What's Going on in Private Credit?

**Howard Marks** (0:02)
This episode uses an AI reader. This is The Memo by Howard Marks. What's going on in private credit?
The general field called credit has seen massive innovation over the course of my career. Its popularity has increased steadily, and its scale and role in the world of finance have multiplied. The other day, an Oaktree colleague asked me about the developments that brought the credit sector to where it is today. I came up with the following list. 1970s, acceptance of non-investment grade debt. 1980s, popularization of leveraged buyouts and increased corporate leverage. 1990s, broadly syndicated loans and tranche securitizations. 2000s, the rising trend toward alternative investments, subprime mortgage lending and mortgage-backed securities. 2010s, expansion of direct lending. 2020s, marketing of direct lending vehicles to individual and retirement investors. The investment world I first encountered in the summer of 1968, consisting exclusively of stocks and high-grade bonds, seems quaint and provincial in retrospect, given the developments just listed. These advances have transformed the investment management business, and Oaktree and its clients have been major beneficiaries. All the changes just listed involved, or were facilitated by, the thing now broadly called credit, essentially non-government debt. I'll lay out a brief chronology to set the scene. Prior to 1977 to 78, it was virtually impossible for a company lacking an investment-grade credit rating, Jipple Beer or above, to issue bonds publicly. The speculative-grade debt that did exist was primarily that of previously investment-grade companies that had run into trouble and been downgraded, so-called fallen angels. Companies lacking investment-grade ratings were generally limited to taking out bank loans or borrowing from insurance companies through private placements. Michael Milken is generally credited with the idea, implemented in the late 1970s, that non-investment-grade companies should be able to issue bonds if their interest rates are high enough to compensate for the risk of default. This kind of risk-return thinking helped enable the development of today's US high-yield bond market of roughly $1.5 trillion, along with most of the other developments under discussion here. A few small leveraged buyouts took place in the mid-1970s, but the popularization of high-yield bonds in the 1980s enabled LBO funds, small companies and takeover artists to borrow enough money to acquire much larger companies than was previously possible. That led to a massive expansion of LBOs, creating the industry that renamed itself private equity in the 1990s. The idea of pulling debt instruments and selling off tranches with varying seniority, risk, and thus interest rates began with the creation of mortgage-backed securities in the 1970s, most often associated with Louis Renier of Solomon Brothers, and expanded in the 1980s and 90s. Prior to the 1990s, banks made loans, some of them to non-investment-grade companies, and syndicated them to a handful of fellow banks. But then broadly syndicated loans, leveraged loans, or senior loans were developed by Wall Street. They were sold to institutional investors in large amounts, growing to today's market of roughly $1.5 trillion in the US. The significant increase in the ability to issue this type of financing helped fuel the growth of private equity. After the tech bubble of the late 1990s imploded in 2000, leading to the first three-year decline in the S&P stock index since the Great Depression, investors became uninterested in the stock market and stayed that way for a decade. And when central banks reduced interest rates to fight the resulting economic and market malaise, investors sought returns above those available on bonds. With stocks and bonds out of favor, investors looked for a new solution. They turned to hedge funds and private equity, which had held up relatively well, and the label Alternative Investments was born. Hedge funds couldn't find enough bargain-priced opportunities to accommodate large amounts of institutional capital, so many investors gravitated toward private equity as the solution du jour. The first $10 billion private equity funds were organized. Around the same time, corporate debt began to be securitized in structured credit vehicles, such as collateralized loan obligations, or CLOs. The banks that packaged these vehicles with internal leverage from tranching found eager buyers for both the high-yielding junior classes and the over-collateralized senior classes. The strong demand for CLOs and the profits available from structuring them created a need for loans to securitize, leading to increased issuance of broadly syndicated loans. Many of the same banks packaged subprime mortgage loans extended to questionable borrowers into residential mortgage-backed securities, or RMBS. Remarkably, the bankers were able to obtain thousands of AAA ratings on RMBS backed by liar loans. When the highly flawed nature of these loans and structures came to light, the result was the global financial crisis of 2008 to 2009 The GFC ended with the banks poorer, chastened and re-regulated, and as a result, there weren't enough bank loans available to meet the needs of the burgeoning private equity industry. Investment managers moved to fill the vacuum through non-bank lending or private credit. The fastest growing component was direct lending. Private loans to mid-market, private equity sponsored portfolio companies with sub-investment grade ratings. Please note, private credit and direct lending aren't synonymous. The latter is a subset of the former. The many stories mentioning private credit these days are really about direct lending. I'll try here to be conscientious about making the distinction. Most who comment aren't. Most recently, it has become popular to market investment vehicles holding direct loans to individual investors in retirement accounts. This increased the capital available for direct lending and ballooned the assets under management of managers who scooped it up. The Normal Pattern.