Barbarians at the Redemption Gate

When interest rates are pushed artificially low in the midst of constantly-increasing costs of living, the avenues by which average Americans save and grow their wealth are limited. Frugality—demonstrated by spending less than you earn and socking away a portion of your income in bank CDs—becomes an exercise in frustration as widespread price inflation eats away any nominal increase in wealth.

In the ensuing search for higher yield, average Americans are pushed to take more risk in order to earn returns that have a chance of outpacing relentless price inflation.

A few years ago, this dynamic was exemplified by the collapse in commercial real estate valuations, especially in the apartment sector. After years of aggressively soliciting the funds of average Americans to purchase and develop apartment complexes—many poorly built and in awful areas—asset managers promptly saw apartment values decline below their corresponding loan balances. In a great number of cases, those average Americans lost their entire investment.

However, in a coordinated effort to avoid loss of their own capital, the most well-connected real estate asset managers and lenders lobbied the Federal Reserve and federal government for special favors, notably access to cheap loans originated from money newly created at the expense of those same taxpaying Americans. The authorities eagerly complied.

Today, the same story appears to be playing out in the private credit sector. And as distress builds there, the same resolution—access to cheap, newly-created money provided at the expense of the taxpayer—is likely to be pursued again.

Private Credit

As companies go about the business of pursuing profits, they must acquire the materials and personnel to do so. This often requires them to borrow money. Conventionally, this type of borrowing—especially for firms that are not already huge—is done through banking channels. A company officer calls up a banker, explains the need for a loan, and the banker and his committee decide one way or the other based on a thorough credit analysis.

Private credit aims to bypass this process by lending investor capital directly to corporate borrowers. On its own, there’s nothing nefarious about this. Non-banks are perfectly capable of performing a thorough credit analysis, raising capital, and allocating it as they see fit, depending on their particular risk-reward framework. 

But today’s private credit industry is not quite so benign. In the context of widespread asset bubbles, artificially-low interest rates, and aggressive inflation, the average American “retail investor” is easy pickings for slick asset managers whose talents comprise salesmanship above all else. That’s because those asset managers pitch—to a cohort that has plenty of money but very little discernment—high yields, quarterly returns, and diverse exposure to corporate credit within private credit offerings.

There are at least a couple catches here. 

First, the quality of the credit in which the capital is being invested is only discernible to someone with the skill to evaluate it. The average American investor in these funds is therefore flying blind, simply responding to marketing gimmicks as opposed to a fundamental understanding of where their money is going.

Also, the funds are somewhat illiquid. Investors can’t simply sell out anytime they want and expect to get their capital back. That brings us to the current situation.

The Gate

Earlier this year, one of Blackrock’s private credit vehicles, HPS Corporate Lending Fund (“HLEND”) received redemption requests from investors equal to 9.3 percent of its total shares. This is a remarkably high number of investors who wanted their capital back at once. Blackrock promptly limited redemptions to 5 percent of total shares quarterly, a process known as “gating.”

Around the same time, Blackstone’s private credit fund (“BCRED”) received redemption requests equal to 7.9 percent of their shares. Blackstone responded by injecting additional capital into the fund via direct contributions from Blackstone’s corporate balance sheet and senior staff.

Soon after, Cliffwater’s Corporate Lending Fund experienced redemption requests equal to 14 percent of total shares. Cliffwater also gated their investors at 7 percent quarterly.

Similar episodes occurred at various other private credit vehicles managed by large firms like Morgan Stanley, Blue Owl, Ares Capital Management, Apollo, and KKR.

In each case, gating redemptions at 5-7 percent and various liquidity support measures were taken to ensure that investors were not able to get their money out as and when desired.

Cockroaches

Regardless of the reasons behind the redemption requests, it is reasonable to conclude that prudence requires gating those redemptions at a certain level, especially when the investments were marketed as not entirely liquid. Allowing unlimited redemptions would create a first-mover advantage to investors in times of distress, likely compelling a run on the respective funds. And because the underlying assets are not liquid, redeeming investors on the spot would require widespread fire sales and large subsequent losses.

However, it is also true that apathy breeds laziness. When asset prices only go up—almost entirely because of inflationary monetary policy and not, in any material way, because of fundamental underlying health—the average investor loses their critical faculties, such as they are. A race to the bottom ensues, chasing yield at the expense of safety and familiarity.

The extent of this has been seen recently in the failure of two companies that were customers of the private credit funds. Tricolor and First Brands were utterly incapable of making profits. As it turns out, both were fraudulent. There are certainly many more such cases. As one of the primary lenders to fraudulent companies, JP Morgan CEO Jamie Dimon described Tricolor and First Brands as cockroaches—indicating many more are yet to be discovered.

Misaligned Interests

The essence of the problem in private credit is a conflicting set of interests among the players involved combined with an environment of excess liquidity in capital markets brought on by the Federal Reserve.

Asset managers are compensated primarily by how much capital they can deploy, not the quality of their investments. They are therefore compelled to raise as much money as possible from the fiat-wealthy—but generally clueless—retail investor segment. 

Retail investors, for their part, are forced to seek out opportunities that provide higher yields—at least on paper—because bank CDs and similar instruments are yielding less than nothing on a real basis as a result of the permanent policy of artificially-low interest rates enforced by the Federal Reserve and US government. This means, of course, that retail investors venture into areas about which they have no clue, making them easy pickings for the slick flim-flam salesmen at the investment banks and asset managers operating these private credit funds.

The likely outcome of the growing distress in private credit is more money-printing by the Federal Reserve, bailing out the firms engaged in shoddy lending. As expected, the average Americans who invested in these funds will end up paying for their poor decisions through ever more inflation.