In the classic John Ford movie, "The Man Who Shot Liberty Valance", a distinguished Senator (played by Jimmy Stewart), whose career was built on having outdueled a gunslinger, reveals in flashbacks to a reporter that the killer was actually the John Wayne character. The Senator is incredulous when the reporter tears up his notes regarding this revelation but the reporter tells him, "when the legend becomes fact, print the legend." Similarly, with respect to retail private credit, many critics have decided to run with the legend rather than the facts.
The conventional wisdom is that the current stress in private credit demonstrates that it is ill-suited to retail investors because it is too risky, too illiquid and too opaque. Some suggest eerie parallels to the Great Financial Crisis. With private credit critics referencing a canary in the coal mine or a private credit powder keg, we are in the midst of a hyperbolic cliche festival. Indeed, the oft quoted “cockroach” comment was made in the context of loans made to First Brands and Tricolor that were, in fact, bank-led, bank-syndicated - not private credit.
The narrative has now turned to non-traded Business Development Companies. BDCs date back to the 1980s and were authorized by Congress to raise capital for private companies. This type of capital has quickly funded American growth through multiple cycles. During the COVID-19 pandemic, the Ukraine conflict and the regional bank crisis, private credit provided critical financing to the U.S. economy when banks stepped back.
For individual investors, retail private credit provides a straightforward bargain: earn a premium return for trading away some degree of liquidity. Over the past 20 years, private credit has delivered a higher return than public non-investment grade loans (9.6% versus 5.0%).
One cannot, however, expect both to invest in illiquid assets and also benefit from unlimited liquidity. These semi-liquid vehicles strike a balance by providing liquidity until the aggregate amount of repurchase requests exceeds 5% of invested capital over a quarter. Proration is then utilized, at a time of market stress, to protect investor capital by avoiding a sale of assets below their intrinsic value to satisfy redemption requests. This design feature passed the test when a semi-liquid real estate vehicle, BREIT, had to prorate redemptions for the only time in its nine-year history in 2022. The proration, however, lasted only for about one year and investors received, on average, full redemption in four months. BREIT inflows are now net positive and it returned 8.1% net last year (compared to 2.9% net for the public REIT Index).
Critics call these vehicles opaque, which is inexplicable given that funds like BCRED, the non-traded BDC offered by Blackstone, make annual (10-K) and quarterly (10-Q) SEC filings with each of its loans identified and currently valued.
A related claim, that retail customers do not understand the withdrawal limitations, is belied by the fact that the prospectuses for these semi-liquid products prominently describe withdrawal limits throughout the selling document, including the front page in bold. Moreover, unlike public stocks, unlisted BDC shares are bought through independent financial intermediaries who have a duty to inform their clients of the tradeoff between illiquidity premiums and limited liquidity. There is, unsurprisingly, no evidence that customers were unaware of the limitations on withdrawal.
Another leading nominee for private credit myth is that any current weakness in unlisted credit vehicles signals that they are too risky for retail. In fact, the type of credit in the BDCs are mostly first lien senior secured loans. In assessing the risk in the sub-investment grade asset class, the liquid markets, non-investment grade default rates have historically been about 3% and private credit's non-accrual rate has been below that level. To be sure, there will be isolated defaults in non-investment grade lending, and AI poses disruption risk for various sectors, including software. As a result, private credit defaults should rise from the historically low levels seen over the past several years. The risks to private credit will, however, be mitigated given that the first lien senior secured loans held by BDCs have significant equity cushions (e.g., the average equity cushion of a BCRED loan is 60%).
The myth most designed to attract media attention is that private credit stress heralds a new Great Financial Crisis. The GFC arose from defaults in subprime mortgages issued by banks subject to demand deposits and with leverage as high as 30:1 (and still more than 10:1 today). In contrast BDCs, which typically operate with no more than 1:1 leverage, predominantly invest in first lien senior secured loans and have limitations on withdrawals. Fed reports have noted that private credit, which represents only about 9% of all corporate borrowing, is unlikely to amplify market stress and that the risks from banks lending to BDCs are limited.
The narrative fueling the adverse media attention on private credit retail vehicles may be unrelenting, but as George Orwell said, "however much you deny the truth, the truth goes on existing."
John Finley is Senior Managing Director and CLO of Blackstone and this opinion piece is drawn from his recent remarks at a private markets roundtable organized by the SEC in Washington, D.C.
