(Bloomberg) -- Hedge funds are betting that trade wars, a shrinking economy and rising strain among borrowers will begin to hit private credit in the US. So far, the gamble’s paying off.
Short sellers have made about $1.7 billion on paper so far this year from wagers against seven of the biggest direct lenders, including Apollo Global Management Inc., Ares Management Corp. and Blue Owl Capital Inc., according to data compiled by S3 Partners LLC.
While direct lenders have touted tariff-induced volatility as a chance for them to grab a larger slice of the debt market, their share prices have fallen in recent months on policy and economic uncertainty. Adding to the headwinds, the International Monetary Fund warned last month of concern among market participants that borrowers’ deteriorating credit quality has not been reflected in the industry’s loan valuations.
Alternative asset managers are “very exposed if we do have a recession. If company revenue falls, cash flow falls which means leverage goes up and free cash flow goes out the window,” said Scott Roberts, a senior managing partner at Belvedere Direct Lending Advisors.
Ares and Apollo declined to comment. A spokesperson for Blue Owl directed Bloomberg to the company’s most recent earnings call, in which Co-Chief Executive Officer Marc Lipschultz noted that choppy credit markets can give companies more incentive to borrow from private lenders.
S3 says there’s evidence that ebbing volatility has led to profit taking recently by the short sellers, who borrow stock and sell it in the expectation of buying it back at a lower price later.
Vulnerable Borrowers
Market participants are also worried about fierce competition between private credit funds pushing down returns, and that a focus on loans to weaker and smaller companies exposes them to borrowers most vulnerable to a recession. Many direct lenders have never been through an extended downturn, they add, making it harder to know how the loan books will perform.
Others are more optimistic. Business-development companies, a type of private lender, are “low-levered vehicles, so they have solid embedded capital cushions if recession does hit and they have to mark down their portfolios,” said Clay Montgomery, vice president in Moody’s Ratings’ private credit team.
Shares of asset managers have broadly been weakening this year. Firms like Apollo and Ares have private equity units, and any short sales could be tied to a bet against the outlook for other money management businesses.
But valuations in direct lending remain a concern. Just 40% of private credit funds reporting data to the US Securities and Exchange Commission use third-party appraisals, the Bank for International Settlements pointed out last year.
“There’s substantial evidence that suggests direct lenders — through optimism and/or self-interest — are camouflaging problem loans, postponing defaults and bankruptcies, leading to potential over-statement of loan valuations, portfolio yields, and fund returns,” Jeffrey Diehl and Bill Sacher of Adams Street, which manages $62 billion of assets, wrote in a report last week.
They raised particular concerns about loans issued on the assumption that borrowers would pay their interest in cash, but were then changed to let them defer those payments.
Creditors are increasingly turning to these costly notes, known as payment-in-kind. More than a quarter of net investment income at a sample of BDCs tracked by Bloomberg Intelligence was made up of PIK at the end of the fourth quarter of last year.
“PIK loans are often valued surprisingly high, with approximately 75% valued at over 95 cents on the dollar by the end of September,” EY wrote in a report last month. “This discrepancy raises doubts about the consistency of valuations, especially when compared to similar loans in the public market, which are often valued lower.”
Week In Review
Bond issuance picked up in the US as sentiment stabilized. Debt sales in Europe from investment-grade companies and financial firms hit the highest weekly total since February, while the US high-grade market’s $38 billion far surpassed the prior week’s $25 billion.
Among the notable issuers, Alphabet, the parent company of Google, sold $5 billion of notes. Goldman Sachs Group Inc.’s private credit fund also tapped the US high-grade bond market this week, selling $1 billion of notes.
Wall Street banks finally got the last of Twitter’s buyout debt off their balance sheets. A group of banks led by Morgan Stanley sold the last $1.2 billion of debt tied to Elon Musk’s social-media platform, now known as X Holdings Corp., which cost $44 billion, including $13 billion of debt.
When the dust settled on April, US corporate bonds had essentially gone on a wild ride to nowhere. US investment-grade and junk bonds finished essentially unchanged in a month that saw huge initial declines from President Donald Trump’s planned tariffs, then a recovery after he paused the levies.
Whirlpool Corp. was cut to junk by S&P Global Ratings and Moody’s Ratings, which cited potential pressure from tariffs and the company’s relatively high debt load.
Apollo Global Management Inc. and other investors have bought the first known bonds that offload risk from bank loans extended to private credit funds known as business development companies.
Nscale, a startup that is less than a year old, is already trying to raise about $2.7 billion to build artificial intelligence infrastructure on the back of a pending partnership with ByteDance Ltd., the Chinese owner of TikTok.
The bonds of department store Saks Global Enterprises sank deeper into distress earlier this week after a call with management fell short of reassuring investors’ concerns about its financial outlook.
Clearlake Capital Group is in talks with both banks and private credit funds to replace short-term financing for its buyout of Dun & Bradstreet Holdings Inc. and potentially contribute more equity into the deal.
Carlyle Group Inc. is nearing a $464 million sale of bonds backed by music rights for artists including Katy Perry, Keith Urban and Benny Blanco.
Sunnova Energy International Inc., a seller of rooftop solar-panel systems, is in discussions with its creditors to borrow money to finance a potential bankruptcy.
The sale of the bankrupt DNA data bank 23andMe is facing delays as the company tries to find a lead bidder that can quickly clear regulatory hurdles and guarantee customer privacy rules will be honored.
There were also a few ratings changes this week. S&P Global Ratings downgraded small-appliance maker Conair Holdings to CCC+, predicting weakened operating performance this year because of increased US tariffs.
Whirlpool Corp. saw its credit grades cut to junk status by Moody’s Ratings, which cited weak consumer demand, a slow housing market and the company’s high debt load.
There was some good news, too. S&P said it’s no longer considering cutting Boeing Co.’s debt to junk status, citing the planemaker’s $24 billion cash balance and other factors that give it a cushion to absorb future difficulties.
On the Move
Brad Dunkin is joining Morgan Stanley as the head of North America special situations group sales based in New York.
BDT & MSD Partners alum Adam Piekarski is starting anew and has formed Derby Lane Partners, a new real estate credit investment firm, according to a person with knowledge of the matter.
Vikram Rai, a veteran municipal-bond strategist, left Wells Fargo & Co. earlier this month.
JPMorgan Chase & Co. is hiring Rommel Medina, a longtime municipal-bond underwriter from Barclays Plc, as well as Ty Savastio, a public finance banker from Morgan Stanley.
--With assistance from Dan Wilchins and Rheaa Rao.
