Private Credit’s “Big Short” Moment is Here (Steve Eisman)

Steve Eisman, an investor who predicted the 2008 financial crisis, is now raising concerns about private credit and its potential risks to the market. Private credit involves lending outside the traditional banking system, where companies borrow from private funds or non-bank lenders instead of big banks. This shift occurred after the 2008 Global Financial Crisis (GFC), when stricter regulations made banks more restricted in the types of loans they could make. As a result, the demand for borrowing moved to non-bank lenders, leading to the growth of private credit. The main criticism of this development is that increased banking regulations post-2008 didn't eliminate riskier lending; they simply moved it from a visible sector to a less transparent one, hence the "private" in private credit. This lack of transparency means the full extent of problems in private credit may not be known until they're already unfolding. Many of the biggest private credit lenders are well-known alternative asset managers like Blackstone, Apollo, KKR, Aries, and Carlyle. These firms, which initially gained prominence in private equity by buying and selling companies for profit, realized they could also provide the debt financing needed for these acquisitions, essentially lending money to themselves to buy companies. Today, they raise vast sums from pension funds, insurance companies, and retail investors to issue loans to businesses. These loans often go to smaller, more leveraged, or riskier companies than traditional banks might prefer, allowing private credit firms to charge higher interest rates and offer attractive yields to investors. An important aspect of this system is that private credit firms also borrow money from major banks. This means that instead of banks directly lending to risky companies, they lend to private credit funds, which then lend to risky companies. This adds another layer to the process, but still exposes banks to potential losses if private credit funds struggle. The immediate problem highlighting the risks in private credit is the "SAS apocalypse," referring to a brutal sell-off in the software industry. Many software companies are under pressure due to investor concerns that AI will either reduce their revenue growth (as many platforms charge per user) or render their software obsolete. Steve Eisman notes that private credit is overexposed to software companies, whose valuations have declined significantly due to AI's impact on their traditional business models. Some estimates suggest that 25% of direct lending loans are to software companies, particularly those bought by private equity between 2018 and 2022. Journalism from the Wall Street Journal indicates that many private credit fund managers are downplaying their exposure to software. Software is often the largest industry for these funds, but some firms have been misreporting their exposure. For instance, if a private credit firm funded a healthcare-related software business, they might report it as healthcare exposure rather than software. An investigation found that while four major funds (Blue, Blackstone, Aries, and Apollo) reported an average of 19% software exposure, their true average was around 25%. Blue was particularly misleading, reporting only half its actual software exposure. This suggests that the industry is trying to "massage the data" to conceal the true extent of its software exposure, potentially leading to significant losses if the software industry faces major problems due to AI. The overarching risk is that if AI severely impacts the cash-generating abilities of these software companies, and if they need to refinance loans in the near future at higher interest rates, many may struggle to repay their debts. Given that a quarter of private credit loans are to software companies, this could become a significant problem. This situation also creates a short-term issue for retail investors: illiquidity. Because private credit loans are not publicly traded, they are highly illiquid. While institutional buyers have historically accepted lower liquidity for higher yields, the rise of retail investing in private credit has led firms to offer ways to appear liquid, typically allowing redemptions of 5-7% of assets per quarter. However, with the revelation of software exposure, many investors are trying to exit. Several large private credit funds, including Blackstone's BCRED, Cliffwater Corporate Lending Fund, Morgan Stanley North Haven Private Income Fund, and BlackRock Hend Fund, have received redemption notices exceeding their caps, leading to unfulfilled redemptions. This indicates that the market anticipates loan losses from software and investors are trying to withdraw. The question arises whether this situation poses a systemic risk. Since major banks are involved in financing private credit funds, losses in private credit could lead to losses for banks, as well as pension funds, insurance companies, and other entities with retail exposure. While the impact would be felt and trust in the financial system could erode, Steve Eisman believes it's unlikely to be a GFC-level threat. He notes that the leverage in banks is currently about half of what it was before the GFC. During the GFC, big banks were leveraged around 40 to 1, whereas in private credit (specifically Business Development Companies or BDCs), the leverage has been 2 to 1 since 2018. In conclusion, while the full extent of AI's impact on private credit remains unclear due to the private nature of these investments and the misleading reporting by some firms, it appears that private credit could face significant challenges. If smaller, lower-quality software companies are severely affected by AI and cannot refinance their loans at higher interest rates, private credit firms will likely incur substantial losses, and investors will lose money. However, based on current understanding, the problem doesn't seem large enough to cause widespread havoc in the broader banking system, unlike the GFC.