High-Yield Was Oxy. Private Credit Is Fentanyl.

Illustration by Gracia Lam

Illustration by Gracia Lam

Investors are hooked, and it won’t end well.

Private equity assets have increased sevenfold since 2002, with annual deal activity now averaging well over $500 billion per year. The average leveraged buyout is 65 percent debt-financed, creating a massive increase in demand for corporate debt financing.

Yet just as private equity fueled a massive increase in demand for corporate debt, banks sharply limited their exposure to the riskier parts of the corporate credit market. Not only had the banks found this type of lending to be unprofitable, but government regulators were warning that it posed a systemic risk to the economy.

The rise of private equity and limits to bank lending created a gaping hole in the market. Private credit funds have stepped in to fill the gap. This hot asset class grew from $37 billion in dry powder in 2004 to $109 billion in 2010, then to a whopping $261 billion in 2019, according to data from Preqin. There are currently 436 private credit funds raising money, up from 261 only five years ago. The majority of this capital is allocated to private credit funds specializing in direct lending and mezzanine debt, which focus almost exclusively on lending to private equity buyouts.

Institutional investors love this new asset class. In an era when investment-grade corporate bonds yield just over 3 percent — well below most institutions’ target rate of return — private credit funds are offering targeted high-single-digit to low-double-digit net returns. And not only are the current yields much higher, but the loans are going to fund private equity deals, which are the apple of investors’ eyes.

Indeed, the investors most enthusiastic about private equity are also the most excited about private credit. The CIO of CalPERS, who famously declared “We need private equity, we need more of it, and we need it now,” recently announced that although private credit is “not currently in the portfolio . . . it should be.”

But there’s something discomfiting about the rise of private credit.

Banks and government regulators have expressed concerns that this type of lending is a bad idea. Banks found the delinquency rates and deterioration in credit quality, especially of sub-investment-grade corporate debt, to have been unexpectedly high in both the 2000 and 2008 recessions and have reduced their share of corporate lending from about 40 percent in the 1990s to about 20 percent today. Regulators, too, learned from this experience, and have warned lenders that a leverage level in excess of 6x debt/EBITDA “raises concerns for most industries” and should be avoided. According to Pitchbook data, the majority of private equity deals exceed this dangerous threshold.

But private credit funds think they know better. They pitch institutional investors higher yields, lower default rates, and, of course, exposure to private markets (private being synonymous in some circles with wisdom, long-term thinking, and even a “superior form of capitalism.”) The pitch decks tell of how government regulators in the wake of the financial crisis forced banks to get out of this profitable line of business, creating a massive opportunity for sophisticated underwriters of credit. Private equity firms maintain that these leverage levels are not only reasonable and sustainable, but also represent an effective strategy for increasing equity returns.

Which side of this debate should institutional investors take? Are the banks and the regulators too conservative and too pessimistic to understand the opportunity in LBO lending, or will private credit funds experience a wave of high-profile defaults from overleveraged buyouts?

Companies forced to borrow at higher yields generally have a higher risk of default. Lending being perhaps the second-oldest profession, these yields tend to be rather efficient at pricing risk. So empirical research into lending markets has typically found that, beyond a certain point, higher-yielding loans tend not to lead to higher returns — in fact, the further lenders step out on the risk spectrum, the less they make as losses increase more than yields. Return is yield minus losses, not the juicy yield posted on the cover of a term sheet. We call this phenomenon “fool’s yield.”

To better understand this empirical finding, consider the experience of the online consumer lender LendingClub. It offers loans with yields ranging from 7 percent to 25 percent depending on the risk of the borrower. Despite this very broad range of loan yields, no category of LendingClub’s loans has a total return higher than 6 percent. The highest-yielding loans have the worst returns.

The LendingClub loans are perfect illustrations of fool’s yield — investors getting seduced by high yields into investing in loans that have a lower return than safer, lower-yielding securities.

Is private credit an example of fool’s yield? Or should investors expect that the higher yields on the private credit funds are overcompensating for the default risk embedded in these loans?

The historical experience does not make a compelling case for private credit. Public business development companies are the original direct lenders, specializing in mezzanine and middle-market lending. BDCs are Securities and Exchange Commission–regulated and publicly traded companies that provide retail investors access to private market platforms. Many of the largest private credit firms have public BDCs that directly fund their lending. BDCs have offered 8 to 11 percent yield, or more, on their vehicles since 2004 — yet returned an average of 6.2 percent, according to the S&P BDC index. BDCs underperformed high-yield over the same 15 years, with significant drawdowns that came at the worst possible times.

The above data is roughly what the banks saw when they decided to start exiting this business line — high loss ratios with large drawdowns; lots of headaches for no incremental return.

Yet despite this BDC data — and the intuition about higher-yielding loans described above — private lenders assure investors that the extra yield isn’t a result of increased risk and that over time private credit has been less correlated with other asset classes. Central to every private credit marketing pitch is the idea that these high-yield loans have historically experienced about 30 percent fewer defaults than high-yield bonds, specifically highlighting the seemingly strong performance during the financial crisis. Private equity firm Harbourvest, for example, claims that private credit offers “capital preservation” and “downside protection.”

But Cambridge Associates has raised some pointed questions about whether default rates are really lower for private credit funds. The firm points out that comparing default rates on private credit to those on high-yield bonds isn’t an apples-to-apples comparison. A large percentage of private credit loans are renegotiated before maturity, meaning that private credit firms that advertise lower default rates are obfuscating the true risks of the asset class — material renegotiations that essentially “extend and pretend” loans that would otherwise default. Including these material renegotiations, private credit default rates look virtually identical to publicly rated single-B issuers.

This analysis suggests that private credit isn’t actually lower-risk than risky debt — that the low reported default rates might promote phony happiness. And there are few things more dangerous in lending than underestimating default risk. If this analysis is correct and private credit deals perform roughly in line with single-B-rated debt, then historical experience would suggest significant loss ratios in the next recession. According to Moody’s Investors Service, about 30 percent of B-rated issuers default in a typical recession (versus fewer than 5 percent of investment-grade issuers and only 12 percent of BB-rated issuers).

But even this may be optimistic. Private credit today is much bigger and much different than 15 years ago, or even five years ago. Rapid growth has been accompanied by a significant deterioration in loan quality.

Private equity firms discovered that private credit funds represented an understanding, permissive set of lenders willing to offer debt packages so large and on such terrible terms that no bank would keep them on its balance sheet. If high-yield bonds were the OxyContin of private equity’s debt binge, private credit is its fentanyl. Rising deal prices, dividend recaps, and roll-up strategies are all bad behaviors fueled by private credit.

Private credit funds have innovated to create a product that private equity funds cannot resist, the ideal delivery vehicle for the biggest hit of leverage: the unitranche facility, a single loan that can fully fund an acquisition. This kind of structure can be arranged quickly, does not always require multiple lenders, and is cost-competitive. These facilities, unlike collateralized loan obligations, do not require ratings, so lenders face no ratings-based restrictions on their lending. Until recently, this structure had primarily been targeted at smaller acquisitions that were too small to be financed in a first- and second-lien structure in the leveraged loan market — so it filled a gap. But unitranche deals are now rivaling large leveraged loans: Both Apollo’s and Blackstone’s private debt businesses have announced that they see growth in the private credit market and are targeting loans in the billions.

And like bad addicts, private equity firms demand more debt with lower quality standards to fund their buyouts. Private equity firms have demanded that private credit firms make larger and larger loans relative to EBITDA; they adjust EBITDA to make those loans even bigger; they drop covenants and other lender protection; they renegotiate any loans that go bad to keep the privilege of lending to a given sponsor’s deals.

Private equity firms have been paying higher and higher prices for deals in an increasingly frenzied market for small businesses. Average deal valuations are now about 12x adjusted EBITDA, and possibly as high as 16x GAAP EBITDA — much higher than the previous peak, in 2007. Along with these higher prices have come demands for ever-higher leverage levels. Increasing competition between syndicating banks and between private credit providers has caused lenders to accede to higher debt levels and more-permissive credit agreements.

Private equity firms have been pushing egregious adjustments to their definitions of EBITDA to increase initial leverage and make covenants less restrictive. The result is that true multiples are likely one to two turns higher than reported. These add-backs are questionable at best: The evidence thus far is that leveraged borrowers have not been able to hit their EBITDA projections. According to S&P Global Ratings, EBITDA for 2016 private equity–backed issuers came in an average of 35 percent lower than projected, with a third of issuers missing by 50 percent or more. Zero percent exceeded projections in 2017, and a puny 6 percent managed to surpass them in 2018.

Lender protections have been getting progressively weaker. After analyzing just how weak these covenants have become since the financial crisis, Moody’s recently adjusted its estimate of average recovery in the event of default from the historical average of 77 cents on the dollar to 61 cents.

Maybe all of this would be okay if private equity firms were buying phenomenal companies and improving their operations. But private equity firms have been purchasing increasingly worse companies. In 2019, for the first time the majority of private equity dollars went to companies that were unprofitable, according to data from Empirical Research Partners.

And the operational metrics have been less than stellar. Moody’s tracked 309 private equity–backed companies from 2009 to 2018 and found that only 12 percent had been upgraded, whereas 32 percent had been downgraded “mainly because they failed to improve financial performance as projected at the time of the LBO or experienced deteriorating credit metrics and weakening liquidity.” As for upgrades, half of them occurred after the companies had been taken public.

Private credit is the fuel for private equity’s postcrisis boom. New private credit funds seem to arise every day to issue loans to this increasingly hot sector of the market, but the old hands are issuing warnings. “They think any schmuck can come in and make 8 percent,” Tony Ressler, co-founder and chairman of Ares Capital Corp., one of the best-performing BDCs, told Bloomberg. “Things will not end well for them.”

Today private equity deals represent the riskiest and worst-quality loans in the market. Banks and regulators are growing increasingly worried. Yet massive investor interest in private credit has sent yields on this type of loan lower, rather than higher, as the deteriorating quality might predict. As yields have fallen, direct lenders have cooked up leveraged structures to bring their funds back to the magical return targets that investors demand. Currently, we suspect that a significant number of private equity deals are so leveraged that they can’t pay interest out of cash flow without increasing borrowing. Yet defaults have been limited because private credit funds are so desperate to deploy capital (and not acknowledge defaults). Massive inflows of capital have enabled private lenders to paper over problems with more debt and easier terms.

But that game can’t go on forever.

Credit is a cyclical business: Lending practices continue to deteriorate until credit losses cause lenders to pull back.

When banks provided most of the debt, pullbacks happened only if banks tightened their lending standards. In a world where institutional investors provide most of the capital, they occur when fund inflows dry up. At that point, the market resets to take account of losses that no longer seem so theoretical.

Default cycles require not just insolvency, but also a lack of external funding to give highly leveraged companies another chance. If there is no funding source to replace that which is lost, then the weakest companies default, trading and credit losses mount, and fund flows get even worse. This is a version of what Ben Bernanke in his famous paper termed the financial accelerator: A crumbling leveraged loan market and private credit market would affect not just the institutional lenders providing loan capital; it would quickly ripple through to the private equity funds, as sub-investment-grade loans are the lifeblood of that industry.

In a recent paper, Harvard Business School professor Josh Lerner warned that “buyout effects on employment growth are pro-cyclical.” He and his co-authors argue for the existence of a “PE multiplier effect” that “accentuates cyclical swings in economic activity” and “magnifies the effects of economic shocks.”

This is exactly why banks and regulators — like those addicts who, by dint of grace and hard work, wean themselves off their addiction — have avoided the booming business of lending to fund private equity. It’s time for institutional investors to consider the same.