The Issue at Hand by Madison Investments
Private credit was originally developed to finance loans that were too complex, illiquid, or long-term for traditional banks and public bond markets. It filled an important gap by matching those investments with institutional investors, such as pension funds and life insurers, that could commit capital for extended periods.
Over the past decade, however, the asset class has grown dramatically. Increased demand for annuities, broader retail participation, and the search for higher yields have fueled demand well beyond its traditional investor base, raising new questions about liquidity, valuation, underwriting standards, and portfolio risk.
In this episode, Chris Aleman and Bill Ford examine how private credit has evolved, what has changed as the market has grown, and how investors and their advisors can evaluate both the opportunities and the risks. Whether you’re evaluating private credit directly or through insurance products like annuities, you’ll come away with a practical framework for understanding what you own, why it may offer higher yields, and the questions every investor should be asking.
Key Takeaways
- How private credit emerged to fill a financing gap left by banks and has since outgrown its natural investor base.
- How increased demand has expanded the types of loans being financed, creating risks beyond liquidity alone.
- A practical framework for understanding where the additional yield comes from and the risks that generate it.
- The key questions to ask before investing, including liquidity, valuation, downside scenarios, and where you sit in the capital structure.
The Discussion
Chris Aleman: Hello and welcome back to The Issue at Hand. I’m Chris Aleman, and today I’m joined by Bill Ford, Head of Reinhart Fixed Income here at Madison Investments and Portfolio Manager.
How you doing, Bill?
Bill Ford: I’m doing all right. Thanks for having me, Chris.
Chris Aleman: Today we’re going to be talking about private credit, and I feel like that opens up a can of worms in terms of what we’re talking about. But what we’re trying to talk about is private credit and how investors and advisors can look at simplifying what’s actually happening. I think I want to start there. At the base of this, what is private credit?
Bill Ford: Private credit is lending that is not done by banks and not done in publicly traded bonds, that is usually related or historically has always been related to more complex long term and in some ways, carrying other risks type of lending that banks were not well suited to do, and that didn’t really fit well within the publicly traded bond market.
Chris Aleman: You hit something there – the idea of long-term. And I think to your point, banks probably steered clear of this. So, who were the initial investors in products like this that wanted long-term assets?
Bill Ford: Really, it’s been a lot of the more classic institutional investors. The two main ones would be pension funds and life insurance companies because both of those have extremely long-term liabilities where they have a lot of funding that is locked up for years, if not decades, that they need to be able to try and get a long-term superior yield on. But because the money is locked up for so long, they don’t have to worry about liquidity. They don’t have to worry as much about market moves, and they can deal with a lot more of the complexity and especially the illiquidity of the asset class. And so they’re a natural fit for those investors’ liabilities.
Chris Aleman: When we mention life insurers, I think the initial point that you’re making there is that there was a need for this type of asset, and they had the investors that actually wanted something like this. So that makes total sense to me. Everything seems fine.
So then, what happened when annuities started getting into the midst with private credit?
Bill Ford: What we’ve really seen is that private credit has grown beyond its natural demand in terms of the natural investors for it. It’s also grown in a lot of ways, likely beyond the natural demand of private credit borrowers. So that you’re now seeing a case where the private credit managers are trying to bring in more funding and more money than their traditional investments.
Chris Aleman: Demand has just increased exponentially.
Bill Ford: They’re also trying to push out a lot of the investments being made beyond what has historically been a good fit.
Chris Aleman: What do you mean by that? That they’re trying to push out the investments?
Bill Ford: It’s just a case where the asset class has grown so much from where it initially started off, especially following the pullback of the banks after the Great Financial Crisis. Private credit stepped in to do a lot of the lending that banks had historically done, but no longer were doing. The amount of money that has come into the asset class and the amount of money that is trying to be invested in the asset class has really grown a lot beyond that. And whenever that happens, what you’re going to have is that more marginal investments are going to be made because the next best opportunity to invest is usually the one that you would have left off before, but now you’re going to go and pursue.
Bill Ford: So what you’re starting to see is both in terms of trying to raise the funds and trying to find places to invest the funds. The asset class has, on both sides of that, perhaps grown out a little beyond its traditional borders.
Chris Aleman: Well, then let’s stop there. So when you’re saying it’s grown this much, I feel like a lot of the things that have come out in the news recently, we’re starting to see cracks in that. Whether it’s some of these companies that are actually taking losses, we’re starting to see some of the redemption requests and some of them not even getting fulfilled. So, what cracks are you seeing right now that people should be made aware of?
Bill Ford: I think some of the cracks that we’re starting to see are on both sides of what you were talking about. One is that you are starting to see losses that are related to some of the high-profile bankruptcies or other issues. First Brands has probably been the most high profile and the one that started a lot of conversation about this. Now that was a case where First Brands was relying on a lot of private credit-funded factoring platforms, but ultimately it’s not that a private credit-funded factoring platform is an issue. It’s that First Brands was just a massive fraud.
Chris Aleman: I think that’s the other thing that I want to get across is that, there was a need for some of these types of investments. But it’s again when you have some bad players getting into it, we have to be wary of that.
Bill Ford: And then what you’re seeing on the other side is that private credit has grown in terms of the investor base beyond just a lot of the traditional pension funds and life insurers. And what you’ve started to see there with these business development companies is an effort to expand the funding of private credit managers. Really moving more into more retail types of investors who have not historically had the ability to deal with illiquidity in long timeframes. And so what you’re really starting to see there is either the non-traded business development companies or what you’re hearing a lot about right now, where people are making redemption requests, but by contract, when you invest in one of those, they can limit their redemptions to a percentage.
Chris Aleman: You’re locked in for much longer.
Bill Ford: It turns out that had never really been an issue for retail investors because nobody really had a lot of redemption requests. Now they do, and so now a lot of these business development companies are capping the redemptions to say, “no, 5% is the limit, and we’re going to hold to it”. That on its own is not a bad thing because that is what allows private credit to make a lot of the investments that they do. It’s the idea that the money is locked up. It’s not like in a bank or somebody’s retirement account where they can say “no, I need the money right now”, and you have to give it to them. So, in a lot of ways, that is kind of the point.
Chris Aleman: Well, I think this goes back to your earlier point: demand has just grown so much that the traditional investors, it’s not them anymore. And I think one of the things I want to wrap this back in – what we do here is we also try to say, “here is an example”. We try to say, “hey, what’s the best case for this? What’s the worst case for this?” I don’t want to say it’s all grim. So, when we’re looking at what could potentially help in the current environment for private credit, and I guess related to annuities, what do we need to have happen? Does the economy just need to trudge along and we’ll be fine, or do we need another catalyst to happen? And on the flip side, what happens if we have an economic slowdown? What could potentially happen from there?
Bill Ford: I think we would see that the upside case is that the economy continues to trudge along or muddle along. There will be losses in this asset class; the people managing private credit funds will take losses. It is a riskier asset class than a high quality investment grade bond portfolio, but they also are receiving yield that should compensate them for that.
Chris Aleman: So on that scenario, we’re okay. Some acceptable losses are okay, again, because you’re even compensated for the yield. That makes sense.
Bill Ford: Some acceptable losses are okay. I would advise caution in the sense that for players that are newer or less established and haven’t been doing this for as long, and that are seeing really significant asset growth, I would question: Do they really have that many suitable opportunities, or are they sort of pushing the edges and pushing the boundaries and moving into some of the more marginal opportunities? Which is where you’re going to see losses that are beyond what the yield can compensate.
Chris Aleman: So what happens? I don’t know if it’s the worst-case scenario, but in an economic slowdown? Maybe not even crazy, but just a little bit of an economic slowdown. What happens to these types of assets?
Bill Ford: Again, I think most of them will probably be in a good place. They will certainly see more losses than what you would see in a lot of higher-quality credit types of things. But, again, this is something where if you’re a long-term investor, you’re going to look at it and say the higher yields that I’m able to get over very long time periods will compensate me for the losses I may take in some of these short-term types of credit events and types of credit cycles. Now, backing off to temper that is the idea that since private credit has grown to the extent it has, it has never really been through a full credit cycle where losses are taken and the bad things are cleared out, and so to some extent we just don’t really know how exposed they are to how dodgy a credit that is out there and what they will actually face in an actual credit cycle.
Chris Aleman: Well then in that case, I want to we want to prepare our advisors and our clients. What are the types of questions that either the advisors should be asking about either the private credit industry in general or even their clients asking about how their annuities are structured? What are the types of questions that we should be thinking about?
Bill Ford: One of the first ones that you should ask anytime you’re offered an investment that offers you a lot of additional yield is, additional yield does not come without some type of additional risk, and understanding what are those risks- is it really complexity and structure and liquidity, or is it just worse credit? And understanding what is the risk that is generating that additional yield. You also really want to look at who owns that risk or who takes the first loss on that risk and who’s backing it up, and where do you fit in that structure of when losses happen.
Chris Aleman: What is it? Who owns it?
Bill Ford: There’s questions about how liquid is the investment, but when you’re talking about private credit, one of the whole points of it is: it is by design, illiquid. It is meant to be locked up for a long time, and that in part that’s because these things are so complicated and have all these different risks that it would in a lot of ways be difficult to mark them to market and if they were mark to market every day and people were moving in and out based on that, that just wouldn’t work for the types of investments that the private credit funds are trying to make. Again, how are they valued these are not publicly traded.
Chris Aleman: I feel like we’re going to run into a little bit of an issue in terms of the valuation, but I think again, at a minimum, we need to figure out: what it is, who owns it, how liquid it actually is, and then is there some value to it? I think that’s going to be the summation of what people should be asking.
Well, I think that’s a good place to stop for now. So, I want to thank everybody for listening. I want to thank Bill for joining me today, talking about private credit. For more information and disclosures, please visit MadisonInvestments.com. And if you haven’t already clicked subscribe, please do so. Thank you for joining us today, and take care.