Private credit is looking shakier

Where it stands: Just this week, two of the biggest players in the market — Apollo Global and Ares — said they were limiting the amount of money investors can withdraw from their funds to existing thresholds even as investors are clamoring to get their money back.

• Moody's, meanwhile, has lowered the credit rating of a fund run by KKR and Future Standard to junk.

Zoom out: The top worry is over the loans made by private credit, in particular loans to software firms whose business is threatened by AI.

• Goldman Sachs analysts estimate that in a worst-case scenario for private credit loan defaults, losses could rise to about $105 billion.
• That would mean a cutback of 5-6% in new lending to the private sector.
• Sounds bad, but Goldman notes that there was a 55% pullback in the wake of the financial crisis.

The big picture: How big of deal is all this? Some fear a financial crisis retread, while others say it's just a self-contained setback. Still, there are some issues:

• Opaqueness. Banks are subject to regulations and reporting requirements. Private lenders, not so much.
• Lax lending. When investor demand for private credit got hot last year, loan standards relaxed, as Mike Reynolds, vice president of investment strategy at Glenmede, laid out in a note this week.
• The share of private credit loans that allow borrowers to make payments in kind rose to 8% last year, doubling since 2019, Reynolds noted. Instead of making payments in cash, borrowers roll the amount due onto their existing balance. That means the loans just keep getting bigger.
• There's also been growth in so-called covenant-lite loan structures, he said — which basically means that borrowers don't need to flag underlying stress when times get tough.
• Systemic ties. Banks have lent an increasing amount of money to nonbank firms. Nearly $2 trillion in loans has been made to nonbank lenders, according to federal data — that's up from $1.5 trillion just last year.
• About a quarter of those loans go to private credit, and another quarter to private equity, per a Goldman Sachs analysis last year.

• Life insurance companies also have big and growing exposures.

Threat level: "It's so interconnected with the economics of everything," says Laks Ganapathi, CEO and founder of Unicus Research.

• A downturn in the credit cycle could mean higher costs for borrowers using "buy now, pay later" platforms, which rely on private credit funding, she says.

Catch up quick: Private credit funds aren't liquid — investors can't pull out all their money and set off a bank run. That protects the market from collapse, but it doesn't mean everything is great.

What to watch: The European Central Bank said Tuesday it would be looking at banks' private credit exposure. And the Financial Times reported that the Securities and Exchange Commission is looking at a credit agencies' ratings on private credit loans.

Between the lines: If you recall what Wall Street was like before the financial crisis, you can see some echoes: lax lending standards and regulation, inflated ratings from the credit agencies, banks and insurers pouring in money, complex structures.

• It's why you're starting to see more warnings.
• "The echoes of 2008 are becoming harder to ignore," writes Brian Judge, research director of the Program on Finance and Democracy at the University of California, Berkeley in a piece on Project Syndicate.