[1]Breathless headlines confront us daily about the perils of private credit. A place where clueless investors’ equity goes to die and, more broadly, a threat to the safety of our capital markets. Is it the plaything of villainous and rapacious chancers who act without regard to the equity stake of their investors feasting on AUM whilst NAV dwindles? Much of the mainstream media has embraced that narrative and our gloriously elected representatives, from both the increasingly populist left and the right, sensing an opportunity, are climbing over each other’s backs to get on board the denunciation train.
Boy, if that were right, it would indeed be bad. Thankfully, that’s not reality. Virtually all private credit sponsors are honest, smart and hardworking, looking to generate returns for themselves and their investors. Do losses happen? Sure. Indeed, the alternate lending universe is perhaps more sensitive to deteriorating market conditions because of the construction of their capital stack, their use of leverage and higher risk tolerance. A higher risk tolerance is baked into the cake. Private credit has a higher cost of funds than other institutional lenders and that means they need to sometimes take on more risk to earn the higher return needed to pay their investors. The flip side of this, of course, that these investments offer higher returns. This is a feature, not a flaw. Most investors know this (which apparently our political masters don’t seem to appreciate or, if they do, are prepared to ignore it). If someone investing in the space hasn’t figured that out yet, he or she probably needs a keeper and certainly shouldn’t be investing in anything.
We’ve recently democratized alternate investment to permit retail investors in these vehicles and that has turbocharged the “concerns” of our politicians who are delighted to bay about the malfeasance and deviltry of the denizens of Wall Street in a very fact-free sort of way because, well, it plays well with the folks.
Are there reasons to be careful about investing in private credit? Sure. First, let’s agree that well intended, generally competent and careful sponsors make mistakes. They make mistakes in assessing risk, in understanding their borrowers and their borrowers’ business and they make mistakes in projecting (guessing?) market conditions. Sometimes they invest in the wrong things at the wrong time. Losses ensue. Not news.
Most of the marquee losses in recent days are attributable to bad actors. There are some bad actors out there. As Captain Renard said in Casablanca when finding out there was gambling in Rick’s…“I’m shocked…shocked!” There are bad actors in private credit. Frankly, there are bad actors everywhere you look across our markets, our politics and our institutions (if they were all as charming as Max Bialystock, at least we’d get a giggle with our losses). Bad behavior comes with the human condition. Priests, doctors, philanthropists, influencers (I can’t believe that I’m actually recognizing that as a profession, but times change), educators, and, not to be overlooked, our governmental elites all have their fair share of bad actors (okay, politicians perhaps have a slightly higher percentage of these folks). We’ve recently seen a handful of catastrophic losses due to misbehavior which have occasioned substantial notoriety, but these fails actually are few and modest in scale compared to the multi-trillion size of the market as a whole.
In the telling of the news media (at least those rather few media outlets that actually ever even think about markets and finance)and the warblings of our politicians, private credit is a homogenous thing, a dangerous blob. Whether investor’s money is used to finance corporates, real estate, bitcoin or bad Italian movies that have been gifted to the Vatican (yes, I actually did that), all these are seen as the same. The reality, of course, is that every deal, every investment vehicle, every market segment is different and often in ways that are indeed fundamental.
With the media storm and the politicians’ growing fascination with the opportunity to preen and virtue signal around real and perceived malfeasance in private credit, the Eye of Sauron, for now, is largely focused on the corporate private credit market. (Recently, the Dems have demanded a hearing on private credit in 401(k) plans and the Fed is looking at and is showing anxiety about banks providing back leverage to the private credit marketplace. Just to be clear, that’s just the opening salvo of what’s ahead of us.)
I am absolutely certain that this heightened scrutiny, this attention, this investor anxiety and the excitement of our pols will migrate from the corporate sector to the commercial real estate space. What worries me is that the views and nostrums embraced about corporate private credit will be thoughtlessly and mechanistically transposed to the commercial real estate lending sector, and that shouldn’t happen.
Private credit as a whole does not deserve the current vilification it endures, but it’s happening and is likely to get worse. Private credit investing in commercial real estate should not be swept up unthoughtfully in whatever might happen to the broader credit market.
The commercial real estate lending space is different. (I’ll note in passing that sometimes those distinctions are not even highlighted by some prominent sponsors, perhaps because they have multi-strat strategies and picking out the differences might be viewed as implicitly criticizing corporate offerings. Can’t do that.)
Private credit financing commercial real estate is close to a trillion dollar business right now, having stepped into the vacuum caused by the retreat of the banks and inability of the GSEs and the lifecos to materially increase their allocations. It is a vitally important part of the commercial real estate environment and has been functioning…well.
Again, my point here is not to disparage corporate credit but to make the point that commercial real estate is fundamentally different in very important ways that make it less subject to the percussive value destruction that results from unanticipated event risks that often happen in other sectors. Why?
- We’ve Got Dirt. Let’s start with the fact that we have dirt. Dirt is easy to find, hard to misplace and even harder to nick. No one has ever taken dirt across state lines.
- Good Law. Our ability to create first priority mortgage liens on the asset class is supported by very settled statutory and case law. This provided a lot of clarity around our structures and the efficacy of our security arrangements. While some bad actors in other arenas have managed to pledge the same collateral multiple times, it is much more difficult to do so in the commercial real estate mortgage space.
- Diversity. While in the CRE space we absolutely rely on the competence of the sponsor (and anyone in the space knows that the value of good real estate can be effectively destroyed by bad management), the underlying cash flow is embedded (typically) in a multiplicity of leases. This is a powerful engine of diversity. A corporate loan is generally tied to the performance and balance sheet of a single borrower whose structure, organization and business will likely be complex and can significantly impair credit quality. Get it right, all’s good; get it wrong…disaster. In a commercial real estate transaction, risk is diffused across multiple leases. While individual tenants may suffer the same level of complexity and opaqueness that haunts the balance sheets and results of operation of corporate credits, the large number of tenants which characterize commercial real estate lending transactions ensures that the fail of one tenant in most cases will not impair the performance of the mortgaged assets as a whole.
- Simpler Structures. CRE structures tend to be less complex than corporate exposures and that’s largely because the collateral is simpler and more homogeneous across the entire sector. There are less moving parts, less heterodox assets in which a perfected security interest must be created. To only slightly misquote the Ragin’ Cajun, “It’s a mortgage, stupid.” CRE security documentation is pretty uniform; a note, a mortgage, an assignment of rents and a bad boy guarantee. That’s less complex than what often is needed to perfect security interests to backstop corporate exposures.
- Recourse. From my days in the distressed debt world, I was always of the view if I controlled the cash and had recourse to a warm body, lender would win. While P&I recourse is as unusual in the CRE space as in any other, CRE has a very strong and well established bad boy guarantee structure and we’ve seen almost no degrading of the protection that the bad boy provides across market cycles where discipline has been well maintained even when competitive pressures have been enormous. In contrast, the corporate market has a much more heterodox approach to recourse.
- Underwriting. There is a very large body of custom, usage and learning around the underwriting of commercial real estate exposures. We’ve been doing it for a long time and have done it over trillions of dollars of CRE exposure. Our trade organization, the Commercial Real Estate Finance Council, effectively promotes best practices. It promotes common underwriting standards, common disclosure regimes and provide a forum to address issues that impact investors, servicers, securitizers and portfolio lenders in the marketplace. Through this process, issues are identified and addressed. This facilitates a level of uniformity and a certain ruggedness that makes our structures more durable.
- Cash Management. The companion of recourse helping to ensure that lenders get repaid is cash management and cash management is characteristic of the CRE lending market. Yes, there is variability; yes, there are things called leaping cash management (frankly, an oxymoron) but reserves and control of the cash are much more characteristic of the CRE markets than any other.
- Disciplined Covenant Structures. The covenant structure in corporate credit is considerably variable. Not so in CRE. Documentation and covenant structures in commercial real estate lending tends to be more homogeneous. In some measure, again, is brought to us by the work of our trade organization, the requirements of our ratings agency friends and custom and usage. Note that while the ratings agencies only rate securitizations, the discipline of the underwriting and diligence process associated with securitization has been disseminated widely through the portfolio lending marketplace and created best practices which are highly uniform across the entire CRE lending landscape.
- Talent Reservoir. Everyone has heard that real estate is different, because it is. The community that makes, packages and invests in commercial real estate loans is generally focused exclusively on the commercial real estate space. There are no asset tourists in our space. The business is rather ring walled from a talent perspective and this creates a deep reservoir of experience and skills which is second to none (talking my book as a long-term member of the business). Moreover, it’s been scientifically proven that the folks in the commercial real estate finance space are nicer than in any other sector.
Private credit is getting a bad rap with isolated bad outcomes woven into a narrative that is more political than strictly economic. Private credit is important to the economy, it de-risks the banks and distributes credit risk across a large investor community. It is not snake oil. The private credit that funds commercial real estate is among the least risky sectors in the broader market.
I worry that problems in other sleeves will begin to impair private credit lending in the commercial real estate space (remember that notion that it’s just big old blob?). One of the lessons of the GFC was contagion. I painfully remember assuring friends and colleagues that what was going on in the no-doc, cov-lite, sub-prime residential mortgage world would never affect the staid, careful, lower risk commercial real estate space, and yet it did. What happened after the GFC was bad. Anxious investors fled the CRE market in an instinctive involuntary muscle twitch sort of way. The investor base took quite a while to come back. In the meantime, considerable damage was done to our markets which could have been avoided.
Watching the rising tide of both public and political anxiety around private credit should impress upon us the importance of making the case forcefully that our sector is a safe place to go to invest. In the GFC, our politicians were delighted to find a new drum to beat on, and beat on it they did. We saw the creation of law and regulation that, while providing a brief feel good sugar high and impressed the folks, but produced little efficacious risk reduction. Worse, it imposed costs and created inefficiencies in the market which ultimately impaired capital formation. We got pain for little gain.
This could happen again. It’s important for those who think that the commercial real estate private credit business is a responsible and important part of our broader credit markets to man the barricades early.
[1] I apologize for the interregnum as Italy and the beach intervened, but I should be back to my normal cadence from now on.