As private lending has become the hottest asset class in global institutional investment markets, some cracks in the juggernaut are starting to show.
Swiss bank Julius Baer last week announced it would be exiting the private debt asset class after it reported net credit losses of 586 million Swiss francs ($679 million) related to its exposure to Austrian property company Signa. The bank’s CEO, Philipp Rickenbacher, also announced he would step down. The news came on the heels of an announcement that FINMA, the Swiss financial regulator, had started investigating the bank’s relationship with Signa, as well as its risk management procedures.
The losses were bigger than analysts expected, and Romeo Lacher, chairman of Julius Baer Group Ltd., said in a statement, “Our 2023 results reflect our determination to end any uncertainty regarding our private debt business through this full loss allowance.” Lacher also said the bank would refocus its efforts on so-called Lombard lending, a type of loan available to the bank’s wealth management clients based on the strength of their investment portfolios and mortgages.
Problems are coming to light in the direct lending books of other banks, too. Japan’s Aozora Bank Ltd. revealed its 2023 earnings results would take a hit on the back of bad U.S. commercial real estate loans. As CIO recently reported, restructurings are ticking up, and the market for restructuring finance is starting to get more challenging as well.
Shifting Market
Banks operate under a more stringent regulatory regime than non-bank direct lenders, which likely accounts for at least some of why Julius Baer pulled back from the asset class. However, the story of how the bank got in deep with Signa offers some takeaways for investors in private debt funds. According to a Financial Times recounting, the bank made multiple loans to the company that were paid back—until they were not.
Lenders often consider prior repayment track records as part of the underwriting process, and private credit managers are often quick to point out that track record is a big part of their models: They want to build relationships with company founders and sponsors. Building that relationship frequently includes providing them covenant-light loans with terms that favor borrowers.
That model may need to shift in this economic environment. “Private credit has put a lot of money into companies to support them over the past 10 years,” says David Larsen, a managing director in the alternative asset advisory practice at Kroll LLC. “But we’re now in an economic environment where not every investment is going to pay off. Even in the best of times, not every investment pays off.” Larsen says private credit investment teams are not in the business to lose money, but when economic conditions change, it can take time for loan books and underwriting models to catch up.
Emphasis on Diligence
Private credit funds are also fresh off another solid fundraising year, which makes them well capitalized and ready to put money to work. Doug Mintz, partner and co-chair of the business reorganization group at law firm Schulte Roth & Zabel, says this supply/demand dynamic is likely to keep activity high.
“There’s always a risk with a rapidly growing market that credit standards will decline. That pricing for lenders will get worse and that risk will increase,” he says, adding that investors—not just managers—will want to be especially focused on doing their due diligence on those deals, to make sure they are comfortable with the risks non-bank lenders are taking. Private debt deals are typically unrated, and leaning on a benchmark may not always be straightforward or fully representative of a given portfolio.
That diligence is also important because private debt really has not yet experienced a significant downturn, Mintz says. That means it is not totally clear how these funds will react. Using recent periods like the COVID-19 crunch of 2020 may not be a good stand-in for how deals behave under stressed conditions.
“2020 was such a specific and very short period of distress. I don’t think it’s an analog to what we are likely to see over the next couple of years,” Mintz says. “The challenge with private debt is that its rise as an asset class has happened over the past 10 years, and the last meaningful period of distress was over 15 years ago. So people are coming into this without a frame of reference. Private credit did provide a lot of liquidity during 2020, and there are large funds that have been raised recently to focus on distressed transactions. But I don’t think we can extrapolate from those two data points. I think investors will want to focus on due diligence if they want to manage risk.”
Tags: Aozora Bank Ltd., David Larsen, Doug Mintz, Julius Baer Group Ltd., Kroll, Philipp Rickenbacher, Private Credit, Private Debt, Risk Management, Romeo Lacher, Schulte Roth & Zabel
