Let's get to the big story.
Breakdown.
While the $1.8 trillion private credit industry showing cracks for years, direct lenders have been aggressively financing the software boom, with some estimates tying up 40% of sponsorbed loans in the tech sector, while warning signs are already flashing.
Blue Owl Capital permanently halted quarterly redemptions for one of its retail-focused private credit vehicles and in turn dragging down heavyweights like Harris Blackstone and Apollo.
Now UBS strategists are sounding the alarm.
Warning that if AI triggers in aggressive disruption, defaults could surge from current lows to a staggering 15%, drawing comparisons to the 2008 financial crisis.
Well joining me on this Friday morning to weigh in is Dan Rasmussen, founder and managing partner of investment firm Verad advisors.
Good morning, Dan.
Thank you so much for joining me.
So there are plenty of opinions surrounding Blue Owl.
So do you think this is an isolated incident, or do you think this could potentially be the start of a wider contagion?
Look, private credit for years, if you think about its origin, came out of the 2008 financial crisis.
In the wake of the 2008 financial crisis, the Federal Reserve and regulators told banks they could no longer engage in this type of risky lending.
And so Apollo and Aries and all of these other firms leaped into the market to say, you know what, this is a great opportunity.
We can make these type of risky loans, and it's going to end better for us than it did for the banks in the 2008 financial crisis.
That was the origin story.
And now we're seeing that origin story come right back around with folks saying, well, gee, you're engaging in just the type of bad behavior that these banks did, and it's ending in predictably the same way.
And Dan, I do want to get your take on the catalyst here.
We're hearing a lot of opinions that skeptics including JPMorgan CEO Jamie Dimon and also Mohammed El-Erian saying that they see echoes of the run up to the 2008 financial crisis.
So tell me about what you believe is the catalyst here and how exactly does the recent boom in artificial intelligence also push those specific borrowers towards potential default.
Yeah, so I think the first thing you have to understand when you enter lending markets, markets are efficient, is that higher yields predict higher default risk.
And for years private credit said, hey, we can earn higher yields with no more, no additional risk.
Uh, but in reality they were taking big, big additional risk.
What was the risk they were taking?
Well, most private credit loans go to back leveraged buyouts in the private equity industry, and probably about 40% of those leveraged buyouts were somehow related to software.
So what you're seeing now is people are looking and they're saying, wait a second, if 40% of these loans were to software companies, and these software companies. are all under major threat from AI disruption.
You know, what are those loans really worth?
And because these loans are to small private equity backed companies that nobody's ever heard of, it's really hard to reassure investors that things are OK.
The asset class is way too opaque, and that opacity, the private nature of it, is exactly what's.
Creating this big fear in the market, and it's justified fear because those loans, such a large percentage of them were done to companies with no assets and often no profits.
They were done on the basis of recurring revenues, and now we're seeing those recurring revenues might not recur, and you've got no assets and no profits to back them up.
It's a big problem. and almost on a daily basis it does seem as though we hear about plenty of companies investing and funding artificial intelligence and of course this week the focus was on Nvidia's earnings, but I do want to ask you about UBS just revising the worst case scenario and also warning that defaults could leap from around 4% today to a staggering 15%.
So what do you make of that?
And do you think they're just overreacting?
And what about the street?
Potentially severely underpricing this risk.
Look, I think, you know, as I said, you know, higher yields predict higher default rates, uh, and we've got a very long history of that.
You can see, uh, credit ratings and yields relative to bankruptcy rates over 100 years across multiple cycles from folks like Moody's and who have this data, uh, and what you find if you look at that data, is that folks that have been lending at the yield levels.
Spread levels that private credit is lending in a crisis, we'll see bankruptcy rates north of 25%.
I think 15% is conservative.
I think 15% is if there's no economic crisis, right?
If, if we just have a, if it's just isolated to this sector, fine, it's 15%, but if we see any macroeconomic turmoil, the numbers could jump quite a bit.
And while I have you here, I do want to ask you about interest in particular paid in kind interest because we are looking at that creeping back to post pandemic highs.
So why do you think investors should be paying close attention to this metric and what does this actually tell you?
Yeah, so paid in kind interest is when you say, well, I'm not going to pay you any cash interest, or maybe I'm going to pay you half of my cash interest normal rate would be, and instead you're just going to add the money to my loan, right?
It's like a consumer saying, I'm not going to pay my credit card bill and you can just put the interest on the loan, right?
I mean, it's not a good sign, right?
I think everyone knows it's not a good sign, and the more the pick goes up, the more you realize that these lenders, that these borrowers don't have the cash flow to support it, which was obvious at the inception that these companies were too small, too risky. too low margin to support the amounts of debt.
This is $1.82 trillion of debt placed on the smallest, riskiest companies in the US that nobody's ever heard of that are often bearing, you know, 64 to 6 times recurring revenue in debt, and there's, there's no profit, there's no assets.
It's crazy.
It's been crazy for years, and I think now that interest rates have risen and there's this AI fear to cause concern about terminal values, we're seeing the chickens come home to roost.
And then hard to believe, but we are about to kick off the month of March next week.
So do you want to finally get your take on M&A as well as what we're seeing in terms of insurance capital.
So do you think the force of a healthier deal making environment could potentially rescue some of the lenders out there before loans go bad.
No, you know, private equity and private credit had this halo effect where everybody thought they were the best asset classes in town, uh, the private, private meant better, private meant long term thinking, and now people are saying that private meant small, illiquid, and risky.
Uh, and as a result, you're, you're seeing fundraising for these types of vehicles plunge, uh, and if fundraising is plunging, um, you know, who, who's the next buyer, right?
You gotta remember that, you know.
40% of these deals, private equity deals get sold to other private equity firms, so fundraising slows.
The exit path gets smaller.
It's a, it's a recurring, right?
It's got this recursive element, right?
The worse the returns are, the worse the fundraising is, the worse the exit environment, the worse the returns.
We're just entering the early part of that spiral.
This is the first time that anyone's publicly said it much negative about private equity or private. credit and I think the cycle is finally turning and so I don't expect a recovery here for years, right?
This is like, this is, think of, think of energy stocks in 2016, right after the big selloff when oil prices crashed.
The recovery didn't come really for 5 or 6 years, right?
And I think you're going to see that type of long term winter in private assets as the bloom comes off the rose.
Well Dan, thank you so much for joining us on this Friday morning.
There's a lot of noise out there, so thank you so much for simplifying this today.
My pleasure, thanks for having me on.
