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The private credit markets are drawing a good bit of attention these days with Blue Owl
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Capital being the poster child for the issues. A sector built on low interest rates and
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plenty of liquidity, the industry is hitting a bit of a rocky road right now. One that has some worry that maybe a
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bubble is forming. Itai Goldstein is professor of finance here at the Wharton School.
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He joins us to discuss what's been going on and what is ahead. Itai, thanks for your time today.
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Thank you. It's good to be with you. So we are seeing defaults, we're seeing redemptions.
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What is behind all of this in the private credit market right now? Well, there is a lot going on, starting
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from all these funds giving loans that in the past banks used to give. But nowadays, given that banks are constrained, this
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lending is moving on to other intermediaries. And these are these private credit funds which
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are giving those loans. Now, those loans are typically not very liquid. So when you're giving these loans, you should
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not allow the underlying investors to be able to take the money out whenever they want.
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And initially, those funds were organized as closed -end funds, which basically means that investors cannot
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redeem. But over time, in order to attract more investors, they became kind of semi-liquid, they
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call it, which means that investors will be able to take some money at some point
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in time. And now, when you combine these things together, you have investors who want to take their
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money out, and you have the underlying asset, which is illiquid. That's kind of the old problem in finance.
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You're creating liquidity, and it works as long as it works. But then if people lose confidence in it,
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then we start seeing this dynamic of a panic. Right. Because some of the collapses we've heard about
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are in a variety of sectors. So it's something within the structure of the company that is the issue with the loans
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that they're getting, correct? Yes. I think there is a combination here. It is true that you see problems across
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sectors. However, I think what ignited the whole cycle is everything related to AI, and the fact
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that AI is now going to put software companies, which were once very promising, but now
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they're going to be put in trouble because of that. Many of these loans were given to software
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companies. So that's kind of the fundamental economic shock that ignited that. But then when you put it on top
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of the structure of private credit, with the underlying asset being illiquid, and people have occasionally
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an opportunity to take their money out, all of a sudden they say they want to take their money out.
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And this is what sparked the flame. The collapses, from what I read, also could potentially have downstream impact on banks and insurers
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as well. Yes, that is certainly part of the concern. The private credit funds in and of themselves
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might not be as big to cause a systemic concern. But the problem is that they are interconnected
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with banks and insurance companies. So some of the institutions that are providing
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the funds to these private credit funds to begin with are insurance companies and banks.
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When you start thinking about financial crisis, you know where you start, but you never know
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where it's going to end. It's kind of like a domino, and you never know how big the shock is going
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to be and how it's going to spread. And that's the concern, that some of the other institutions, banks and insurance companies, are going
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to be affected, and that might cause bigger problems. So in terms of Blue Owl, the first
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quarter saw a pretty sharp retreat by investors. Is this a little bit of panic setting
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in? Is the level of concern overstated, or is there a level of worry that really does
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play out here? So I think it still remains to be seen whether it's overstated or not.
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Certainly, it has some of the ingredients that are very familiar for people who are watching
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financial crisis and studying financial crisis. As I mentioned, there is a fundamental shock,
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in this case, AI and software companies. And then you have a structure that has some form of a liquidity mismatch.
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And once this takes hold, then you can start seeing redemption. And then because of interconnection, it can become
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bigger and spread throughout the financial system. So I would say it's still early to
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tell whether this is overstated or not. There is certainly a reason for concern.
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There are some factors that are mitigating the concern. I mentioned the liquidity transformation, but one thing
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we do have in this sector is they are not allowing unlimited redemptions. Unlike in banks, if people come to the
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bank, everyone can take their money out overnight and the bank has nothing left.
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In this case, they're only allowing 5% every quarter and so on. So it's mitigated by this.
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And this is also what makes it a little bit of a slow-moving panic, slow -moving run, because people know they can't take
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their money out at any point in time. So they're kind of waiting. So I would say it's still ongoing.
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There was a panic in the beginning of the year, as you mentioned. Nowadays, it seems to be winding down a
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little bit. So hopefully it will end without a big catastrophe. But I think it's still early to tell.
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There's also, from what I read about this, the concern around some of the valuations that
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are involved here and whether or not the valuations are being overstated to a degree as
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well. Yes, that is absolutely true. I mean, those loans, in general, are difficult
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to value. Those are private loans and you need to make all sorts of assumptions about the viability
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of the borrower, about the likelihood of default. So those things, in general, are difficult to
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value. They're not traded on a frequent basis. So it's hard to tell exactly what the
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value is. And there has been some concern that all sorts of accounting issues might make this look
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better than it actually is. And certainly this is contributing to the panic. Now, with the closed-end structure, you also
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get this feature that the underlying asset may be valued at some amount, but then when
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people are trading the shares of the fund, they're willing to pay less. And then you have this discount to net
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asset value where the shares of the fund are traded at a price that is lower than what people currently think is the net
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asset value. And we see those things in play now. And certainly they speak to the fact that
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there is a lot of uncertainty and concern about what is the underlying value. So, Itay, obviously the word bubble is being
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thrown out there. Is there a level of concern to that point that there is a bubble forming?
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Or is that a bit of an overstatement, at least right now? So, there are many possibilities for a bubble.
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I think if you take a step back and you think about the overall stock market, there is certainly a big concern of a
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bubble there. And this is fueled by the large amount of AI investment that was going on over
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time and what AI investment might also do to some other firms whose business might be
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disrupted because of AI. Now, private credit could be a different kind of bubble, but it's certainly related.
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And if you're thinking about maybe we'll be starting to see a crash in the stock
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market because of AI or at least some decrease in valuations, then this can certainly spill
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over to what is going on in private credit. And those problems can then reinforce each other.
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So, I will say when people talk about a bubble, I think they're talking about it
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in a more general way than just private credit. Private credit is more of a structural problem
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with lack of transparency, with liquidity mismatch and those things might contribute to each other.
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So, I would say private credit is probably part of the big puzzle of the overall
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fragility that we are exposed to right now in financial markets. Right. So, what do you think is kind of
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the state of the private credit markets at this point? And what then do you want to see
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play out as we move forward here? So, I think overall the state of private credit is probably not great at the moment
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because there was a lot of enthusiasm about it before the recent episode. People saw that as a booming area and
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kind of a new way to provide credit and overcome all the difficulties that we have
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with the banking sector. But certainly everything that we saw now gave a lot of people pause.
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So, I think it will take some time for the private credit segment to overcome all
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these concerns, all these doubts. It will certainly take some time. Whether we see a big crisis or not,
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I think certainly the seed of doubt is there and people are going to hesitate more
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before putting more money into it. So, I would say overall it doesn't look as good as it did before the recent
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episode. Itai, great to talk to you again. Thank you very much, sir. All the best.
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Okay. Thank you very much. Thank you. Wharton Professor Itai Goldstein.