by Brad Houle, CFA
Principal
Head of Fixed Income
Portfolio Management
When a company needs a big loan to buy a competitor or fund a major project, they traditionally go to big banks or sell bonds on the public market. Private credit funds changed this process, allowing for more streamlined borrowing. Private credit funds act as the bank, lending money directly to companies in bespoke deals.
When you lend money to a private company, the rules for financial disclosure are far looser than for public companies. The recent collapse of auto-parts giant First Brands Group exposed just how dangerous this can be.
When Jefferies, the investment bank, pitched the sale of loans to private credit funds, they said First Brands had about $5.9 billion in debt which was manageable. However, when the company ultimately filed for bankruptcy, restructuring advisers discovered that the true debt load was more than $11.6 billion.
First Brands Group allegedly used financial engineering to hide the actual level of debt by using a strategy called factoring. This is essentially selling a company's future revenue (like accounts they are owed by customers) immediately for cash. While First Brands claimed this wasn't really debt, it functioned exactly like debt. Ultimately, this created a nearly $2 billion hole in the balance sheet, raising the question of whether the same revenue streams were being double or even triple-pledged to different lenders.
Similarly, following First Brands, the subprime auto lender Tricolor Holdings abruptly filed for bankruptcy. The failure was allegedly driven by Tricolor using the same portfolio of car loans as collateral to secure multiple, separate lines of credit from major banks like JPMorgan Chase and Barclays.
In layman’s terms, imagine taking out a mortgage on your house. Then, you take that exact same house to three different banks and take out three different mortgages, promising each bank they are the sole owner of the collateral. The scheme only unravels when the company stops making payments, and the banks all show up at the same door.
Another risk comes from the way these loans are valued in private credit. If you own a publicly traded stock or bond, its price is set by the market every day. If the company hits bad news, the price immediately drops, and your assets must be "marked down" to reflect that reality.
Private credit is different. Since the loans are private, the fund managers themselves have significant freedom to decide what their loans are worth. When a company struggles, the fund manager can simply delay marking the loan down or use optimistic projections to maintain a high valuation. This flexibility may create a conflict of interest for fund managers who are often incentivized by their fee structure to look for higher valuations and projections.
Academic researchers are now calling this behavior “mark-to-myth.” They argue that the stable returns that private credit claims are simply an illusion created by this self-governing accounting system. They believe that when real stress hits the market, many of these funds will be forced to drastically write down the values of their loans all at once, leading to a much sharper, more painful correction than would otherwise be expected.
Our view is that there is not a systemic issue with the private credit market. While there has undoubtedly been poor underwriting with some of this lending, most of the loans are performing as expected. Even if greater stress emerges in private credit funds, we don’t believe that there is enough exposure in the economy to create a banking crisis like we saw during the 2008 financial crisis, when residential mortgage-backed bonds failed, creating a banking crisis not seen sense the Great Depression. But this is a good reason to remind those investing in private funds to conduct thorough due diligence and consider potential conflicts of interest.
Takeaways for the Week:
The collapse of Tricolor Holdings and First Brands highlights that there are risks lurking in the private credit markets.
We don’t believe there will be enough disruption in private credit markets to create a banking crisis.