Private Equity Didn't Learn Anything From 2008

Our favorite 'vampire squid' is diving deeper into private credit...

According to the Financial Times, private-equity ("PE") giant Blackstone (BX) is close to raising nearly $400 million for its flagship Blackstone Private Credit Fund (or "BCRED").

The extra cash will allow the $52 billion fund to keep making huge multibillion-dollar corporate loans to clients.

That strategy isn't ridiculous by itself. Blackstone is borrowing money to then lend it at a higher rate. Banks use this approach all the time.

The issue is that it's backing its loans with more loans.

You see, the firm is putting some of BCRED's current loans into something called a collateralized loan obligation ("CLO"). Basically, it's packaging a bunch of the loans together... turning that into a financial security... and selling shares of that security to other investors to fund future loans.

If that sounds a bit risky... well, that's because it is.

This exact type of investment vehicle is what caused the Great Recession to be so brutal and complex. Yet, as we'll explain, it seems as though the PE market has forgotten the risks.

Banks and private lenders love to make securities look safer than they are...

Last week, we explained how in 2019, Banco Santander (SAN) bundled thousands of subprime auto loans into a bond product called "Drive 2019-3."

Combined as one security, they were considered safe. And as long as no more than 60% of that portfolio defaulted, bondholders would make their money back.

Since "only" 25% of the auto loans ended up defaulting, everything worked out. That didn't change the fact that a quarter of the portfolio still went to zero...

And that same phenomenon is happening in the private-credit world today.

Blackstone plans to move some of BCRED's loans into a CLO to raise more money. That includes debt from companies such as software maker Zendesk, cybersecurity company Mimecast, and health care management provider Unified Women's Healthcare.

Just like with Drive 2019-3, bucketing all of these loans together makes them look safer as a whole. Even if one loan defaults, it's only a small part of the whole instrument.

Still, this doesn't change the fact that a huge part of the CLO is risky...

The top level of the CLO gets a rating of "Aaa" – the highest possible score – from credit-ratings agency Moody's. The same agency rates approximately one-fifth of the loans in the BCRED CLO as "extremely speculative" or worse.

That's about as low as ratings go before a company is in active default.

And unfortunately, we saw a similar investment vehicle gain popularity right before the Great Recession...

CLOs are structured a lot like collateralized mortgage obligations ('CMOs')...

CMOs were created as a way for banks to offer investors access to varied-risk mortgages. And they ended up being a major reason why the Great Recession was so extreme...

Starting in 2007, many CMOs began including low-quality subprime loans that received safe credit ratings when bundled together... just like what's happening now with CLOs. The only difference is that CMOs were backed by mortgages rather than corporate loans.

Eventually, those CMOs started getting riskier, and the ratings agencies didn't catch on. Rather than just investing in mortgages, CMOs started investing in one another.

That convoluted web made it far harder to understand how risky these instruments actually were.

And when consumers started defaulting on their mortgages, CMO values dropped... causing a chain reaction of investor losses that sparked the financial crisis.

Blackstone's latest foray into CLOs tells us that PE firms are getting desperate...

As we mentioned, about 20% of the BCRED CLO is rated "extremely speculative" or worse. That's way higher than the typical threshold for CLOs that hold publicly traded bonds, which is about 7.5%.

Bank of America projects we'll see the highest annual issuance of private credit CLOs ever next year. So as we head into 2024, this is an important trend to watch. The economy will be walking a fine line as more and more PE firms turn to CLOs to raise cash.

Ultimately, PE firms like Blackstone are playing with fire by adding another layer of complexity – and leverage – to their business model.

If CLOs end up powering the PE market into 2024, it could end with an even more painful recession than we expected.

Regards,

Joel Litman
December 19, 2023