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Private Credit 

David Brooke

This article is part of our new service, 9fin Private Credit. If you're interested in a free trial, contact subscriptions@9fin.com

Cast your mind back to 2017. Many had discovered for the first time what subscription lines were and a flurry of criticism ensued. There was an alarm about whether LPs understood what they did, the juicing of IRRs to make funds look good, as well as the issue of adding a further layer of leverage.

Andrew Brown, a senior consultant at WTW, was reported in the Financial Times saying: “Private equity managers insist that they are trying to help their investors with managing cash flows, but be under no illusion: this is done to manipulate [internal rate of return] calculations in the early years of a fund’s existence.”

The discussion soon dissipated and subscription lines were accepted as one part of the GP playbook. It’s now essentially uncontroversial.

Today, Net Asset Value (NAV) lending’s turn to be scrutinized as part of the discussion on how private credit and private equity fund themselves. (A previous edition of The Unicrunch provided a primer on NAV lending is here).

It’s perhaps an area of private credit that will always raise alarms to market outsiders. More leverage on top of the subscription lines provided at the fund level and the debt backing the company. For those investors in private equity funds, you’re being pushed further down the payout chain. 

Yet whatever alarms there may be about NAV loans, it is the LPs who are seemingly excited about such strategies. As 9fin reported in the last week, Pemberton Asset Management is latest to market a NAV fund, seeking to raise $1.5bn. It follows Hunter Point Capital, which has also launched its own NAV fund. Somebody wants what they are selling.

But what might be leaving some feel uneasy is the underlying cracks in the market. Inflation and high interest rates have weighed down on companies. Debt today is expensive and thus stymieing much transaction volume, including any add-on activity required to grow a company: thus where the increase in demand for NAV loans might be. 

In the last few weeks we’ve discussed how banks are looking more like private credit funds. But it has been true for quite some time that the trend is happening in the opposite direction: private credit funds are looking more like banks. 

Fund finance — what was once the domain of the banks is now becoming fertile ground for private credit firms. In a recent report from Ares, the last 36 months have been especially fruitful as regulatory and capital pressures have weighed heavily on US banks. Ares estimates that the NAV lending market has a current market penetration of 1%, compared with subscription lines at 27%. “A lot of room to grow,” the firm said.

The key word private credit firms like to say is that they are a one-stop shop or in other parlance operate a “cargo pants” strategy — that is to be all things to private equity firms so that no conversation ends with a lender saying they can’t provide that service. 

So if a lender is already funding a sponsor’s LBO, then why not the whole operation? NAV lending is simply private credit following its natural growth trajectory, as Ted Goldthorpe, head of BC Partners Credit, told me in an interview.

“If you cover the sponsor for providing capital to their individual portfolio companies then it probably makes sense for you to be a full-service provider,” he said.

“And if you see the evolution of private credit lenders as replacing banks, then NAV lending is just the next step from middle market lending.”

You’d think by now everyone has had their say on the riskiness of private credit. But the last week saw the turn of the International Monetary Fund, which is perhaps better known for its tussles with Argentina, then it is for reporting on asset managers named after Greek or Roman Gods.

Nevertheless, it is inflation and interest rates that concern the body and the systemic issues of a market that has ballooned in size. 

CRE and private credit are prominent examples of private markets susceptible to substantial corrections because of the lagged effects of higher interest rates. Vulnerabilities in these markets pose risks to banks as well as to NBFIs, which may be exposed to private markets directly or indirectly, for example, through investment vehicles.

Private credit markets could come under significant pressure if inflation were elevated for longer than currently priced in markets, forcing central banks to keep a tight policy stance for longer than expected, and the hoped-for soft landing does not materialize. A deterioration in funding conditions and a worsening outlook could have a disproportionate effect on firms that are highly leveraged and have borrowed using debt instruments with floating rate.

Since the days it was called “shadow banking” private credit has been viewed with suspicion from some regulatory and governmental bodies. The market is arguably too small to be truly systemic but its rapid rise does mean more attention should be paid to what is going on.

The tricky part is that it is an opaque market. Few outside the market get the jargon and those inside of it know little of what each firm is doing. The institutions putting up the cash may be the best bellwethers, but money keeps pouring in — denominator effect be damned!

It may take something blowing up before there is any true action from regulators, but until then stay tuned for more reports.

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