Hedge funds short the giant of the US private credit
This year, US hedge funds have been aggressively shorting private lending institutions and have already made a profit of $1.7 billion.
A few days ago, according to media reports, since the beginning of this year, the seven largest direct lending institutions in the US, such as Apollo Global Management, Ares Management, and Blue Owl Capital, have been under strong attack from short sellers.
According to data from S3 Partners LLC, short sellers have already recorded a paper gain of $1.7 billion from their bets against these institutions.
The operating model of private lending institutions is usually to provide loans to small and medium-sized enterprises. However, with the economic slowdown, the continuation of the trade war, and the deterioration of borrowers' financial conditions, the risks faced by these lending institutions are gradually increasing.
Therefore, hedge funds are betting that these risk factors will cause major problems in the private credit market. Although these lending institutions have always claimed that the market volatility brought by the trade war is a good opportunity for them to seize more market share, their stock prices have been continuously falling in recent months.
Deterioration of borrowers' financial conditions
First of all, one of the major disturbing factors in the private credit field cannot be ignored - the deterioration of borrowers' credit quality.
The International Monetary Fund (IMF) warned last month that the deterioration of borrowers' credit quality has not been reflected in the loan valuations of these institutions, which has brought considerable hidden concerns to the market.
Moreover, the competition among private credit funds in the market has intensified, leading to the compression of loan returns. Many funds have lent to weaker and smaller companies, and these companies are most likely to have problems during an economic recession.
Additionally, many direct lending institutions have not experienced a long-term economic downturn, so it is difficult to know how their loan ledgers will perform in such a situation.
In this regard, Scott Roberts, the senior managing partner of Belvedere Direct Lending Advisors, said: "If we really enter an economic recession, the risks for alternative asset management companies will be very high. If a company's revenue decreases and its cash flow decreases, it means that the leverage ratio increases and the free cash flow will disappear."
Where there is pessimism, there is also optimism. Clay Montgomery, vice president of Moody's private credit team, said that business development companies (a type of private lending institution) have a low leverage ratio, and even if they need to write down their investment portfolios during an economic recession, they still have a capital buffer. However, judging from the stock price performance, the stock prices of asset management companies have generally been weak this year.
The problem of overvaluation of PIK loans
In addition, there is a potential risk that cannot be ignored - the valuation of direct loans. The Bank for International Settlements pointed out last year that among the private credit funds that reported data to the US Securities and Exchange Commission, only 40% used third-party evaluations.
Jeffrey Diehl and Bill Sacher of Adams Street, which manages $62 billion in assets, wrote in a report last week: "There is a large amount of evidence indicating that direct lending institutions, out of optimism and/or their own self-interest, are covering up problem loans, delaying defaults and bankruptcies, resulting in potentially overvalued loan valuations, portfolio yields, and fund returns."
They are particularly worried about PIK loans. Currently, more and more borrowers are choosing PIK loans to cope with cash flow pressure. In traditional loans, borrowers usually need to pay loan interest in cash regularly. But in PIK loans, borrowers use other means (such as equity or debt instruments) to pay interest, which leads to the frequent overvaluation of these loans.
The sample data of BDCs tracked by Bloomberg Industry Research shows that at the end of the fourth quarter last year, more than a quarter of the net investment income came from PIK loans. Ernst & Young wrote in a report last month:"The valuations of PIK loans are surprisingly high. By the end of September, about 75% of them were valued at more than 95 cents on the dollar. This discrepancy has raised questions about the consistency of valuations, especially when compared to the valuations of similar loans in the public market, which are generally lower."#privatemarket