No chicanery here (again)

Financial media uncovers some worrying trends in credit that . . . aren't so worrying?

• looking for signs of chicanery, and coming up empty (financial media, edition)

• a troubled car wash, where the debt was priced too high to perfection?

• corporate default rates skyrocketing (or just a chart foul)

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Looking for signs of chicanery, and coming up empty (but not just Random Walk)

A couple of weeks ago, Random Walk checked under the hood for signs of chicanery (in the private credit markets) and came up mostly empty.

The backstory here is that higher-for-longer interest rates are supposed to have inflicted pain on the companies (and their lenders) who thrived on cheap credit. It hasn’t really happened though (in the main).

Or rather, companies, lenders and investors have nimbly adapted to the new normal, and mostly have just kept on keeping on. Sure, there’s been some belt-tightening and some bankruptcies, but nothing catastrophic, and really nothing close to catastrophic, since the banking-crisis-that-nearly-was-but-wasn’t.

The rebuttal is “it hasn’t happened yet.”

You see, so much of the action happens in the private markets, where there is both a will and a way to “extend and pretend,” effectively doubling- and tripling-down on bad credits—without much visibility to the outside world. As long as heads are above water, there’s always a chance that help arrives to save the day. Plus, bankers are what they are, and they will always find ways to keep the music going, even when it no longer makes sense.

For private credit, crazy high returns, but crazy wide variance (if I understand this chart correctly):

Virtus

The private credit pricing premium is running away from the field, but also seems to have the widest swings.

Finally, this is a risk worth attending to, because if there is any setup that has contagion risk, it’s the credit markets, where creditworthiness is tied to the ability to borrow, which in turn is tied to any lender’s willingness to lend, which is tied to the willingness of other lenders to lend, all of which is to say, defaults can have a cascading effect that is self-reinforcing—momentum on the way up, and momentum on the way down. Minsky Cycles, and all that.

Anyways, all of this is well and good, but when Random Walk actually looks for signs of trouble under-the-hood, there hasn’t been that much to latch on to. Doesn’t mean it’s not there, but it’s not obvious where it might be.

Indeed, even when other publications look for trouble, once you read past the headline, the conclusion is “actually, that’s not so bad.” And that is the point of today’s post.

A troubled car wash

To wit, last week Bloomberg reported on the ticking time bomb hidden behind private credit marks, or “Bankrupt car was exposes flaws in private credit valuations.”

It’s a scary headline:

OK, you have my attention.

I too, believe that the marks are too damn high.

You see, one of the benefits of holding a privately traded asset—as opposed to something that trades on an exchange—is that you get to say how much it’s worth. Artificially high marks can disguise the turmoil within.

Private funds occasionally raise some eyebrows when (a) they mark the same assets at very different prices; and (b) they give high marks to assets, which experience distress, shortly thereafter.

Take Zips car wash, for example.

One fund marked it at 93 cents on the dollar. Another had it at 94 cents. A couple more kept it as high as 95 cents.

On paper, private credit firms appeared optimistic about a $654 million loan they had provided to Zips Car Wash. Those valuations, at the end of September, implied a strong chance the debt would be repaid in full.

As it turns out, the auto wash operator was in deep trouble.

Between March and September, Zips had already obtained a 10-month extension on the maturity of the loan, tried and failed to secure viable refinancing proposals, appointed an independent manager and hired restructuring advisers, according to documents filed in bankruptcy court last week . . .

Zips had been under stress since at least 2023, according to bankruptcy documents. Stiff competition after a flurry of buyouts in the car wash industry, rising interest rates and labor shortages had all contributed to make its liquidity tighter and its debt load heavier. Cost cuts and a series of cash injections from private equity owner Atlantic Street Capital did little to stem the bleeding, the documents show.

None of that was apparent to investors in the funds managed by Capital Southwest, HPS Investment Partners, Main Street Capital, Onex Corp. and PennantPark that owned slices of the loan. The September marks above 90 cents on the dollar were disclosed a month or so later, after Zips had entered into a forbearance agreement with a majority of its secured creditors.

Eeek.

An obviously distressed car wash that’s now in bankruptcy, but before then, its lenders were smugly marking its debt at north of 90 cents on the dollar (which is not distressed at all).

And how did they do it? The lenders used one of those ‘distressed exchanges’ to avoid bankruptcy (for a time), but eventually the music stopped, and the reaper came to collect its due: a bankruptcy proceeding, where all laundry is aired.

Exactly as we feared. Private credit is hiding distress with tricky work-outs and artificially high marks.

The markdowns, the horror!

Of course, when Zips’ distress finally came to light, the lenders had no choice but to reprice the debt to better reflect the risk.

I mean, look at these dramatic mark-downs: