Why is Private Credit So Quiet Right Now?

On March 8th the world changed. (It changed before March 8th, but that’s when things really started to shake in the US). And every private credit investor buckled up. This was the moment we had been waiting for. Where we would be tested for our good we were. Where those who were over extended would get exposed.

We began looking around. Who would take a bath first?

Merchant Cast Advance? Receivable Factoring? Commercial Real Estate? Bridge Lenders? Residential RE? Direct Lenders? Subprime consumer credit? Near prime consumer credit?

The real answer is, we don’t know yet. And we’re in the calm before the storm still.

(1) Who will get hit first?

Investors in hospitality will get hit in a real way. Many restaurants, bars and hotels will never come back. The retail spaces they used to occupy are going to be empty. The employees who used to work for them may leave the city, leaving an over supply of apartments. But this stuff takes time.

Lenders are giving a reprieve on rent. Banks like JP Morgan, Wells Fargo and others have already offered forbearance. The lenders, the landlords and the tenants are going to have 2–4 months to figure things out before there is any real scrutiny.

It’ll likely take 2–4 more pay cycles before consumer credit begins to get hit as a result of layoffs in these spaces. Government stimulus helped, some employment will help, and consumer lenders are allowing borrowers flexibility.

Nothing is going to “break” for another 8–16 weeks here.

More likely, the first lenders to get wiped are going to be merchant cash advance lenders who were financing physical retail, and receivable factoring companies who were over-exposed to affected industries.

Why? Because these assets are short duration.

A long-dated loan can survive a bad 3–5 months. If a 5 year loan misses interest and principal payments for 5 of its 60 periods… it’s a pad 2 quarters, but an OK result. But for a Merchant Cash Advance Business, an entire loan book may have just gotten wiped out.

I have seen MCA books trading at huge discounts. But no one can buy these because no one has any idea how to model out what defaults will look like? 10%? 50%? 90%? I have no clue.

Receivable factoring is similarly short duration. So while we see the best trades in these two spaces right now, the amount of fraud and the uncertainty of what defaults will look like, and a lack of duration to recover the books later makes these hard to bid on.

(2) When will be a good time to buy in private credit?

I don’t know. No one does. But it’s probably not right now.

Most lenders I talk to (and I am talking to a lot of them right now) are saying the following:

· Things seem really bad

· But luckily my borrowers are holding on OK

· “XYZ reason their thesis is safe, unique to each person’s marketing pitch”

· They are not over-levered

· They have a big margin of safety

· They are excited to keep investing in Q3 and Q4 when it’s easier to model out what the world will look like

Some of these lenders are lying to me, and to themselves, because they need to safe face. Many others actually believe themselves. Which means many of the investors who are going to get hit don’t even know it yet. Which means the bid-ask on distressed books isn’t tight enough yet to transact.

For Direct Lenders, they don’t really know what kind of impact the private companies they finance are going to incur? How effective will layoffs be? Who’s going to be able to raise additional equity? Who’s going to see customers churn, turn off subscriptions, and how much will they miss their plan by? For how long?

It’s going to take 2 quarters or more for these loans to go into foreclosure.

In RE, tenants aren’t paying rent, but we don’t know at what rate. I’ve heard 10% delinquency rates, and I’ve heard 85% delinquency rates! Insane! How are you supposed to model that out? No asset owner is going to sell yet, because they’re not being forced to by their LPs or lenders (in private markets) yet, and if there aren’t buyers who are confident in a base case, there is no bid.

Asset-based lenders who fund tech-enabled originators haven’t started to see enough data tape feedback yet. March may have shown early indicators (it likely did). But April will be the first real blow. And May will be even worse. Both the borrowers and lenders are working through a lens of optimism right now. Or at least a lens of hope. There are negotiations happening… reductions of interest, restructurings, equity capital being used to buy back bad loans… but this can only last so long.

My guess is the real issues in these books will be too hard to fix without a major restructure of foreclosure in May, June or July. It’ll take from July through September to actually get these deals done.

And also, who wants to foreclose right now? Courts are closed? And what judge is going to be sympathetic to a lender trying to foreclose on an asset right now?

(3) Be Patient

For a lot of investors, who have waited ten years for a downturn… there is a temptation to pull the trigger. But it’s better to be too late than too early. Just wait… things will break, but it’ll take time. 3–6 months maybe. But there isn’t going to be a snap back of the economy.

Many small businesses are simply closed forever. The government can stimulate a market, but it cannot mimic the real economy. The worst thing investors can do right now is to go too fast.

The line we use internally is: “Are we looking at a trade? Or a Business?” And we don’t do trade, we try to invest in assets that will give us an enduring return for years to come. The trades popping up now are short duration have negative selection bias, are rife with fraud, and will go away. But the investments that appear over time… those are the ones we’ll build our next 5–10 years off of.

[5'9", ~170 lbs, male, New York, NY]. I blog about investing. And usually about things I’ve learned the hard way. Opinions are my own, not CoVenture’s