Rise and risk of private credit

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THIS week, the saga of Malaysian-born Patrick James enthralled readers about how the little-known businessman in the US racked up so much debt in his autoparts businesses that has now led to lenders being at risk of losing their money.

James had left for the US back in the 1980s, which is why so little is known of him here. Even in the US, he had kept a low profile.

His First Brands group was headquartered in Ohio and grew phenomenally, mainly through acquisitions funded by debt. It has now filed for bankruptcy and there are allegations of misusing receivables such as duplicate invoices to dupe lenders.

Even more interesting is that part of the funding came from private credit. And it is these creditors who now face the painful prospect of not being able to collect on their debt.

So what is this private credit phenomena and how is it different from other forms of funding?

The topic is even more relevant today because some big-name financial commentators have warned that private credit can lead to the next big financial crisis and some even draw parallels with the subprime mortgage crisis that led to the 2008 global financial crisis (GFC).

In fact, it was after the GFC that private credit began to emerge and has not stopped growing, particularly in the US, where big firms now manage significant private credit funds.

Private credit is said to fill a gap of providing loans to companies that cannot secure traditional banking loans. It is said to be the result of the aftermath of the GFC when new regulation required banks to shore up capital, tighten risk management and deleverage.

So private credit is essentially the provision of loans by non-bank companies and hence are subject to looser regulation.

It is also to be differentiated from public credit (the bond market) and private equity (which entails equity and not debt).

Private credit operators raise funds from investors, promising them a high yield and in turn lend out that money to companies that are willing to pay a higher interest rate than what banks charge.

These borrowers are willing to pay higher rates because they are not getting funding from the banks. In the US, private credit now accounts for around US$1.3 to US$1.5 trillion of lending, working out to around 15% to 20% of lending.

In Malaysia, the peer-to-peer lending platforms, enabled and licenced by the Securities Commission (SC) from 10 years ago, can be considered as private credit. However, they only account for a small percentage of total loans in Malaysia.

As at January this year, the total outstanding loan size by banks in Malaysia was RM2.4 trillion while P2P lending platforms have cumulatively lent out around RM8bil.

More are getting into it. Last year Ekuiti Nasional Bhd (Ekuinas) launched an RM800mil private credit fund. Navis Capital has also launched its own private credit fund.

In the US, it has become a trend for private equity firms to start private credit funds. The reasons are obvious – some of that capital can go towards loans of its investee companies to give them a better chance of success.

These private equity firms also have strong relationships with pension funds (the typical limited partners or LPs in such funds).

Higher risk profile of private credit

One characteristic of private credit is that it entails higher risk simply because it is the provision of loans to enterprises that are not able to access traditional sources of loans. No matter how it is packaged, this higher risk element is always there.

Compounding matters is this: providers of private credit generally do not have the track record and infrastructure of robust risk management, due diligence and loan recovery compared with banks.

Initially, this was overcome by the private credit provider being extra strict with the terms and conditions and covenants.

However, due to intense competition in the US by private credit providers, those standards have dropped in the race to grow their loan book.

This is why Jamie Dimon, CEO of JPMorgan Chase, has been warning about the risks associated with private credit markets, noting that it could potentially trigger the next financial crisis if economic stress hits. He has highlighted concerns over the sector’s relaxed regulations, opaque underwriting standards, and aggressive leverage.

More recently, following the bankruptcy filing by Malaysian-born James’ First Brands group, Dimon reportedly said: “I probably shouldn’t say this, but when you see one cockroach, there are probably more. And so we should – everyone should be forewarned on this one”.

That said, the Malaysia scenario is still far removed from that. Regulators here are pretty strict about who they allow to provide private credit.

Nevertheless, the P2P platforms have been doing brisk business. But what is their rate of non-performing loans (NPLs) and defaults? It does seem low, as many platforms do report low NPLs.

However, the methodology of how these platforms calculate their NPLs and even their assets under management (AUM) are not standardised.

In some cases, loans get rolled over multiple times, with the borrower agreeing to pay a higher rate each time. Each of those loans is also calculated as an addition to the platform’s AUM or loan book, despite the borrower being the same party. Hence there is a need for the regulator to impose more stringent and standardised rules on these platforms.

Buyer beware

Private credit is an increasingly sought after product by investors due to its promise of high yields.

The attraction is sweetened by monthly payouts, something that tends to always hearten investors.

For now, aside from the P2P platforms, any private credit product being sold to investors in Malaysia can only be accessed by accredited investors.

The pitch must attract them. The product is long-term, providing a high yield and does not suffer from the volatility of say bonds or equities.

The flip side is that there is no liquidity – these products aren’t yet traded on secondary markets.

Furthermore, these products are made up of loans being lent to certain companies. Ultimately, you are then taking a bet on that company, which incidentally, isn’t able to turn to traditional funding avenues for whatever reason.

Then again, the funding gap especially for small and medium enterprises in countries like Malaysia is a real problem.

Private credit goes some way towards plugging that gap. But it is important to appreciate that this newish asset class is high-risk, no matter how much you dress it up. Buyer beware.