How to tackle private credit’s ‘cockroaches’ as contagion fears build
Private credit investors say active portfolio management, tighter lending standards and greater risk discipline are now paramount as the sector navigates rising default rates. After J.P. Morgan CEO Jamie Dimon warned last week of “cockroaches” lurking in private markets, fears of contagion and a potential repeat of the 2008 subprime lending crisis have driven central banks to put the sector under closer scrutiny. But how worried investors should be about private credit “depends,” according to Thomas Friedberger, deputy CEO at Tikehau Capital. “We shouldn’t be worried about the fact there are defaults because private credit, at least on the high yield part of private credit, is about structuring instruments that are risky.” Friedberger said that defaults in the credit market are “normal,” and added that the ways in which private asset managers manage defaults will ultimately make the difference as default rates tick up. “It’s not a 2008-like scenario — for the moment,” Freidberger told CNBC’s “Squawk Box Europe” on Tuesday. He stressed that maintaining discipline on structures and covenants — and ultimately having “boots on the ground” — is key to navigating the current cycle. Private markets have come into sharper focus following the recent high-profile collapses of First Brands and Tricolor in the U.S., both of which relied on complex borrowing arrangements spanning asset-based financing, broadly syndicated loans and private debt. On Wednesday, U.K. lender Barclays became the latest bank to get caught up in the issue, disclosing a £110 million ($147 million) loss resulting from exposure to car dealership Tricolor. U.S. investment bank Jefferies had earlier revealed a $715 million position in auto parts maker First Brands via its Leucadia Asset Management unit. The Chicago Board Options Exchange’s Volatility Index — often dubbed the market’s “fear gauge” — spiked to a near six-month high last week, reaching 25.31 on Oct. 16, amid fears that more regional U.S. banks could be exposed. “When you see one cockroach, there’s probably more,” J.P. Morgan CEO Jamie Dimon said of the recent credit market stress during the bank’s third-quarter earnings last week. “Everybody should be forewarned on this.” Laura Cooper, senior macro strategist at Nuveen Asset Management, said the recent market upheaval ultimately reinforces the need for closer analysis, active portfolio management and “sharper differentiation” between managers. “It’s less a ‘bubble to burst’ than a late-cycle phase where risks are rising unevenly,” Cooper said in a note. ‘Insect repellent’ Now, central banks are turning their attention toward the sector. The Bank of England is preparing to launch a review exploring how less-regulated private equity and credit markets impact the real economy. It will also look at how they might perform during periods of economic turbulence and the potential risks to broader financial stability. The BoE’s high-level system-wide explanatory scenario, which is expected to take between nine and 12 months, will engage with a number of private market firms. “The big question today is: are these cases idiosyncratic, or are they what I’d call the canary in the coalmine?” said Bank of England Governor Andrew Bailey. “In other words, are they telling us something more fundamental about the private finance, and private assets, private credit, private equity sector?” “That is still a very open question—it’s an open question in the U.S., I think it’s a question we have to take very seriously.” Bailey — who was giving evidence at the U.K. Parliament’s House of Lords Financial Services Regulation Select Committee’s meeting on the growth of private markets on Wednesday — said there is a lot that is still unknown about First Brands and Tricolor. “I don’t want to sound too foreboding at this point, but the added reason this question is important is that if you go back to before the financial crisis, when we are having this debate about subprime mortgages in the U.S., people were telling us: ‘No, it’s too small to be systemic’,” he said. “It’s idiosyncratic in that sense and that was the wrong call.” Earlier, Joachim Nagel, president of Germany’s Bundesbank and ECB governing council member, warned that “spillovers” from the private credit market pose a regulatory risk. “We have to take a close look at it,” Nagel told CNBC’s Karen Tso at the IMF and World Bank annual meetings in Washington last week. Friedberger highlighted the importance of alignment of interest between manager and investor. He noted that recovery rates in private credit — especially in direct lending instruments — can go from zero to more than 100% of investor principal. Cooper said private credit still offers “healthy fundamentals, supportive technicals, and attractive yields” for investors. But she stressed the importance of tighter underwriting standards, coupled with a sharper focus on both how and where capital is deployed. “The cockroaches aren’t everywhere, but a bit of insect repellent doesn’t hurt,” Cooper added.
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