7 minute read
1. Flawed Valuations Undermine Stability of $1.7 Trillion Private Credit Market
- Amidst the flourishing private credit market, fund managers frequently assign overly optimistic valuations to their loan portfolios.
- Regulators are starting to express concern, raising questions about these numbers.
What you need to know: The rapid rise of private credit funds can be attributed to a straightforward proposition aimed at insurers and pension funds entrusted with long-term investments - invest in our loans and sidestep the price fluctuations inherent in other forms of corporate finance. With these loans seldom trading — often never — their value remains stable, giving investors consistent and hassle-free returns. And according to Bloomberg1, this compelling offer turned a niche market on Wall Street into a $1.7 trillion industry.
But after the swift increase in interest rate hikes by central bankers over the last two years, has placed significant strain on the financial positions of corporate borrowers, resulting in many struggling to meet their interest obligations. Suddenly, a key advantage of private credit— which allows these funds to independently determine the value of their loans rather than subjecting them to the volatility of public markets — is now appearing as one of its most significant potential weaknesses (ironically).
Why it matters: The absence of clear valuation standards is a common grievance within private credit markets, a concern that is now unsettling regulators. While such ambiguity may have been overlooked during periods of near-zero central bank interest rates (when no one cared), financial watchdogs are now apprehensive that the lack of overview could potentially reveal a wave of problematic loans that have lurked in the shadows.
Now the Dunham Deep Dive: This shouldn’t come as a surprise. After 2008, private lending funds and companies began moving into the market as banks scaled back – grabbing a significant amount of market share since then.
But, alas, private credit doesn’t take away the risk of lending - it’s just playing hot potato with it, jumping from one hand to the next.
And what was once the cornerstone appeal of private credit funds – aka that they could determine the value of their loans - is now emerging as one of their most significant potential weaknesses.
The fear now is that from the surge in private credit, some of these loans they extended haven’t seen realistic valuations - especially over the last two years as the Fed hiked up interest rates (which push bond prices down).
Worse is that the thinly traded nature of this market may render it nearly impossible for most outsiders to accurately gauge the value of these assets, but identifying red flags becomes comparatively easier.
For starters, the number of private credit funds holding the same publicly traded debt, yet valuing them significantly higher than their quoted prices in the public market (see chart below)…
Quite baffling, isn't it?
Now, you may be wondering, “How is this even possible?”
But, honestly, are you surprised? This reminds me of the 2008 great financial crisis when major banks were “valuing” their mortgage loan books far higher than they were even worth.
Beware.
2. Rate Hikes Are Making Consumers Pessimistic, More Than Economists Realize
- A recent paper suggests economists underestimate the effect of Fed hikes on consumer mood.
- Consumers - especially those heavily dependent on credit cards - are feeling this crunch deeply.
What you need to know: Even with a growing US economy, historically low unemployment rate, and declining inflation, US consumers remain gloomy – which has puzzled many economists. Yet, a recent paper2 authored by researchers from the IMF and Harvard University, which includes former Treasury Secretary Lawrence Summers, suggests that the elevated borrowing costs might offer an explanation.
Why it matters: According to the paper, the increased expenses associated with borrowing - which are not typically factored into inflation calculations (key point) - could underlie the recent divergence between official inflation metrics and consumer sentiment. Essentially, consumers are incorporating the cost of borrowing into their perceptions of economic well-being, a factor that economists have not been considering, as per the researchers' findings.
Now the Dunham Deep Dive: This brings up a great point – because even with such a “strong” economy, households are feeling bleaker (consumer confidence is still far below3 pre-pandemic levels)
What gives?
Well, the paper – which I agree with – highlights the fact that as consumers grew more addicted to credit, the price of money (aka interest rates) became a considerable factor.
Put simply, the more debt is used, the more interest rates matter.
For instance, although the price of a car is factored into the Consumer Price Index (CPI, the inflation measure), the expense of financing the vehicle is not accounted for (most households depend on financing a vehicle now rather than paying outright with cash).
And as credit card debt, auto loan debt, other debt forms, and unpaid balances all increase4 - the cost to finance all this debt is a considerable factor that should be accounted for when gauging consumer health.
To put this into perspective, as the chart below highlights, the surge in non-mortgage interest payments has exploded over the last two-odd years.
Thus, the amount consumers are paying to service their outstanding debt has risen substantially, which is an issue all on its own – such as having less disposable income to spend, fears of a “debt trap” (when individuals require more debt to keep rolling over old debt), and potential fallout from rising delinquencies and defaults.
Something to monitor.
3. Incoming Dilution: Debt-Heavy Firms May Turn to Equity as a Lifeline as Interest Expenses Soar
- Issuing shares is now cheaper than taking on loans for the first time in 20 years.
- Companies bogged down with debt may now turn to issuing stock to raise capital – potentially putting pressure on prices.
What you need to know: Companies in the US are experiencing a significant shift as, for the first time in over two decades, it has become cheaper to raise capital through share sales rather than debt issuance. According to Bloomberg5, this transformation, driven by central banks' elevation of interest rates to historic levels, has compelled CFOs to reassess their financing strategies and are increasingly turning to equity markets for capital.
Why this matters: Despite expectations of limited equity issuance, a potential shift towards greater reliance on equity over debt could have significant implications for corporate finance and broader markets, albeit the likelihood of such a transition remains uncertain.
Now the Dunham Deep Dive: This “de-equitization” wave (aka the era of debt-fueled share buybacks) is beginning to end. And this is a reason I have been skeptical of market prices lately.
While it’s true that markets continue higher, there are two big structural reasons for this (on a macro level).
- There are much fewer publicly traded companies today than thirty years ago. To put this into perspective, in the U.S. alone, there were over 7,500 publicly traded companies in the late 1990’s. Now it’s about 4,000 (and the same trend has occurred in the UK and Germany). That’s a near 50% decline.
I’ve written in-depth about this before in a previous Morning Pour with all the data and charts. Read here - ‘Corporate Cannibalism’: How Monopoly Powers and Corporate Concentration Are Helping Widen Inequality. - Companies issued fewer shares amid a very low-interest rate environment post-2008 (choosing debt instead). Meanwhile, they’ve bought back a significant number of shares – thus reducing shares outstanding and pushing prices higher. See the chart below to visualize this.
These two pillars fed off each other to fuel equity prices higher (aka less supply of both public companies and shares outstanding combined with higher demand from buybacks and passive inflows).
And while I don’t expect this trend to change much in the long term, for now, it appears that these debt-strapped firms may turn toward issuing new shares (adding to the supply).
Thus, any influx of initial public offerings (IPOs) or secondary sales (issuing stock) may temporarily dampen valuations and reduce short-term returns.
We’re already seeing this sentiment change as two big sources of de-equitization - leveraged buyouts and buybacks - have already declined as debt costs rise.
Remember, companies used to find it cheaper to borrow debt to buy their shares back (which would inflate per-share earnings and push prices higher).
But today, that math doesn’t add up. . .
Anyways, who knows what will happen? Maybe this is just noisy data.
As usual, just some food for thought.
Have a great rest of your weekend.
Sources:
- https://www.bloomberg.com/news/articles/2024-02-28/how-private-credit-market-boom-is-hiding-potential-valuation-problems?srnd=homepage-americas&sref=nD2OD0Ri
- https://www.bloomberg.com/news/articles/2024-02-26/the-sting-of-higher-rates-could-help-unravel-consumer-sentiment-mystery?srnd=premium&sref=nD2OD0Ri
- https://tradingeconomics.com/united-states/consumer-confidence
- https://www.newyorkfed.org/microeconomics/hhdc
- https://www.bloomberg.com/news/articles/2024-02-27/reddit-campari-aston-martin-turn-to-equity-markets-for-much-needed-cash?sref=nD2OD0Ri
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