‘Good times lead to complacency’: Legendary investor Howard Marks is latest to flag private credit
Some of the biggest names on Wall Street are growing increasingly skeptical about the booming private-credit market, including JPMorgan Chase CEO Jamie Dimon and DoubleLine CEO Jeffrey Gundlach.
You can now add legendary investor Howard Marks to the list.
In his latest client memo, the Oaktree Capital Management co-chairman warned that the collapse in September of US-based car-parts maker First Brands and auto-lender Tricolor Holdings is exposing the lax due diligence that can happen in a rapidly growing market.
“The key observation is that good times lead to complacency, risk tolerance, and carelessness, as people bid aggressively for assets and compete to make loans,” Marks wrote. “And then, bad times expose the results of that carelessness, as investments that were entered into without an adequate investigation and margin for error fail to hold up in a hostile environment.”
To put it more succinctly, “many flawed decisions…are made in booms and exposed in busts,” Marks added.
According to a report from Moody’s last month, US private credit assets under management have tripled over the past decade, far outpacing other forms of credit. And banks have been focusing on growing their loans to non-depository financial institutions (NDFIs), which reached $1.2 trillion at the end of June.
This includes about $300 billion to private credit providers, which has helped accelerate the growth of the sector.
“As banks compete with non-bank lenders and simultaneously finance them, asset quality challenges may surface,” Moody's wrote. “The recent bankruptcy of Tricolor shows that bank lending to NDFIs can result in significant losses, and underwriting and collateral controls can fail even when loans are secured.”
Marks argues that the problem isn’t really systemic — meaning that there isn’t anything inherently wrong with the lending market — but rather "systematic," which points to a recurring behavioral issue that arises in the financial markets during specific periods.
“In simpler words, there’s nothing wrong with the plumbing,” Marks said. “But imprudent loans and business frauds often occur in clusters for the simple reason that people who make investments and loans are highly prone to error in good times.”
Red flags are getting overlooked
The Financial Times reported on Monday about the proliferation of small, specialized rating agencies, or “second-tier shops” that have now “shot to prominence by catering to the booming private credit market.”
This has led to concerns that private capital groups are using these specialized agencies to “shop” for the most favorable rating scores.
And as private credit has grown into a $3 trillion alternative asset class, Marks senses that investors have become more risk-tolerant, which can sometimes lead to mistakes that aren’t made when they’ve become more risk-averse.
These mistakes can especially happen in sub-investment grade investing.
He points to the red flags that were there with First Brands, including the fact that it was a company that had only been operating for six years but was already reporting $5 billion in annual sales. The company was also reporting profit margins that were higher than industry averages.
Marks also noted that First Brands was “controlled by an individual with almost no media references or online profile,” and the company had “a significant litigation history, including allegations of misconduct.”
In explaining how a company with these red flags could still get financing, Marks explained that “private credit often involves companies that don’t file disclosure documents with the SEC,” which means that investors have to rely on information provided by bankers and auditors.
It is only after taking a position in a company when investors get access to the company’s “data room.”
Oaktree had taken a small position and began looking further into First Brands last summer. While the red flags “weren’t conclusive” since the full scope of problems were only exposed after the company’s bankruptcy filing, “these observations hinted at weaknesses and suggested problems,” Marks noted.
“In investment research, conclusions usually aren’t compellingly obvious, but instead built up from inferences and probabilities,” Marks wrote. “It’s not a matter of one decisive discovery at an ‘aha moment’ but rather the assembly of individual snippets of information into a ‘mosaic’ that leans toward a conclusion based on what in law is called ‘a preponderance of the evidence.’”
He said that Oaktree has the scale that allowed it to dig deeper with its research, but also pointed to the fact that “a thorough job of credit research costs the same whether you’re considering investing $50 million or $500 million.”
Marks added that while “private credit has been the rage of late, all else being equal, it’s great to hold public debt that can be exited more readily if you sour on the credit.”