principal. SL Green Realty, on the other hand, sold a 49.99% stake in its 245 Park Avenue office building to Japan’s Mori Trust at a valuation equal to its purchase price ($2 billion), and immediately after this transaction was announced, the share price quickly recovered to its previous valuation.