Money Stuff: Private Credit Marks Will Matter

What does this tell you about stock market efficiency?

A BlackRock Inc. private debt fund plunged the most in almost six years after it disclosed writedowns across a series of troubled investments and waived some of its fee.

BlackRock TCP Capital Corp., a publicly traded middle-market lending fund, fell as much as 16.7% in New York trading Monday. The fund said on Jan. 23 the writedowns would result in cutting its net asset value by 19% as of the end of last year.

Such a decline in the asset value “is very unusual and likely will rekindle private credit fears for the sector,” Truist Securities analyst Arren Cyganovich said on Monday.

The fund struggled in part because of its exposure to e-commerce aggregators — companies that buy and manage Amazon.com Inc. sellers — as well as troubled home improvement company Renovo Home Partners, which has filed for bankruptcy with plans to liquidate. The fund disclosed that six investments comprised roughly two-thirds of the decline in net asset value.

The vehicle is a business development company, which pools together private credit loans and trades like a stock. BlackRock said it has waived one-third of its management fee for its last quarter.

BlackRock TCP “expects to cut its net asset value per share to between $7.05 and $7.09 for the quarter ended Dec. 31,” down from “$8.71 as of Sept. 30.” The stock closed at $5.86 on Friday and was trading around $4.98 at noon today, down about 15%. So (1) BlackRock announced that the value of TCP’s loans fell by 19% and (2) the stock fell about 15%. 

You could imagine a world in which, last week, TCP’s investors thought their loans were worth $8.71 per share, but then BlackRock told them that actually they were worth 19% less, so the stock fell by 19%, but that’s not what happened: The stock fell about 15%. (Also, both last week and today, the stock trades at a big discount to net asset value; presumably that discount largely reflects the capitalized value of future fees to be charged to the fund, though it might also reflect skepticism about the NAV.) Instead you need a model like:

• On Friday morning, TCP investors kind of already knew that the loans were worth less than the stated NAV, so they were not totally surprised when BlackRock confirmed that, though the news was worse than they expected; or
• On Friday morning, TCP investors thought everything was hunky-dory, but then BlackRock was like “actually you’re down 19%” and the investors were like “oh you’re just exaggerating, it’s not that bad,” and the stock did not fall the full 19%.

I feel like only the first bullet point there is really plausible. Investors paid attention, they thought “hey, this fund has exposure to a bankrupt company, maybe this Sept. 30 NAV is kind of stale,” the stock traded below NAV, and then when BlackRock marked down the NAV, some of it was already baked into the price.

This is a common theme in private credit. Private credit, by and large, does not trade, and private credit funds have a lot of leeway in determining the fair value of their loans. Critics worry that their marks are sometimes too optimistic, that private credit funds will often tell their clients that their loans are all worth 100 cents on the dollar when really they’re worth 60.

At some level, in traditional private credit, this doesn’t matter that much. Institutional private credit is traditionally a buy-and-hold investment: Some investors commit to a private credit fund, the fund makes loans, the fund calls cash from the investors to make the loans, the fund holds the loans until maturity, the loans mature, they either pay off or they don’t, and whatever money the fund gets (minus fees) goes back to the investors. Midway through the life of the fund, it is of some academic interest whether a particular loan should be marked at 0 or 60 or 100 cents on the dollar: If the fund tells investors “this loan is worth 100 cents on the dollar because it will definitely be paid back,” and in fact the borrower is in trouble and the loan ends up not getting paid back, then that seems intellectually sloppy and possibly dishonest.

And if the marks are wrong, there might be some real consequences. Perhaps the investors are regulated insurance companies and the marks on their private credit portfolios affect their regulatory capital ratios. Perhaps the fund has gotten leverage from banks, and the banks need to know the value of their collateral. 

But broadly speaking the point of private credit is that you don’t have to worry about the marks very much: You make the loan at 100 cents on the dollar, and eventually it is either paid back or it isn’t. If it’s paid back, then it was worth 100 cents on the dollar. If not, not. Eventually you just find out the answer. Your fund’s estimates along the way are of some second-order interest, but if you are a buy-and-hold investor they just don’t matter that much.

BlackRock TCP isn’t quite like that. It’s a BDC, which means that its stock trades on the stock market continuously at market prices. If you invest in TCP, you don’t have to hold it until maturity. (In fact, there is no “maturity”; BDCs are generally perpetual vehicles and reinvest proceeds when loans mature.) You can buy or sell it on the stock market whenever you want. If you thought the NAV was $8.71, so you bought some shares at $5.86, and then the next day BlackRock told you “actually it’s $7.05” and the shares fell to $4.98, you might feel aggrieved. (Though, given the discount to NAV, perhaps you had some notice that $8.71 was not actually the right value.)

But, from a fund perspective, BDCs are basically perpetual capital: You can sell your stock anytime, but you sell it on the stock market to whoever wants to buy it, not necessarily back to the fund. The fund never has to give you back your money, though (1) it generally passes interest payments on to shareholders and (2) many BDCs will do occasional stock buybacks to return money to investors.

As we have discussed a few times, though, including last week, the structure of private credit is changing to appeal more to retail investors. To market private credit broadly to retail investors, and particularly to their retirement accounts, private credit needs to offer more liquidity. Retail investors need to be able to take their money out, and private credit managers have launched lots of funds that “offer investors options to cash out periodically, in contrast with closed-end vehicles that typically lock up capital for a set amount of time, a drawback for individual investors.”

And if you let investors take their money back, you will generally do it at NAV: You will say something like “anyone can buy new shares at the net asset value, or take their money back at the net asset value.” And so NAVs really matter. If you tell investors “this fund’s loans are worth $8.71 per share,” but actually they are worth $7.05 per share, then:

• Investors might know that, or at least suspect it;
• They will want their money back, because getting paid $8.71 per share for a pot of loans worth $7.05 per share is a good deal; and
• That’s bad for other investors: Paying out $8.71 per share for a pot of loans worth $7.05 per share reduces the value left in the fund, pushing the net asset value down.

It is a classic bank run dynamic: If a private credit investment is worth $7, but you can cash out for $8, you should, and everyone will, and eventually there will be $0 left. And everyone knows this and will be twitchy. 

Of course the classic buy-and-hold private credit model is supposed to be immune from bank runs, because it has long-term locked-up capital from patient investors. But that’s changing to appeal to retail. And as it changes, it becomes much more important that the marks be correct.

One thing that I sometimes think about is that sandwich shops do not have reputational risk from their customers. [1]  Like, if Jeffrey Epstein had gone to the same sandwich shop twice a week for years, and each time he went he gave them money and they gave him a sandwich, and then he got arrested for sex crimes, and he kept going to that sandwich shop, and they kept selling him sandwiches, and eventually he was arrested again and died in jail and became a quite notorious figure, no one would blame the sandwich shop. No one would be like “they ignored red flags of his sex crimes and served him sandwiches.” No one would be like “they failed to do their know-your-customer checks and thus did business with a known sex criminal.” No one would be like “they looked the other way and allowed him to launder his ill-gotten criminal proceeds into sandwiches.” No one would be like “they enabled him to do his crimes for years by feeding him sandwiches.” Everyone would be like “well, they sell sandwiches, and if you show up with money they’ll sell you a sandwich, and it’s not their responsibility to decide if you’re a good person or look into your criminal record before selling you a sandwich. They probably didn’t even know who he was. It’s just a sandwich shop.”

Most businesses are like that, and some are not. In particular, banks are not. Jeffrey Epstein did in fact use the services of some banks, and after Epstein became a notorious figure the banks got in a lot of reputational and legal trouble. “Banks are the first line of defense with respect to preventing the facilitation of crime through the financial system, and it is fundamental that banks tailor the monitoring of their customers’ activity based upon the types of risk that are posed by a particular customer,” said a New York regulator who fined Deutsche Bank AG $150 million for letting Epstein have bank accounts. JPMorgan Chase & Co. also paid a nine-digit settlement for missing Epstein’s red flags.

In some ways this is strange — surely the best people to prevent child sex trafficking are law enforcement officers, not banks? — but in other ways, you know, sure. Banks do have a quasi-regulatory function; they are “the first line of defense” against certain sorts of crime. There is no legal or customary expectation that sandwich shops will “know their customers” — that they will require customers to fill out forms and provide ID to get a sandwich — whereas there very much is that expectation for banks. A bank should know who it’s dealing with, and deal with the right people, because a bank’s services are … something? Important? Particularly useful in committing crimes? Legible to the government? My Bloomberg Opinion colleague Paul Davies writes:

Banking and finance is one of the most heavily regulated industries in the world — and for very good reasons. No society wants criminals, terrorists and money launderers to have easy, unfettered access to a system that can help fund their destructive endeavors or that looks after their profits.

But they can have sandwiches; that’s fine.

This situation is not as clear as I am perhaps making it out to be. It’s not “banks are not allowed to provide checking accounts to people with criminal records,” or “if a bank’s customer commits a crime then the bank is responsible for that crime,” or anything like that. Banks can provide checking accounts to people with criminal records. (“JPMorgan Chase is committed to giving people with arrest or conviction histories a second chance,” says JPMorgan.) It’s more like, you know, if your customer commits some really bad crimes, and you should have known about the crimes, you run some risk — not a certainty, some risk — that some prosecutor or plaintiff will blame you. It’s “don’t turn out to have been Jeffrey Epstein’s banker.” It’s not a set of black-and-white rules about who is and is not allowed to be a customer; it’s a series of risk assessments. Some customers are riskier than others.

Anyway, in January 2021 some events occurred. Last week, a US federal prosecutor testified under oath that the Justice Department had “proof beyond a reasonable doubt” that President Donald Trump committed quite serious crimes in connection with those events. For reasons, those alleged crimes were never prosecuted, and perhaps the allegations are untrue. But! Donald Trump’s banks, in February 2021, shortly after the alleged crimes allegedly occurred, faced a problem. They were providing banking services to someone who … you know! “Someone whom federal prosecutors strongly believed had committed very serious crimes,” is perhaps a way to put it, though you could put it other ways depending on your political and other views. 

The point I’d make there is that that’s risky, not purely as a matter of partisan politics, but because “high-profile people with red flags suggesting that they have committed bad crimes” are the customers you don’t want. Obviously “vengeful people who will in the future become the president of the US again” are the customers you do want, sort of, [2]  but that’s hard to predict. Or maybe it isn’t, but in any case there are risks either way. JPMorgan chose wrong:

President Donald Trump sued JPMorgan Chase & Co. and its chief executive officer, Jamie Dimon, for at least $5 billion over allegations that the lender stopped offering him and his businesses banking services for political reasons.

The complaint, filed Thursday, accuses the bank of trade libel and breach of implied covenant of good faith. It also claims Dimon violated Florida’s deceptive trade practices law. In response, the bank said it doesn’t close accounts for political or religious reasons.

Here is the complaint, which is not exactly what you would call compelling. (Davies: “The suit is so thin that there’s a high chance it will get dismissed.”) One funny quote comes toward the end:

When Plaintiffs and JPMC began their relationship, Plaintiffs and JPMC entered into the Agreement, which governed the parties’ relationship. See Exhibit A.

The Agreement states: “Closing Your Account. Either you or we may close your account at any time for any reason or no reason without prior notice. …”

In the Agreement, JPMC reserved the right to terminate any existing banking relationship at any time and for any reason.

However, neither the letter nor the spirit of the Agreement authorized JPMC to terminate an existing banking relationship with a client for an unlawful purpose. 

I do feel like both the letter and the spirit of “we may close your account at any time for any reason or no reason” is that they could close the account for any reason or no reason, but I suppose there’s room for disagreement.

If you own a gold mine, the traditional way to make money is gold mining. You could get some shovels, dig the gold ore out of the mine, crush it up, extract the gold, form it into gold bars, transport it to market and sell it. This is a good business because gold is valuable, but it is also hard and expensive and environmentally messy.

You might have a thought process like: “Look, this is all pointless. We will do all this work to dig up and refine the gold, and then we will sell it, and then it will just go back into underground vaults. We could just leave it underground, and everyone could just agree that we have X amount of gold that is worth $Y in our own, somewhat inconvenient underground vaults, and we could sell that. Just sell Unmined Gold Tokens.”

We talked about this approach a few months ago, because a company called NatBridge Resources Ltd. was doing it in a particularly funny and explicit way: It owned some gold reserves, had no plans to dig them up, but used a “digital mining process” to create crypto tokens corresponding to the gold, which it could sell. But in principle there is a simpler and marginally less silly approach, which is:

1. Start a company.
2. Acquire a gold mine.
3. Take the company public.
4. Boom: Your stock is a form of Unmined Gold Tokens.

That is: The total value of the stock of a gold company is roughly the expected value of the gold it has in the ground, discounted by the amount of money it will have to spend digging it up. If you don’t dig it up … well, the math there is left as an exercise for the reader.

In practice, if this is your approach, you do need to be a bit silly. You don’t have to go around being like “our Unmined Gold Tokens are just as valuable as gold jewelry and much more environmentally friendly,” but you do have to go around getting people excited about your stock. At one level your company is valued based on gold, the oldest and most solid form of money. At another level, your company is kind of a meme stock. Anyway:

Hycroft Mining Holding Corp., the owner of a non-operational gold and silver mine in northern Nevada, has seen its shares soar more than 425% over the past two months as precious metals prices have climbed to record highs.

That’s delivered glittering returns for its largest investor, Canadian billionaire Eric Sprott, a longtime gold bug whose stake has increased 746% in value to more than $2.1 billion.

Hycroft is riding the updrafts of a staggering rally in the spot silver and gold market that has seen prices soar in the past year. Even though Hycroft doesn’t yet have a clear plan to mine its underground reserves, the company’s stock still serves as a way for investors to buy into the precious metals boom.

“Think of it as a massive, in-ground ETF,” Bank of Montreal precious metals analyst Brian Quast said in an interview. “There’s a whole bunch of silver there that they might or might not be able to get out, and people really want exposure to silver right now.” …

Hycroft hasn’t actually mined any gold since 2021; instead, it’s focused on cheaper methods, including reprocessing previously mined ore that’s already above ground. The majority of its assets are underground, but it doesn’t yet have a clear plan to resume mining operations. The company hasn’t reported generating any revenue since 2022, when it brought in just $33 million, according to data compiled by Bloomberg.

Sure. We talked about Hycroft a few times back in 2022, when it got an equity investment from Sprott and from AMC Entertainment Holdings Inc., which is in part a movie-theater company but in larger part a meme-stock company, and which was presumably investing in gold mines for meme-y reasons. 

It is fun to imagine the wrong analysis:

1. Magic: The Gathering is a card-based game produced by Wizards of the Coast, a gaming company that was acquired by Hasbro Inc. in 1999.
2. Magic cards can have high and volatile values, with some selling for millions of dollars.
3. Why would you pay a lot of money for a Magic card? Well, they are collectibles: People collect them, some are rarer than others, you buy rare Magic cards the way you might buy rare baseball cards. They are also arguably art: There are pictures on the cards, and some are prettier than others. They are also part of a competitive game that people like to play, sometimes for money, and some cards are more powerful in the game than others, so you might pay a lot of money to buy a card that will help you win games.
4. Also, though, Magic cards are arguably an investment in the Magic game and its ecosystem. You might buy a Magic card thinking something along these lines: “I like Magic, the game. I think that Hasbro will do a good job of developing and promoting the game, so it will become more popular over time and more people will want to play it. This will increase demand for Magic cards, including this rare powerful one that I am buying. So its price will go up and I will be able to resell it at a profit, if I am right about Hasbro’s ability and desire to develop and promote the game.”
5. This analysis suggests that Magic cards are something like securities: They are “an investment of money in a common enterprise with profits to come solely from the efforts of others.” You invest money (buying the cards directly from Hasbro, or in the secondary market for rare cards), there’s a common enterprise (you are all part of the Magic game), you expect profits (from reselling your cards) and those profits come from the efforts of others (Hasbro, in developing and promoting the game).
6. There is precedent. In 2021, a company called Stoner Cats 2 LLC sold some collectible pictures of cats. Some of the cats were, one assumes, rarer or prettier than others; they were collectibles and/or art. But Stoner Cats 2 also planned to make an animated web series about the cats starring Mila Kunis and Vitalik Buterin (really), and you might have thought that, if the series was successful, the value of the cats would go up. The cats did not share in the profits of the show — they were not equity — but they were somehow useful in watching the show, in something like the way Magic cards are useful in playing Magic. So you might have bought the cats speculatively to bet on the success of the show, a success that would be due solely to the efforts of the company (and Mila Kunis), not you. The US Securities and Exchange Commission concluded that the cats were securities, sued Stoner Cats 2 for securities violations, and reached a settlement. We talked about this in 2023.
7. Are Magic cards similarly securities? If you bought some cards and their price went down, could you sue Hasbro for securities violations? If Hasbro said, you know, “we don’t plan to print more of this fancy card” and then did, driving the price down, could you sue for securities fraud?

Like I said, this is the wrong analysis. For one thing, the Stoner Cats precedent comes from an earlier and more aggressive SEC, and I can’t imagine the SEC taking a similar position now, or winning on it in court. For another thing, the Stoner Cats precedent was from crypto — the pictures of cats were crypto nonfungible tokens, not cardboard cards — and I can’t imagine the SEC or a court ever taking a similar position about cardboard trading cards. Still, one lesson of crypto is that lots of things are kind of a little bit like securities, so you could dream.

In any case, no, the shareholders are suing:

A group of shareholders of Hasbro stock has filed a federal lawsuit against CEO Chris Cocks and company executives for what they claim are “breaches of their fiduciary duties as directors and/or officers of Hasbro, unjust enrichment, waste of corporate assets, gross mismanagement, abuse of control” - and violations of the Securities Exchange Act.

In the 76-page complaint filed in the U.S District Court of Rhode Island on Wednesday, plaintiffs Joseph Crocono and Ultan McGlone, who say they have been Hasbro shareholders who have held common stock since 2020 and 2021, respectively, claim that the company’s public statements were “materially false and misleading” on shareholder calls between 2021 and 2023. …

“Given the nature of Magic’s secondary market, the rate at which new Magic card sets are printed and sold directly impacts the value of existing Magic cards to collectors. As such, the overprinting of new Magic sets would reduce the value of existing Magic sets. Although analysts and investors consistently inquired as to whether the Company was in fact overprinting Magic sets, the Individual Defendants repeatedly denied such speculation,” the lawsuit maintains.

The lawsuit says that a damning report by Bank of America in 2022, however, found that Hasbro was “overproducing Magic cards, which have propped up Hasbro’s recent results but are destroying the long-term value of the brand.”

Here’s the complaint. Sure, why not.

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