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In private credit, liquidity is bad

The virtues of illiquidity

Bloomberg’s Laura Benitez reports on an innovation coming to the private credit industry:

Apollo Global Management Inc. is seeking to build a marketplace that would allow investors to buy and sell high-grade private assets more easily . . . The alternative asset manager is in discussions to partner with banks, exchanges and fintech firms to deliver real-time information and intraday prices for private credit deals . . . Such a marketplace would allow Apollo to trade and syndicate the debt it originates on a bigger scale and be the first of its kind in modern-day private markets …

“We’re focused on building a true marketplace — open architecture, collaborative and built for scale,” [Apollo’s Eric] Needleman said.

Wall Street likes to move assets around. Trading generates fees. Now that private credit has become its own asset class and investor money is cascading in, it was inevitable that someone would come along with a machine that moves private credit assets around.

This is a bad idea. As Unhedged has written, private credit has five virtues that set it apart from publicly traded assets such as good old high-yield bonds:

There are companies that, for various reasons, are a poor fit for the public bond or syndicated loan markets. They will pay more for debt capital from a private credit fund which accommodates their specific needs, including the need for privacy.

Private credit companies can craft tight debt contracts that protect investors in ways the standard, squishy contracts of the high-yield bond and syndicated loan markets do not.

Loans initiated by private credit are not marked to market, which means lower volatility, or at least the appearance of lower volatility, which lowers those loans’ correlations with publicly traded bonds, stocks, and so on. This improves the (real/apparent) risk-return balance of investors’ wider portfolios.

The bilateral relationship between a private credit lender and a single borrower means that, if the borrower should run into trouble, there is a better chance of a clean resolution than if the debt was owned by multiple parties, each with their own interests and all out to screw one another.

In contrast to bank lending, in particular, private credit funds tend to be less leveraged than banks (one to one versus 10 to one) and do not use deposit funding, so there is less chance of an asset liability mismatch. Private credit might reduce systemic risk.

To the extent that private credit assets are traded on an exchange such as the one Apollo envisages, they are traded at prices. That means they become more volatile, or at least more visibly volatile. That dilutes virtue 3, unless of course the prices established on the marketplace are kept secret and no one is forced to mark their positions to market accordingly, which would be immensely dodgy. This is quite important, because it is not clear that private credit as an asset class generates risk-adjusted excess returns relative to bonds or stocks. In other words, the lack of volatility and correlation may be the whole point of the asset class.

And to the extent that private credit assets become liquid and tradeable — especially if those assets are sliced up into pieces to improve liquidity further — virtue 4 is diluted too, because the relationship between lender and borrower is no longer enduring and bilateral. Who know who the borrower is going to have to negotiate with when things go awry.

There are probably also some questions about virtue 3 and virtue 5 in a real-time marketplace. If private credit firms start doing deals with a liquid market place in mind, do the debt contracts drift towards standardisation? And who knows how leveraged the people buying the loans on the market place will be?

Unhedged is not part of the-next-financial-crisis-will-start-in-private-credit mob. The point here is just that a liquid marketplace makes private credit more like public credit. This means you get the trickier risk characteristics of private lending, with less of its virtues. What’s the point?