Private credit: Performance vs. liquidity

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Steve Dulake: Welcome to J.P. Morgan's Making Sense. My name is Steve Dulake, Co-Head of Global Fundamental Research, and today we're going to discuss what's happening in private credit, where the market stands right now, what investors are focused on, and what we may see next from regulators as the asset class moves through a period of price discovery. Joining me for today's conversation is Jake Pollack, Head of North American Credit Trading and Global Credit Financing. Jake, you bring a unique and real-time view into portfolio positioning and market dynamics. So it's great to have you back on the podcast.

Jake Pollack: Steve, it's great to be here with you again.

Steve Dulake: Let's dive right in. Um, there's been a lot of conversation around private credit lately. As a high level first question, how are you thinking about the state of the market today?

Jake Pollack: Yeah, so I think there's, there's two separate but related issues dominating the private credit narrative, uh, today. One, is investor liquidity, and the second is underlying performance. So liquidity hadn't been an issue for a long time in private credit until the advent of retail vehicles. In a nutshell, these vehicles have raised money from predominantly high net worth investors, and the funds offer 5% liquidity per quarter to investors. Recently, investor redemptions have exceeded that 5%, and several of these vehicles have capped redemptions at 5%. Now, this is a feature, not a bug. It's actually a good thing for long-term holders who are not redeeming their interests, because it protects the fund from having to monetize illiquid investment at, at suboptimal prices to meet liquidity needs. But it's, it's bad for sentiment whenever you have headlines saying investors, you know, can't get their money out. I do think it's important to zoom out a bit. Only about 15% of direct lending AUM actually sits in retail vehicles. The vast majority of the 1.8 trillion, uh, in direct lending sits in institutional hands, and there's very long-term capital i- in those hands. The, the more important question is performance and how we think that's gonna change over time. Now, that's where it gets a bit tricky. Default rates today are actually pretty low. They're, they're below historical norms for leveraged lending. We do think default rates are gonna increase from here. Part of that is just mean reversion. And that's even before you layer on potential hits from, you know, sectors that might be disrupted by, by AI. A- and we are focused on specific sectors, software, services, and a few others, and, you know, we think investors are too. Spreads are starting to widen in direct lending to compensate for those risks, and we think that's appropriate.

Steve Dulake: What about investor focus? Last year, it was PIK, payments in kind. This year, it has been the proportion of software loans and private credit portfolios. Given your oversight of the financing business here at the firm and the window it provides to you into those portfolio exposures, what are you able to share with respect to both PIK and software loans?

Jake Pollack: Yeah, so PIK is something we've been focused on for some time. Much of it has actually been underwritten that way, where the PIK is really kind of like a, a, a kicker, almost an equity kicker on top of the cash portion of the coupon. Now, th- this isn't to minimize the issue. You know, when interest rates went up in 2022, the ability for, for a borrower to kind of toggle their coupon payment to either cash or payment in kind became a more prominent feature in credit markets. And when we do hit a cycle, people should expect an increase in these loans flipping to payment in kind, which is a credit negative. So it's something we're focused on, but, you know, we think it's quite manageable today. Software, to your question, uh, it, it's about 20% of private credit. Services is another sort of like 20% or so. T- these sectors have generally been some of the best performing sectors, but investors are increasingly concerned that AI can disrupt these business models. Um, as I've mentioned, we haven't seen this in the revenue and EBITDA numbers yet, but we are tracking things like pricing, customer retention, and other KPIs to get a forward look into the health of these businesses. I think o- one last point, in the, in the BSL market, about 14% is software and technology. Um, now th- th- that, that's a pretty healthy dataset, about 250 billion worth of loans. And that, that broader segment is trading at kind of north of a 750 basis point spread to maturity. And it does auger for a f- a, a, a state where a percentage of that cohort will ultimately, you know, be distressed or, or have to restructure. So, you know, I, I think the public markets are telling us that there, there are certain pockets of software that, that you should be worried about, and we are certainly focused on that in our own exposures.

Steve Dulake: In terms of our own financing and portfolio exposures, what can you share with listeners about the marking rights that we have and how we exercise them?

Jake Pollack: Yeah, so J.P. Morgan has always had marking rights. We mark on the basis of the performance of the collateral, and we also adjust marks based on spreads in the market. We did this in 2020, we did it in 2022. What I would say is in past cycles, J.P. Morgan has marked earlier than maybe some others in the market. And I think our clients have seen us behave quite rationally when things get dislocated. Uh, I think one, one good example of this is how we behaved in the middle of COVID, right? We actually grew our business substantially, and we had multiple clients ask us to refinance them out of other facilities, you know, during that time. Uh, and I actually see a lot of similarities, you know, today to 2020 and 2022. So I think, you know, it's really a through cycle question. J.P. Morgan will be there for our clients through cycle when things are good and bad. And I think that's a very important thing both for GPs and for LPs.

Steve Dulake: How are you thinking about regulators on the go forward? Do you expect any changes in their focus, and is it something that you're preparing for?

Jake Pollack: Yeah, you know, it's an interesting question. I think, you know, growing up at this firm for the past 22 years, I, I always expect, you know, regulators to focus on our businesses. Um, and as markets grow, and certainly private credit has grown, it's rational to expect an increased focus. So, you know, I, regulatory focus doesn't really worry me. We run a very strong business, so we're always, you know, we, we always expect oversight and we, and we plan for it. So yeah, I think as the, the market continues to grow and there's more, uh, you know, uh, exposure to an asset class, you're gonna naturally see more of a look from the regulatory community, and, you know, the, I think the industry, uh, is gonna continue to, uh, to embrace that.

Steve Dulake: So Jake, we hosted a very successful business development company conference, um, in our offices. You actually participated in the event. Um-

Jake Pollack: Yes.

Steve Dulake: ... Kabir Caprihan, who was the main host who, um, for those of you that don't know, is our lead on the credit side in terms of bank and non-bank financial coverage, his main takeaway was that we are likely in a price discovery phase for the next one to two quarters in the absence of a pickup in deal flow as lenders and borrowers recalibrate to the repricing we've seen. Additionally, not many software loans mature before 2028. Do you agree with that summary?

Jake Pollack: Yeah, I do. I, I think, um, it, it's a good point. So the, the software loans I mentioned, there's sort of a 750 basis point, uh, spread to maturity in the public markets. And, you know, I think both in the public market and in private credit, the 2028 to 2029 maturity wall is a big factor. So it, it is unlikely that you're gonna see a material amount of restructuring or default activity before that time. These companies have generally been performing well and the cash flows have, have a recurring nature to them. 2028, 2029 is when you're gonna start seeing some discussions with the sponsors who purchased the companies. And, you know, certainly in the 2021 cohort of certain software loans, you had very high multiples paid for businesses. Um, it, it is, it is clear that in certain circumstances, those multiples may have been too high, and discussions have to happen on how much leverage the business should have relative to, frankly, the, the, the terminal value of the business and the cashflow characteristics of the business. I do think that is kind of the underlying nature of the price discovery in software and certain services businesses. And I think the, look, it's a healthy process to be thinking two years out for how that's gonna happen. And, and, you know, I think, again, it's healthy for lenders to look at, at spreads and look at spreads in, in various markets and underwrite appropriately for the range of outcomes that can happen. So I think what's happening now is actually an appropriate reaction to an increasingly uncertain environment. So actually, Steve, I have a question for you. You've previously said that 2026 wouldn't be the year that private credit would be stress tested. Obviously, the asset class is going through some form of a stress today, even if maybe not what you originally envisaged. Has this changed your thoughts on private credit's role or kind of its place in the overall ecosystem?

Steve Dulake: Um, for my first answer is, what do I know clearly?

Jake Pollack: (laughs)

Steve Dulake: Um, given that the asset class is undergoing something of a, of a stress test. But you're right, this wasn't the stress test that perhaps we and everybody were thinking. I think in most people's minds, the stress test that the asset class would, would suffer would be when we hit, uh, a material downturn in economic activity-

Jake Pollack: Yeah.

Steve Dulake: ... I would say, the sort of stress test that we have today is, not to downplay it, but I would call it a little bit of a kerfuffle with respect to the retail investing space. History would say that you tend to see stress or financial accidents, um, not that this is a major systemic financial accident, but you tend to see stress, uh, and volatility when you have asset liability mismatches. I think that's what we're seeing with respect to some of the retail participation in what is, as you rightly said, an asset class that is broadly well asset liability matched.

Jake Pollack: Yeah.

Steve Dulake: You know, the second component to the stress is obviously the disruption with respect to AI-related disruption that we're seeing with respect to, um, software and how that resolves itself. Though as we've noted earlier, there aren't many software loans really maturing before 2028. In terms of the longer term place of the asset class-

Jake Pollack: Yeah.

Steve Dulake: ... uh, within the credit ecosystem, I think it's here to stay. I'm very much reminded of CLOs and CLO technology immediately prior to and immediately after, um, the global financial crisis. I think private credit is an asset class a little bit like CLOs and the loan market, which attracted a lot of capital back in '05, '06. I think we've seen the same thing in '24 and '25. Um, we've seen an expansion in the manager base. I think what you saw with respect to, uh, the CLO market was it emerged from the global financial crisis and has become actually systemically even more important from the perspective of loan demand.

Jake Pollack: Yeah.

Steve Dulake: But what you did see temporarily was a contraction, um, in the manager base. And I think we're going to see something similar with respect to private credit. I think as we move through this period, you will see, uh, a contraction in the manager base, but I think this asset class is here to stay. It will survive the stress test that we're currently seeing. I think it will survive the stress test of a deeper downturn when that should happen. So I think there's a particular cohort of company, um, for which private credit serves, and I think that place remains intact.

Jake Pollack: Yeah, a- a- and by the way, I would agree with you. I, I think you're gonna have, uh, an element of the strong getting stronger. I think, uh, you know, firms that, that underwrite well, um, are gonna see, you know, continued growth, and, and they have an opportunity to take share, uh, from some of the, maybe some of the tourists, uh, that have been drawn into the asset class, but don't have, you know, uh, the infrastructure.

Steve Dulake: I'm glad you used the term tourist, because I was thinking of using it-

Jake Pollack: (laughs)

Steve Dulake: ... but so thank you for doing that.

Jake Pollack: Yeah. Uh, you know, one other question. Y- you know, when, when you think about the difference between public and private market default rates, how do you think about that? Do you expect a wide divergence between private credit and public credit when you get to underlying default experience?

Steve Dulake: History would say not. In general, when you look at the correlation between public and private market default rates, they're very well correlated through the cycle, and we've published some data on that, actually with the help of a very seasoned manager-

Jake Pollack: Yeah.

Steve Dulake: ... um, in the space who shared with us their own portfolio experience in some detail. I do think though, um, look it on the go forward, we might see a little bit of divergence between public and private market default rates. The pricing benchmark that we use is B3 loans typically-

Jake Pollack: Yeah.

Steve Dulake: ... to look at public versus, um, private markets. What I would say, is I do think that you will see some divergence. I think that's going to be driven by a couple of factors. Firstly, things like software exposure. Um, arguably, we begin to see that today. And secondly, I do think your point about the big versus the small, the tier one versus the tier two, the seasoned versus the tourist managers-

Jake Pollack: Yeah.

Steve Dulake: ... I think will be a dr- a driver of, uh, dispersion in terms of loss rate, return and default outcomes. So yes, we do expect a little bit more dispersion than we've seen in the past.

Jake Pollack: Yeah.

Steve Dulake: Jake, I think that's a great place to, uh, end today's conversation. Thank you for your time and thank you for your candor in answering my questions.

Jake Pollack: My pleasure. Thank you, Steve.

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