Depending on who you speak to, today's Friday Letter topic is either “the two sweetest words in the English language”, or something that is better not talked about: default.
The first interpretation is a piece of genius from Homer Simpson. The second is the attitude of most private credit funds when it comes to discussing the issue of non-performing loans on their books.
Nobody denies that defaults will happen. It's inevitable that not all facilities will come good, as unforeseen circumstance or misguided credit underwriting cause stresses and strains. That's what risk is all about.
Just as obviously, most private debt funds have no intention of building a portfolio filled with casualties. But neither are they immune to default risk. Some are currently involved in high-profile deals that are going through painful restructurings. Think Towergate, Caesars or RadioShack. Like most things in life, having to declare failure is far less attractive than marking success.
But acknowledging problems and moving to workout is an essential part of the process: for an institution let alone an individual. It's important for the asset class too. At present the silence around bad deals is unhealthy for the private credit industry.
Some market participants are dealing with the issue. In 2006, Medley Capital launched two credit funds, Medley Opportunity Fund Ltd and Medley Opportunity Fund LP. Both were badly hit in the financial crisis, and held a mixed bag of investments, which included some asset-based lending and equity stakes in companies. As things soured it became clear that action was needed. So Medley acknowledged that it didn't have the equity expertise to get the best recoveries for its investors and, with their approval, handed the responsibility for the assets to Crestline-Kirchner, a private equity group in Gadsden, Alabama.
Yet most times when you ask debt funds about the default rate in their portfolios, some will tell you how they haven't had any defaults at all. Others will clam up and refuse to give even a ballpark figure. “It's much lower than our competitors”, they might say. Or even only that's it's “low”.
One legitimate follow-up question would be this: low relative to what? Funds that compare themselves to banks and other large financial institutions with huge historical datasets, diverse credit portfolios and big balance sheets which can absorb losses are probably using an inappropriate yard stick. Even if you narrow it down to the leveraged loan market or middle market bank default rates only, you're not comparing like-with-like.
Alternative lenders should publish their default rates to enable meaningful comparisons with each other. The banks do it, and so should they. This will be painful for some, but it will produce a healthier market in the long run. Regulators are turning their attention towards non-bank lenders, so stepping up with publicly available statistics could mean the difference between positive dialogue with authorities or an antagonistic relationship that could potentially restrict the growth of alternative financing.
If private credit is to shrug off that pejorative tag of 'shadow banking' and take its place as a viable and permanent alternative to bank lending, there must be more transparency, including widely accessible information about default rates. It's part of growing up.