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Speaker 1:
Welcome to Beyond the Portfolio. I'm Henry Cohen, US Head of Investments for BMO Wealth Management. And today's episode is focused on private credit, which is a topic I know many of our clients have questions about. It feels like you can't open a browser this week without a new private credit headline. Fortune is calling it a $265 billion meltdown. CNN is asking if private credit could become a public problem. Even NPR is sounding the alarm, so you know it's hit the main street. And this is no longer an obscure Wall Street thing. We're now talking about a $2 trillion market that a lot of you listening either have money in or have been thinking about in one way or another. So the big question is, how worried should we actually be? That's exactly why I'm excited to have Carol Schleif with us today, Chief Market Strategist at BMO US Wealth Management.
Carol, welcome.
Speaker 2:
Thanks for having me.
Speaker 1:
You actually wrote a piece for BMO a couple weeks ago titled Private Credit: Brewing Crisis or Tempest in a Teapot, which pretty much sums up what everyone's trying to figure out right now. So let me just ask you, how much of this is the media doing what the media does versus this being real smoke that could turn into real fire?
Speaker 2:
As we all know, media's business operating model is to generate clicks to generate interaction. And the old saying goes, "If it bleeds, it leads." So there are a lot of these headlines, and you just named off a few of them that are meant to be inflammatory to get people to click on that and to understand the issue. And there's a multitude of issues that make it harder as it relates to private credit. The first one is in the title itself, private, the fact that we don't have the same flow of information on the industry that we do in other industries. Some of them are public in terms of the different vehicles, but a lot of these headlines conflate two very important issues. One is the perceived health of the underlying assets themselves and what's going on in the industry. And the other piece is as the industry has evolved in recent years, it's come to have a variety of different delivery vehicles in terms of how a broader and broader pool of investors access it.
And a lot of the issues that you've seen, a lot of the headlines you've seen around gates and people trying to get their money out relate to the vehicle itself and not to the underlying asset. And we can get into more how we tease those two apart if you want, but I'll turn it back to you.
Speaker 1:
Well, on that topic, do you want to just elaborate on how concerned you are on the semi-liquid vehicles versus the traditional drawdown closed-end vehicles?
Speaker 2:
Sure. I think it's really important to remember too, and maybe we take a step back because part of the reason that the private credit business has evolved the way it has is that it's filled a really important niche that has been out there in terms of giving small and medium-sized businesses in particular access to credit. And what's happened is every time you've had some sort of meltdown, think back to the 1970s when you had farming crisis and SNL crisis and things like that. In the wake of that, regulators come in and restrict the financial institutions and their ability to provide credit. We've had one of those after another, and the most recent that everyone remembers is a great financial crisis of 08, 09, which related mostly to housing and lending and a lot of things that went on there. But what that's meant is it's created an opportunity for a parallel structure to provide lending activities to especially these small and mid-size businesses.
And when it first started to evolve, there was a ready-end buyer market in terms of very long-term institutional buyers, pension funds, insurance companies, people who had very long-term liabilities that they needed to fund. And so for them, having long-lived assets made a lot of sense. As this industry evolved, they wanted to broaden the user base, and so they created more and more different vehicles to provide access to a broader user base. As it's been pushed more towards a retail and a high net worth end user base, if you will, some of those vehicles hinted at the potential to maybe have some liquidity in that. And I think that's part of what has tripped up, if you will, some of the mindset is that typically in some of these vehicles that hint at inability to withdraw part of the funds, the intent of the fund managers to make sure that aggregate requests for that don't exceed a certain amount in any given period.
And think about that from the flip side, if you go to the bank, ask for a 15-year loan for your house, the last thing you want is the bank to come back in a year or two and say, "Oh, just kidding. We need some of that money back." And so as a manager of a pool of funds, these managers really need to make sure that their steadiness and long-term attention. And that's where some of the vehicles that have been created either give the illusion, if you will, that people can get their money back whenever they want, even if they sign documents that say that that's not necessarily the case. So many of the headlines that we've seen in here recently relate to the fact you've seen headlines say such and such a manager is putting up a gate, not letting all the investors get all of their money back, which only makes sense because if the underlying assets are in solid shape, it's hard for them to find assets to sell in order to meet those redemption requests.
Speaker 1:
Thanks, Carol. So on that topic, I mean, you're making me think about two areas of risks within this market. The first is liquidity where there are people who want redemptions and the redemptions would be an illiquid asset. So is that going to result in any sort of forced selling situation that could result in permanent losses? That's the first question that comes to my mind. And then on a second topic is, what about the actual health of the underlying bonds? Are the underlying bonds still good in most cases? And how are you thinking about defaults versus bonds that are not yet defaulted, but are in distress, the things that really could result in investor outcomes?
Speaker 2:
Great questions. And maybe I'll start with the last one first in terms of how much stress is the underlying industry in. It's really important to remember economically that we haven't had a major economic downturn arguably since the GFC, which is almost 20 years ago now. And so aside from the fact that you did have some interim stress and unusual things go on with the pandemic, but by and large, we have a very healthy economy. Most corporations and institutions have very reasonable levels of indebtedness, if you will, because corporations actually going back decades learned their lesson in the late 80s about being overlevered and for the most part are in very solid shape in a lot of different places. That piece is really important to remember that the health is very solid. Part of the reason people look ascance or start to question what's going on in the private markets is the fact that you have, as we talked about earlier, sliced some of the risk out of the main banking system, created this vehicle where you're putting more risk, more highly customized loans, more individual caveats and things written into the loans than you get in some of the other places.
And so that makes people nervous in terms of the underlying credit. You also had a handful of high profile defaults earlier in this year that caused some write-downs in some selected places that the media, again, whipped into a frenzy over and sent the illusion through that the issue of defaults and credit risk was broader than it is. Many people who have been in the industry for a very, very long time point to the underlying health in broad terms of the industry in terms of a certain low level of default is expected as it is among credit card companies, bank companies. They put loan loss provisions on their balance sheets as part and parcel of how they do deals. Private capital is the same. Private capital investors put investments in a variety of companies and expect some of them not to work out and some of them to work out exceedingly well in the bulk to just generate the kinds of returns.
There's nothing unusual going on in the underlying credits. And actually, one of the things we're seeing is some of the headlines are starting to turn just this week or last week where you're seeing some very large operators and managers start to put together either additional credit lines or raise additional funds strategically to go in and to be able to have capital to put to work in the case that there are distressed sales from other managers. Now, flipping to your other question that relates to the gating and can people access your capital? One of the things that we've seen in the last few weeks as investors in general have become nervous about markets in general and how fundamentals are playing out and where their money is put to work. As that concern has broadened out, a headline or two started to hit about gates being hit such that typically what will happen in these funds is investors have the right on a quarterly basis, a monthly or a quarterly basis to request a certain amount of their investment back.
The firm aggregates all of those and then looks at the total amount of requests relative to the total size of the fund. And what's happened in a case or two in here is that the total amount of those requests instigated by fear, I think more broadly across markets in general and wanting to make sure that people have cash to stash under the bed. The requests for redemptions have exceeded the amount that those funds put in place to begin with. A couple of the funds when that first happened chose to either agree to the higher distribution rate, or in one case, one of the key managers, their senior leaders, they put their own money forth to buy the assets and to basically fund those gates, if you will. Then a couple of weeks ago, you had one of the highest profile managers say, "No, we're sticking to the gate because it's imperative for the way we manage a portfolio." And it's also important from a fiduciary responsibility for those that are choosing not to withdraw to make sure that we don't do anything that disturbs the health of the underlying credit here.
So they told the line on that redemption request. And then what you saw in the next week or two were a number of other firms that had had excess redemption requests also tow the lines. And so naturally the media grabs that makes a big deal out of all of these redemption requests in the way that they frame their headlines much the way that the headlines you kick this off with do.
Speaker 1:
That's really helpful. I liked what you said about not forgetting that there is risk in this market and you expect an above zero number of defaults or bonds to be in distressed when you are in this asset class. We shouldn't be surprised if we see a couple. I guess the question is, at what point does it actually become a real problem that changes expectations in a meaningful way? And even though we're not really seeing that in the defaults, we're starting to hear more and more about bonds and distress that are either having restructurings for amend and extend. I agree with your point about the economy being on solid footing. And I guess that leads me to believe if bonds are bad, then what about the equity? What are your thoughts on that?
Speaker 2:
I definitely think that's it because it's important to remember when you think through worst case scenario liquidation and the order of liquidation, the bond holders are a lot farther ahead than the equity holders are. And so there is that issue there and there's a couple ways to attack it. Number one, the opaqueness of the industry is difficult. If investors come in and the hair on the backs of their neck is a little bit raised because of all the other things going on, not being able to access standard Qs and Ks like you do for equity companies is tough because you don't have the same flow of information. So you really have to lean into making sure that the managers that you're working with are doing their due diligence and how they do it and making sure that they weren't rushing to put capital to work.
Because one of the other things that you hear and hear is people are trying to understand the debt that was put in place in the pandemic. As it matures, it's maturing with interest rates at higher levels. We've got conflict in the Middle East that is also adding to bond yields creeping up, which has people fearing some of the underlying credits. And then there's the aspect too of some shops levering some of that activity. So there's a lot of different layers of concern that for investors get all balled up into the mindset of, get me out and I'll ask questions later. And we see this in the stock market. You get a headline through in the stock market and an entire industry will get hit and then people sort through the remains in the following week. And so we urge people, especially as they're thinking through private credit, either investments you have in or contemplating investments to really take a step back to understand that there's a lot of solid underlying fundamentals.
And one of the other things, and I alluded to this earlier that I'm taking more confidence in is you've seen a couple of very large managers really talk about not only the underlying health of the industry, they've taken to the airwaves, if you will. They're trying to push back both in podcasts and interviews and talking through how the underlying fundamentals remain solid, but they're also putting together funds and starting to accumulate stuff specifically to go in and take advantage of some of these because the underlying credit isn't necessarily distressed, but the person holding that credit may decide that they want to continue to make distributions on a quarter to quarter or month to month basis as the requests come in, which prevents them from investing in other assets, which actually if you're a large manager with a well-heeled balance sheet, it's great having less competition for those loans because it means the pricing doesn't get out of whack.
You have the opportunity to create all sorts of interesting investments for your clientele.
Speaker 1:
Carol, I like what you alluded to that we may actually be seeing some opportunities in the space right now with perhaps a pivot towards bonds becoming either distressed or opportunistic. And then some of these large private credit players going in and taking advantage of things also that could result in perhaps some improvement to the market as a whole. You had also mentioned, I think briefly a topic of leverage and some things that are going on inside of the fund. I know the word leverage is always a scary word because that I think triggers feelings of the subprime crisis in 2008. Given that this is a less regulated industry, do you have any kind of thoughts on if there's any chance that this could result in something like the next subprime or something that has broader implications outside of this asset class and bleeds into other areas?
Speaker 2:
That's a great question. And it's one that a lot of the headlines we're seeing allude to, could this start a run or something hit systemically much like what happened in the GFC? And it's important to remember too that with the GFC, you were dealing with a much larger underlying industry, many more and multiples of leverage and many more unique packages, if you will, that were banks were incented to underwrite loans and underwrite more and be loan production factories. They were then sold off, packaged, sliced and diced and rated in very different ways, but you were dealing with an industry that was substantially larger because you referenced this in the beginning about private credit itself being roughly two trillion. There is some lending that banks have done. There's some joint deals that banks do where if they can't underwrite the loan, they work with private credit to bring clients to private credit.
They do some lending behind the scenes to private credit, but still two trillion relates to something like 14 or $15 trillion worth of size in the lending in US markets in particular, and a credit market alone that's just south of $160 trillion worldwide. And one other way to look at it is in this piece that we wrote a couple of weeks ago, we did talk about the commercial real estate market, because if you recall a couple of years ago, there were distinct fears at the commercial real estate market and what was going on there with a default of a California bank rippling through and the potential to ripple through the economy there. People really feared commercial real estate, talked about the loans repricing and extend and pretend and all the other things that went on there. And yet commercial real estate is two and a half or three times as large as the entire private credit industry is.
And yet we've seen lots of properties change hands. A properties in my own city, I'm based in Minneapolis and I've seen A properties here turn in the last few years at seven to 10 cents on the dollar from where they did late last year. And yet I'm sure there were paying an individual banks and an individual balance sheets, but in no way, shape or form impacted the broader economy. And we've gotten some health in some of those. I saw an article just today talking about increasing rents for some of the properties because people bought them on the cheap and were able to upgrade the facilities and now can rent them out at higher levels. And so private credit, it's important to remember that you're talking about credit that's been extended to small and medium-sized businesses. Yes, there's some pain in some of those that relates to tariffs and supply chains and higher costs, but by and large, the one key theme that's come through over and over again in the last five years in the US in particular is the resiliency of our business community and the resiliency of what's going on.
And so to the extent that these private credit managers are putting debt out there, you know that they're getting a look at the inside financials, if you will, that the companies are lending to. So to the extent that you're investing in one of those, making sure that the company that you're dealing with has sufficient capital of its own, isn't over-levered, doesn't have multiple layers of loans with multiple banks, does its homework and its due diligence and is continuing to hold those companies accountable. And it all loops back to the opening thing about thinking that a lot of the headlines are pretty inflammatory and overdone relative to the underlying health of the businesses that are being underwritten.
Speaker 1:
That's well said. I think it's a nice perspective to remind us where we were at just a couple years ago on the commercial real estate fears and what was going to happen for which that could bleed into other areas. And I think what materialized was a lot more muted than the worst case scenarios. You also mentioned something really important about manager selection within the private credit space and all private credit strategies, all private credit funds are not created equal and just how critically important it is to be with real high quality managers who know what they're doing and avoiding some of the others who perhaps don't. Carol, this has been great. I really appreciate you helping us make sense of all this. I think the bottom line is don't let the headlines make the decision for you, but don't ignore them either. Talk to your advisor, that's what we're here for.
And with that, thanks everyone for joining us on Beyond the Portfolio.
Speaker 3:
Thank you for listening to Beyond the Portfolio. You could follow us on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Mike Miranda.
Speaker 1:
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