For years, private debt served as a substitute for bonds. It offered—though not always—a few extra basis points, financed companies that were not listed on public markets for reasons of size, confidentiality, or sometimes quality, and above all promised an absence of volatility, which in the era of zero interest rates, the crisis of 2020, or the rise in rates in 2022, was a powerful argument for many investors and product marketers, even though this lack of volatility was merely the consequence illiquidity! It is surprising to see a major flaw being presented as an advantage, but it is the nature of marketing... Thus, in private debt, as long as a company did not default, the principal remained valued at 100. It was simple, comfortable, and flattering for portfolios.

Most loans are taken out with maturities of 3 to 7 years, which is typical for LBO financing, and a large part of the private debt market currently outstanding was created in 2020 and 2021, when abundant liquidity and zero interest rates made the segment particularly attractive. (By 2022, as rates had soared, interest from large institutional investors had dried up in favor of bonds, which, because they are valued on a daily basis, had become much more attractive...) At the time, a few dozen basis points of additional yield were enough to convince investors. For several years, there were no signs of tension: no quotations, no spreads, no volatility. But reality always catches up in the end. Companies now have to refinance in a radically different environment: rise in interest rates, economic slowdown, pressure on margins, and changing consumption patterns. And without daily quotations, the warning signs come late, sometimes too late.

Recent examples speak for themselves, such as Tricolor and First Brands, an automotive equipment manufacturer largely financed by private debt, which filed for bankruptcy with more than $10 billion in debt. Renovo, backed by asset managers such as BlackRock and Apollo, saw its valuation plummet from 100% to zero in a matter of weeks (https://www.lesechos.fr/finance-marches/gestion-actifs/blackrock-connait-un-nouveau-deboire-dans-la-dette-privee-2197959). These failures are not isolated: they reflect the tensions in a segment that has grown rapidly and with fewer safeguards than in the public bond markets, which are covered by multiple analysts, investment banks, asset managers, brokers, and other research firms, a diversity that allows for more comprehensive control of the accounts and risks of a given company. As a result, bankruptcies and fraud are also more difficult to detect for a single lending institution than for a “multi-party market,” as illustrated by the recent Broadband fraud that affected BNP and Blackrock: https://www.lesechos.fr/finance-marches/banque-assurances/bnp-paribas-et-blackrock-victimes-dune-fraude-a-500-millions-de-dollars-2196015. It should also be noted that when offering private loans to external investors through their sales representatives, financing banks may be tempted to be less discerning and less strict about covenants than when arranging loans for their own funds. The banking disintermediation observed since the 2008 crisis has therefore probably also been accompanied by an increase in the risk on outstanding loans, particularly in the United States, where regulations are more flexible and investors are more inclined to take risks and seek high returns.

The market is now worth more than $2 trillion, compared to $260 billion before 2008. Structures have become more sophisticated, but the weaknesses are clearly reminiscent of those of the 2000s: multiple use of the same collateral, loans with capitalized interest (PIK), complacent valuations, and the rise of players who lend primarily to deploy capital that they have collected on a massive scale, first from institutional investors and then from private networks believing they have found an El Dorado of high returns with no volatility. But ultimately, the economic principle is the same as that of pre-crisis CLOs, except that bank balance sheets are now largely absent. This protects the banking system and will probably prevent a systemic crisis, but now exposes savers to much greater risk. Central banks will likely show far less concern for savers, proving more willing to let them absorb losses than they ever were to let banks fail, given the need to safeguard the financial system.

One of the most significant developments has been the opening up of private debt to the general public. ELTIF funds in Europe and 401(k) products in the United States now give individuals access to this asset class, which was previously reserved for professionals. The sales pitch is well-rehearsed: stability, real economy, low volatility. But in an unlisted asset, volatility does not appear: it materializes abruptly when an event occurs. And the absence of a price does not mean the absence of risk.

This paradox is now striking: just as large investors are beginning to reduce their exposure, private investors are entering the market massively, attracted by promises of returns and stability at the very moment when flaws are beginning to emerge. This is fairly typical in the history of financial cycles...

Finally, we would note one last point that could make the shortcomings of private debt more significant than those of bonds: the lack of diversification in many portfolios. This is undoubtedly because sourcing and analysis are much more complex and costly than in the bond market, where information is, by definition, public and standardized. We have often observed relatively undiversified portfolios containing between 20 and 50 lines, even though the risk per signature was equivalent to that of a bond portfolio. As a result, defaults will be relatively much more costly if they occur in this type of portfolio, whereas bond portfolios generally contain between 100 and 200 different issuers.

In summary, private debt is not a bad instrument. It has simply reverted to what it should never have ceased to be: risky, illiquid, opaque credit, whose apparent performance masks structural weaknesses. The financial system is more resilient than it was in 2008, because banks no longer bear these risks; savings, on the other hand, are more exposed. And as is often the case in finance, when returns appear risk-free, it is almost always the risk that we cannot see.

 

Matthieu Bailly