Retail private credit is an unsolvable problem

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Good morning. While war whips oil, stock and bond prices around, it is easy to miss news from the stranger corners of the market. This week, the crypto exchange Kraken was granted access to the Federal Reserve’s payments system, the first time a digital asset dealer was stitched into the traditional financial system in this way. It’s a big moment and we discussed it in yesterday’s Unhedged podcast. Give it a listen and let us know what you think: [email protected].

Private credit cannot square the retail circle

The private credit headlines are not getting better. Just in the FT, and just in the past three days, we have had headlines including “Investors ditch private credit funds on rising worries over bad loans”, “Blackstone’s flagship private credit fund hit with redemptions”, and “Retail investors shun private credit funds after Blue Owl gating”. Normally I would give readers a concise description of what is causing all the ditching, redeeming and shunning. But I don’t have to. My colleague Sujeet Indap has provided an unimprovable one, over at the Lex Column.

I’ll just emphasise a couple of Sujeet’s points. The root of the problem is not “a broad collapse in asset quality”. Private credit loans come, by design, from the lively lower end of the credit spectrum. And the mad rush of money into private capital almost certainly means there has been some hasty underwriting. But the economy is chugging along fine, AI has not destroyed any businesses yet, and falling interest rates are making borrowers’ lives easier. There is no reason to think a credit crisis is afoot (though the set-up for having one at some later point is pretty good). The problem is on the liability side of private credit’s balance sheet — redemptions and how to manage them.

Sujeet also nails it when he writes that “the problem for asset managers is that the size of the future fee opportunity is diminishing as retail customer . . . take fright”. This is why the stocks of the “alternative asset managers” look like this:

These stocks had been priced for years of growth as their products, formerly the domain of institutional investors, were to be let loose on normal folks’ retirement savings.

That looks trickier now. In order to sell an investment product to retail investors, you have to offer them some liquidity. You can’t require a multiyear lock-up, as you can with an institution. The industry standard has settled at quarterly redemptions up to 5 per cent of a fund’s value.

There are two problems. First, just because there is no such thing as being a little bit pregnant, there is no such thing as an investment product being a little bit liquid. At some point in the cycle, no matter how generous the liquidity limit — 5 per cent, 10, whatever — investors will want more. And when they are told “no”, their demands will only increase. Second, you cannot add liquidity to a private credit investment without diluting or destroying its special virtues.

We are seeing the first problem now. Even the shadow of a gentle turn of the credit cycle has enough investors demanding redemptions that the industry’s biggest fund — Blackstone’s Bcred — needed investment from its mother company and its employees to meet the outflows. Imagine, please, what the situation will be when there is a proper decline in the credit cycle or a recession. Passing the hat internally is not going to get the job done then.

The second problem is worse. Illiquidity brings real advantages to private credit: it allows fund managers to work out credit problems over time, rather than being forced into fire sales. And by eliminating the need to mark loan values to market, illiquidity creates the appearance that returns are neither volatile nor correlated with the public markets. But even quarterly liquidity cracks that facade; with liquidity comes the need for reasonably fair and timely marks. This is even true when redemptions are met out of cash reserves, rather than by selling loans. Because if a fund lets anyone redeem at what looks like an inflated mark, everyone will want to redeem at once, and it’s right back to problem one.

Retail private credit will not immediately collapse under the weight of its internal contradictions. It’s a big industry with a lot of inertia. But what we are seeing now are not growing pains. They are symptoms of a chronic disease which will prevent the industry from achieving the growth it once dreamt of.

(Armstrong)

Korea

The Korean stock market, which has had a bonkers year, has had a super-bonkers week. The Kospi sold off 7 per cent on Tuesday, and then another 12 per cent on Wednesday (its worst day on record), before recovering by nearly 10 per cent on Thursday:

The losses look even worse in dollar terms. As with other global markets, US-Iran conflict jitters are part of the story here. Korea is highly dependent on oil imports and traders are forecasting two rate increases from the Bank of Korea this year on inflation risks. But this does not fully explain why the country had such a meltdown. Japan, which is similarly oil-dependent, was much calmer.

In part we are seeing the reversal of AI frenzy in a market dominated by semiconductor companies. “Korea’s equities have benefited from extreme exuberance, perhaps speculative excess, and were due a break. Indeed, earnings expectations had grown sky-high even compared to other AI beneficiaries,” says Thomas Mathews of Capital Economics.

There had been signs that the market was ahead of itself. Korean retail investors have an appetite for risk and speculation, as we’ve written about before. This year in particular, there was a lot of buying on credit; Bloomberg reports that margin debt reached a record high in February. Fundamentals became obscured by the speculative frenzy and war worries provided an excuse to take profits. What would normally be a “technical correction” is magnified by retail participation and quant trading, says Peter Kim at KB Securities.

That said, this was a market event, not an AI event. Chipmakers Samsung and SK Hynix — accounting for 40 per cent of the Kospi — have fallen 10.3 per cent and 9.4 per cent respectively this week, as of Thursday. But non-chip companies such as Hyundai Motor, Hanjin and Kia fell much more.

Can confidence return? The rally’s key drivers, corporate governance reforms and AI, are intact. But investors may not want to play in a market with volatility that would make a cryptocurrency blush. Foreign investors remain net sellers over the past three days even as domestic individuals have resumed buying. As Kim put it:

The Korean market will be much better off by being tethered to global markets again. I like Korea to outperform, but not so much that it creates an unsustainable exuberance . . . 20 per cent, 30 per cent a year will be great. You don’t have to have, say, 60 per cent upside in two months.

(Kim)

One good read

Round trippers.

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