Money Stuff: Private Credit Has Some Debt

The simple story of private credit is that private credit funds raise money from investors and use the money to make loans. The investors’ money is locked up for a long time, so there is no maturity mismatch: Unlike, say, a bank, a private credit fund can hold its loans to maturity and will never have to give investors their money back early; there can never be a “run” on private credit funds. Sure, certain retail private credit funds — non-traded business development companies — promise to give investors up to 5% of their money back each quarter, but other types don’t. And those outflows are small and predictable, so those BDCs will never have to do fire sales of loans to meet redemptions. [1]

This story is, approximately, half true, in the crude sense that about half of the money that private credit funds use comes from their investors. The other half is borrowed. A private credit fund might raise $100 from investors, borrow $100 more, and make $200 worth of loans. This is a crude number — some funds will borrow less, others more — but “around 1x levered” is a decent ballpark estimate. [2] Some of this borrowing comes from banks, which makes some people worry about systemic risk to the banking system, and some comes from the bond markets.

The recent private credit news has involved a lot of non-traded BDCs getting redemption requests for more than 5% of their shares this quarter. A few have decided to redeem more than 5%, but most have said no and stuck to the 5%. As we discussed yesterday, a simple way to interpret those withdrawals is that investors in private BDCs do not trust their net asset values. If the managers of your BDC tell you that the fund is worth $100 per share, and you think that it’s worth $80 per share, then you should withdraw as much money as they’ll let you: They’ll pay you out at the $100 net asset value for shares that you think are worth only $80. There is a lot of suspicion of private-credit marks, which tend to move more slowly than public asset prices, and publicly traded BDCs do in fact trade at large discounts to NAV, so this makes sense as an explanation. (There are other possible explanations, including a preference by individual investors for liquidity.)

But here I want to discuss the leverage. The fact that the typical private credit fund is levered has at least two interesting interactions with those withdrawal requests.

First: Leverage magnifies gains and losses, and in particular it magnifies any discounts. As Boaz Weinstein pointed out on the Money Stuff podcast, you have to look at GAV, not NAV. If a private credit fund owns $200 of loans, and it marks them at 100 cents on the dollar but they are really worth only 90 cents on the dollar ($180), and it has $100 of debt, then:

1. It will report a gross asset value of $200, and a net asset value (assets minus debt) of $100.
2. The real gross asset value is $180, and the real net asset value is $80.

A 10% discount on the loans — a 10% gap between the marked value of the loans and their actual market value — creates a 20% discount on the fund.

Now, if every private credit fund marked its loans perfectly — if everyone agreed that the loans were worth what the funds say they are worth — then this would not be a problem; two times zero is zero. But if there’s any disagreement over the value of the loans, the fund leverage magnifies it. And the more levered a BDC is, the bigger its net asset value discount should be, holding its marks constant.

Second: Leverage goes up with withdrawals. If a private credit fund owns $200 of loans, with $100 of debt and $100 of shares outstanding at NAV (1x leverage), and then investors ask for 5% of their money back, and the fund gives it to them, then now there are only $95 of shares outstanding. How much debt is there? Probably $105, if the fund draws on a line of credit to pay out the shareholders. (Possibly $100, if it sells assets instead.) The fund has gone from 1x leverage ($100 of debt to $100 of equity) to 1.1x ($105 to $95).

This is not the end of the world: Private BDCs don’t normally run at very high levels of leverage, they’re allowed to take on more, and 1.1x is fine. (The rules for BDCs allow up to 2x leverage.) I doubt that leverage ratios are an especially binding constraint right now. And the leverage going up is arguably a good thing, if it means that the BDCs don’t have to do fire sales of loans to meet redemptions.

But the leverage is something to keep in mind. On Monday, “Moody’s Ratings lowered its assessment of FS KKR Capital Corp.,” a publicly traded BDC run by Future Standard and KKR & Co., “to Ba1, or one level into junk, because of what it described as ‘continued asset quality challenges’ that have hurt profitability and the value of the fund’s portfolio relative to peers.” Ratings downgrades are bad generally, and particularly bad in a moment of worry for the private credit business. The FS/KKR downgrade was about asset quality (the value of the loans), not withdrawal-related leverage ratios, and FS KKR’s (book) leverage ratio is not especially high. But its response to Moody’s focused on its liability structure:

“FSK remains well positioned despite the decision,” a spokesperson for the fund, referring to its stock-exchange ticker, said in an emailed statement. “It has a strong, well‑laddered liability structure with no 2026 unsecured maturities and limited near‑term maturities, enabling us to continue supporting our portfolio companies and navigate the current market environment.”

It is partly true — it is half-true — that private credit is funded by long-term locked-up equity investors. Some of those equity investors are, perhaps, a bit confused; they thought they could get their money back whenever they wanted, and are now annoyed to find out that they can’t. That is genuinely annoying for them, though it is also good for systemic stability: If private credit funds don’t have to give back their money when investors get nervous, then there won’t be fire sales and bank runs. The current wave of private credit unpleasantness supports the core pitch of private credit, that its funding model is safer than bank lending: Everyone is mad, but the funds don’t have to liquidate.

But the other half of the story is the debt. Unlike bank deposits, that debt is also mostly not runnable; it tends to be long term and not have margin triggers. (Mostly!) So it’s not like private credit funds are getting their own loans called in and having to liquidate. Still, when people are nervous about private credit, debt makes that nervousness worse.

We talked last week about anti-private equity. The theory is that a lot of people — consumers, employees, politicians, etc. — don’t like private equity ownership of their local plumbing or pest control or traffic flagging business, so there is a market niche for non-private-equity ownership.  (Here is a 2021 paper finding “that acquisition announcements by PE funds are associated with reductions in customer visits to target firm outlets, but only when the target was not already owned by a PE fund.”)

And then, because I am a financial engineer at heart, I suggested structuring around that. Set up some sort of not-quite-ownership structure, a variable interest entity or management services agreement or cash-settled swap or something, so that (1) a private equity fund can acquire effective control and economic rights to the local plumbing business, (2) the grandson of the founding plumber can cash out but (3) they can tell everyone that the plumbing business is still locally owned. (This is approximately how private equity buyouts of medical practices work: The practice remains owned by doctors or lawyers, but the PE firm’s “managed service organization” owns a lot of its cash flows.) As I mentioned, a reader pointed me to American Operator, a company that “helps operators — typically a longtime employee or industry veteran — co-purchase retiring owners’ businesses,” apparently (1) initially acquiring about 90% of the equity and (2) saying that its “goal is to keep Main Street in the hands of Main Street,” great trade.

My basic point here is that “private equity ownership” is, by hypothesis, bad, but at a vague intuitive level; it’s not like there are well-designed regulations to block Bad Private Equity Ownership. It’s just that people get mad about it. So you’d think there would be ways to achieve the economic equivalent of private equity ownership while also telling people not to get mad about it.

If you take this stuff seriously, and I am not at all sure that you should, you might say: “Oh, sure, now there is just a vague intuitive objection to private equity ownership. But as private equity ownership becomes more pervasive, and as financial engineers get to work, it will become more formalized. States and countries will pass rules against private equity ownership. Or, more likely, voluntary certification regimes will spring up: Some trade organization will bestow a seal of No Private Equity Here, and that seal will be valuable in attracting consumers and employees, and that trade organization will look through your financial-engineering tricks.” The analogy is to environmental, social, and governance investing: “No PE” could be something that consumers want the way that “ESG” is something that investors want, and in both cases there will be third-party certifications to make sure that people are getting what they want.

Anyway here is the Locally Owned and Operated certification:

Stand out and build trust with customers who prioritize supporting local businesses. Our Locally Owned and Operated certification verifies your commitment to the community, helping you attract loyal patrons dedicated to keeping their spending local.

You get a little shield. Delightfully, American Operator runs the program.

There is a folk belief that, if you borrow money from a company, and the company goes bankrupt, you don’t have to pay back the money. This is not generally true. If you lend money to a company, and the company goes bankrupt, it might not pay you back; the bankruptcy interrupts payments on its loans. Not your loans. (Not legal advice!)

This is not entirely black and white, though. You might owe money to a bankrupt company, but it might owe you something in return: You might owe it money in exchange for some continuing service, or you might owe it money in exchange for a product that hasn’t been delivered yet, or maybe it at least has to send you invoices for the money you owe. And the company, being bankrupt and disorganized, might stop doing whatever it owes you. And you might say “well, if the company stops doing what it owes me, I will stop sending it money, that’s only fair, right?” This is kind of a natural intuition, though my impression — still not legal advice — is that the US bankruptcy code does not entirely share it. 

So, if you borrow money from a car dealership to buy a car, and the car breaks down, and the dealership goes bankrupt and stops returning your calls about fixing it, can you stop paying the loan? Intuitively you might say “yes, of course, that’s only fair.” But the dealership’s creditors, and the bankruptcy court, will have other ideas. Bloomberg’s Steven Church and Angelica Serrano-Roman report on the Tricolor Holdings bankruptcy:

The case pits what’s best for the individual car owners against the interests of wealthy bondholders and lenders. After Tricolor went bust, federal officials appointed a trustee to examine almost 40,000 allegedly fake loans and piles of questionable documents and disputed warranty obligations. Lenders say Tricolor used the same vehicles as collateral multiple times, and court documents indicate that Tricolor falsely inflated the value of its loan portfolio by more than half, to $1.7 billion.

One customer, who asked not to be identified because she’s undocumented, bought a 2019 Chevrolet Silverado last year from Tricolor for $35,000. The truck developed serious engine trouble a week after she drove it off the lot, but the company refused to fix the problem and today she still has to pay $600 every two weeks for a vehicle that’s unusable. ...

Roughly half of Tricolor’s customers are in default on their loans, according to a person familiar with the portfolio who asked not to be named discussing private information. If more borrowers quit paying, the court process set up to repay banks and bondholders could be thrown into chaos, and the lenders’ losses might soar. 

Tricolor has been charged with various schemes to package fake loans and borrow against them, which is bad for its creditors. But if you are one of Tricolor’s borrowers, you might say “Tricolor was going around selling fake loans, so who’s to say my loan isn’t fake?”

When I teach the Securities Regulation class at a law school, I will roll up my sleeves, loosen my tie, sit backwards on a chair and explain to my students that:

1. The moon emoji is securities fraud, but
2. The poop emoji is not.

This is not legal advice, and it’s not even really true, but it’s kind of true. In a simpler and more literate age, the way that people made factual claims in public was by writing or saying words, and courts could interpret those words to decide if they were true or misleading. Now we communicate in emojis, and so a body of law has grown up to interpret those emojis. The moon emoji, a federal judge has really concluded, could be interpreted by a reasonable investor as “an expert insider’s direction to buy or hold.” Emojis can have binding legal effect.

Similarly, in the olden days, traders made binding contracts with each other by saying the word “done” on the phone, or by typing the word “done” in an electronic chat, or by making an appropriate hand signal in an open-outcry trading pit. Now they can do it by sending the thumbs-up emoji in an electronic chat, which is a pretty straightforward adaptation of the trading-pit hand signals to the world of electronic messaging. 

I am not sure we are quite at the stage where hitting the “Like” button on social media can create a binding legal obligation, but surely we’re getting there? At the Financial Times, Sujeet Indap reports:

Lawyers for Elon Musk and Tesla have asked a Delaware judge to step back from cases involving the billionaire entrepreneur, after her account “liked” a LinkedIn post celebrating his recent legal defeat in California.

Musk’s law firm Quinn Emanuel wrote that because Chancellor Kathaleen McCormick had liked the “inflammatory” post and thereby created “a perception of bias against Mr. Musk in these cases, recusal is necessary and warranted”. ...

McCormick said she was not aware that she had liked the post until “LinkedIn recently reported that I hit the heart-in-hand icon intended to show a sign of ‘support’ concerning a LinkedIn post about Mr. Musk”.

“I either did not click the ‘support’ icon at all, or I did so accidentally. I do not believe that I did it accidentally,” she added, in a letter to attorneys.

Tesla moved its incorporation to Texas almost two years ago, so eventually Delaware judges will be done with Musk-related litigation. I bet they’ll be thrilled when that happens.

Three points that I have made around here are:

1. In choosing which entrepreneurs to back, venture capitalists self-consciously select for weirdos. The job of VC is to maximize variance. If you back a bunch of weirdos, some of them will be wildly successful and others will steal your money, which is better than having them all be pretty good.
2. It can be good for your career to lose a billion dollars: Future employers and investors will be impressed by your ability to take risk, and by the fact that someone previously trusted you with a billion dollars.
3. It can even be good for your career to develop a reputation as a scammer, for reasons that are a bit mysterious to me but that might be connected to the previous two points. Also, these days, a popular way to make money is by being in on some scam, so going around to investors and saying “psst I’m a scammer, you want to work with me?” might be a good pitch.

These things combine to create, you know, kind of bad incentives? The lesson here might be something like “develop the worst possible reputation for being unpleasant, making catastrophic mistakes and stealing money, because in modern business Bad is Actually Good.” I don’t know. Not career advice. Anyway here’s a venture capitalist saying honestly quite conventional things, for a VC:

One of Europe’s top venture capital firms is on a worldwide hunt for “misfit” founders, as it closes in on an $800mn fundraise that will help it double down on a strategy of backing unconventional entrepreneurs.

Hummingbird Ventures has racked up huge returns from early bets on the likes of crypto exchange Kraken and AI “vibe coding” start-up Lovable.

“The kind of founders we look into are truly misfits,” said Hummingbird founder Barend Van den Brande. “They are anomalies . . . we look for signs that they almost built their own theory of the world. If anything, to a certain degree, we want them to be unreasonable.” ...

Firat Ileri, managing partner, said Hummingbird was seeking entrepreneurs who “are almost unemployable” — people who “might not last long” at conventional businesses. “There are our type of founders all across the world.”

You know it’s a European VC firm because they say “to a certain degree, we want them to be unreasonable”; in Silicon Valley they would leave out the qualifier. Either way, though, “unemployable” is good for your career now.

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