Recent weeks have seen increased attention on the private credit markets following the defaults of Tricolor and First Brands. While these are two idiosyncratic stories, their failures have prompted broader concerns about weakening lending standards amid a backdrop of private markets saturated with excess capital.
Tricolor
Tricolor is a subprime auto lender that served mostly low-income Hispanic communities in the Southwest United States, with limited or no access to traditional bank credit. The company’s business model unraveled as delinquencies rose, and allegations of accounting irregularities and fraud surfaced. Tricolor allegedly over-pledged the same collateral and misstated documentation used in borrowing base calculations. The company filed for Chapter 7 (liquidation) bankruptcy, and its default has led to significant write-downs across several bank lenders and ABS investors.
First Brands
First Brands is a large auto-parts manufacturer that grew significantly in recent years through an aggressive acquisition strategy. The Company attempted a broad capital structure refinancing in August, but further diligence revealed multiple concerns including a highly opaque corporate structure, a significant reliance on factoring, and irregularities around receivables and collateral. First Brands filed for Chapter 11, leading to steep losses for receivables investors and the first and second lien loan tranches.
Market Impact
There have been some significant market reverberations as investors are rightfully concerned that two high profile cases of potential fraud and significant losses to creditors have occurred within a 6-week period in private markets. And there are clear commonalities between these cases, including weak governance, excess leverage funding aggressive growth strategies, and off-balance sheet financing.
The fact is that the growth in private credit, particularly over the last 5 years into a multi-trillion asset class, has led to a sharp rise in competition and the need to deploy capital, irrespective of the quality of the opportunity set. As a result, traditional credit metrics, such as interest coverage ratios across private credit are significantly worse than public borrowers. This begs the question – is the current premium in private markets sufficient? We believe this uptick in stress is important to monitor given the aggressive growth in the asset class, its leveraged exposure to lower quality credit, and the general lack of transparency.
Credit Reaction
In recent weeks, we have seen significant selloffs in the equities of business development companies (BDCs). Some of the highest profile names in the sector have experienced 15-35% drawdowns, and the stocks now trading at steep discounts to NAV. BDCs are often viewed as a proxy for private credit, and this weakness could be a sign of trouble brewing beneath the surface in the private space. At this juncture, market discourse reveals that investors are questioning the marks on the loans in these portfolios.
The impact on broad public credit has been more contained, though there are pockets of weakness among certain areas:
- Issuers with exposure to private credit (BDCs) saw credit spreads widening by 30-70bps week-over-week across investment grade issuers, particularly in the BBB- to BBB space.
- Investment grade Banks with auto and credit card concentrations underperformed vs. diversified banks by 20-30bp week-over-week.
- High yield monoline lenders and specialty finance companies lagged the broader index by 75-100bps on average.
- Even highly rated Insurers have seen volatility in FABNs (Funding agreement backed notes) amid concerns around increased exposure to structured/private credit. For example, Athene/Global Atlantic, an A+ rated private equity backed annuity insurers, has been underperforming peers by 15-20bps week-over-week.
RPIA Positioning and Perspective
RPIA has no direct exposure to Tricolor or First Brands. Across our portfolios, we are conservatively positioned in this tighter spread environment. While we do not believe these two defaults signal the start of a broad-based default cycle, they do highlight the risks in a late-stage credit cycle where an abundance of capital is available.
Although we have previously held BDC positions, we reduced and monetized our exposure to this sector considerably over the past year. The sector has outperformed materially compared to banks. Several factors, including lower base rate, diminished private risk premium, rising defaults, and global trade uncertainties, all pose additional headwinds to this space. As of today, our BDC exposures are effectively hedged or near zero across all funds. In the Financials segment of the market, we are primarily focused on high conviction names and larger, diversified global systemically important banks rather than smaller community and regional lenders.
