Substack: Behind the Balance Sheet | Stephen Clapham

Enlightening recent piece on Private Credit Risks from the recent Behind the Balance Sheet site by Steve Clapham. Excerpts:

“Multiple Layers of Leverage

The IMF report highlights that the potential for multiple layers of leverage creates interconnectedness concerns. Leverage deployed by private credit funds is typically limited, but funds that use only modest leverage may still face significant capital calls in a downturn.

They flag that private credit investors, funds, and borrowers deploy leverage extensively, forming a complex multilayered structure. Investors such as insurance firms and pension funds may use leverage and are also subject to margin and collateral calls during periods of high market volatility.

Private credit investment vehicles may employ leverage directly within a fund or through other vehicles and leverage can be increased through more complex strategies such as collateralized fund obligations. In addition, private credit borrowers extensively deploy leverage - most firms borrowing from private credit funds are backed by private equity sponsors, leading to higher debt for the firms or leverage ratios deemed excessive by banks.

These multiple layers of leverage throughout the value chain could magnify losses and trigger spillovers to other markets during a downside scenario of forced deleveraging. “In such scenarios, vulnerabilities among borrowers may lead to large, unexpected losses for funds and end investors.”

Even funds that deploy modest amounts of leverage may still face significant capital calls. That could also force an entire network reduce exposure at the same time and that could trigger spillovers to other markets and the broad economy. I think this could be a particular risk if firms are investing in their own funds.”

“The IMF expressed concern that credit fund managers may be incentivised to delay the realisation of losses as they raise new funds and collect performance fees based on their existing track records. Clearly, there are large incentives to hide losses from investors. I don’t want to accuse the industry of being dishonest, but at least public companies have to have their accounts audited. I am unsure what degree of external scrutiny is being applied in private markets.”

I thought it was informative and well worth the 8-10 minute read. I have no exposure to Private Credit but I did attend a seminar where it was being promoted by Fidelity and elected to place it in the “Too Hard” pole. I wonder if many shrewds have exposure and what their experience has been.