Private credit enters risky terrain with huge bets on consumers

London - First, the private credit companies came for the banking industry’s lucrative corporate loan business. Now, they are grabbing a chunk of their consumer lending work. The pressing question for this thriving, multitrillion-dollar industry is whether it has timed its latest incursion badly.

The likes of Fortress Investment Group, KKR & Co and Carlyle Group have all been hoovering up packages of consumer loans in Europe and the US over the past year. With unemployment spiking unexpectedly in some of the world’s biggest economies, the bet looks riskier than it did a few months back.

Private credit rose to prominence over the past decade by gobbling up much of the company financing traditionally provided by Wall Street, but its success has attracted a horde of new market entrants and the extra competition has pushed down its once stellar returns.

As a result, companies have been foraging in new areas to try to put their vast pots of client cash to profitable use.

Debt taken on by squeezed Europeans and Americans – through everything from “buy now, pay later” (BNPL) to old-fashioned credit cards – has become the latest hot property for private credit funds looking to diversify as banks retrench.

“The consumer loan trade really started to happen in force since the regional banking crisis” in the US in 2023, says Mr Patrick Lo, partner and co-chief investment officer at Waterfall Asset Management.

New York-based Fortress inked a deal this summer to provide £750 million (S$1.27 billion) for a British provider of dental loans. KKR launched a €40 billion (S$57.9 billion) vehicle in 2023 to buy current and future BNPL loans originated in Europe by PayPal Holdings.

Fund managers at these companies say they are only interested in higher-quality consumer lending, but some concede they need to be vigilant about becoming exposed to struggling borrowers when deciding where to invest. Rougher economic times mean people need to borrow more – an opportunity for cash-rich private credit funds – but this also makes it harder for them to honour debts.

Others point out that although asset-based finance is usually secured by real things such as property when lending to companies, it is often not secured against anything when used to fund consumer lending, adding to the dangers.

Credit card delinquencies in the US have risen to their most elevated levels in more than a decade by some measures, and the impact of a higher-rate environment has not been fully felt yet, experts warn.

According to a Bloomberg News survey done by Harris Poll, some 43 per cent of those who owe money to BNPL services said they were behind on payments. More than a quarter of respondents said they were delinquent on other debt because of their BNPL spending.

Some of this also explains why traditional lenders have been vacating the space that private credit is starting to fill.

“I think most banks don’t find consumer debt sufficiently attractive given the risk it bears,” said Mr Marco Folpmers, a partner for Deloitte’s financial risk management team. “BNPL platforms in particular are struggling to make a profit.”

Tougher times

Worries over the global economy spiralled in August after a worse-than-expected US unemployment report triggered a brutal market sell-off.

Goldman Sachs Group economists increased the chances of a US recession in the next year to 25 per cent from 15 per cent, although they said there are reasons not to fear a slump.

Germany also reported an increase in joblessness as Europe’s largest economy slipped back into contraction in the second quarter.

To be sure, despite recent scares, unemployment rates have remained relatively robust through a cost of living crisis. And delinquencies, while rising, are still at relatively low levels historically.

And yet, it is not just the difficult consumer landscape that raises worries about the billions of dollars of unsecured debt being taken on.

The sudden influx of capital will sometimes go to fintech start-ups, such as BNPL providers, which do not have the best credit standards. Compounding that is the knowledge that banks will still try to snag the best-performing assets.

“Funds can never compete with banks’ financing terms,” said Mr Nikolas Tourkas of distressed-debt specialist APS Holding. “There’s always a risk of dropping credit standards during origination.”

New entrants may also not be equipped to predict or monitor risk properly.

“Banks have a large apparatus for monitoring risk and have the teams and budgets to do that,” said Mr Folpmers at Deloitte. “What I understand of these newer fintechs and providers of BNPL is that they don’t have that same analytical capability and it might be difficult for them to separate high-risk clients from low risk. No one has the models that work or the backlog of data.”

Nonetheless, with asset-based finance set to boom, money will keep flooding in to this corner of lending.

Private credit investment in this type of funding – including both consumer and corporate loans – could more than double to US$900 billion (S$1.2 trillion) in the next few years from US$350 billion currently, according to research by Atalaya Capital Management, a specialist in such investments.

“I’ve a nuanced view of this in that it’s interesting to see innovation,” Mr Folpmers concludes. “But this needs more guardrails.” BLOOMBERG