The Private Credit Crisis Is Spreading

Submitted by QTR’s Fringe Finance

The private credit crisis is spreading to another corner of the market that I warned about back in October, when I wrote about 10 parts of the market I’d avoid.

For years I’ve been warning that buy now pay later (“BNPL”) industry was built on a pretty fragile foundation. The quality of the loans was always the obvious problem. The entire business model revolves around extending instant credit with minimal underwriting to consumers making small purchases.

Companies whose primary innovation is allowing consumers to split a $40 online purchase into four installment payments probably aren’t lending to the most creditworthy segment of the population.

If anything, the model practically guarantees the opposite. When financial companies create products that allow consumers to finance extremely small discretionary purchases, they are effectively targeting borrowers who either don’t have the liquidity to cover those purchases outright or who have already exhausted more traditional forms of credit. When consumers are putting things like f**king Chipotle Burritos and Hostess Twinkies on layaway, the borrower pool you are dealing with is not exactly prime.

It is the same dynamic that has been visible in peer to peer lending and fintech credit for years. Platforms like Affirm, along with payment ecosystems tied to firms like Block, built massive growth stories by expanding credit access to people who historically would not have qualified for traditional lending products. For a while that looked like financial innovation, especially when they could find buyers for the loans. In reality it mostly meant pushing unsecured credit deeper down the credit spectrum.

That approach worked beautifully in a zero rate environment where capital was abundant and investors were desperate for yield. It worked great during a 3 year period of Covid where liquidity was unlimited from the Fed. It is slightly less impressive once interest rates rise and credit markets start behaving like credit markets again. In fact, we are watching the “con” of this being called “innovation” being laid bare…first in names like Carvana, then in private credit, now in BNPL. Subprime lending and accounting tricks are simply not innovation, no matter how much of a polish you put on them.

Chart: FT

The latest example comes from a report in The Wall Street Journal describing stress inside a private credit fund managed by Stone Ridge Asset Management. The firm runs the Stone Ridge Alternative Lending Risk Premium Fund, commonly known as LENDX, which buys whole loans and securities tied to loans originated by fintech lenders. That includes buy now pay later loans from Affirm along with personal loans from LendingClub and Upstart. The portfolio also includes merchant financing tied to payments platforms like Block and Stripe.

Recently investors in the fund tried to withdraw far more capital than the structure allows, and Stone Ridge informed clients that it would only be able to honor about 11% of the redemption requests. The fund is structured as an interval fund, which means investors cannot simply exit whenever they want. Instead they are given limited redemption windows and the manager is only required to repurchase a small percentage of shares each quarter, typically around 5% with some flexibility above that. This structure works perfectly well as long as investors remain calm and redemption requests stay modest. The problem appears when investors collectively decide they would prefer their money back. The underlying loans in these portfolios are illiquid and cannot be sold quickly without taking significant discounts, which means the easiest solution is simply to gate withdrawals.

None of this should be particularly shocking. Years ago I wrote that peer to peer lenders and fintech credit platforms were essentially extending loans to people who historically would never have qualified for traditional credit products like mortgages, auto loans, or even standard credit cards. Banks avoided these borrowers for decades for a fairly straightforward reason. When economic conditions tighten, default rates tend to rise rapidly among the weakest borrowers. The fintech model did not eliminate that dynamic. It just delayed it while capital markets were willing to fund the experiment.

Chart: FT

The broader private credit market is beginning to show similar signs of stress. In recent weeks a number of funds tied to large asset managers have already been forced to limit investor withdrawals after redemption requests exceeded the quarterly caps built into their structures. Funds connected to Morgan Stanley, BlackRock, and Cliffwater have all faced similar pressures.

That concern was reinforced days ago by comments from John Zito of Apollo Global Management, who warned that many parts of the private markets industry may be carrying assets at valuations that simply do not reflect current economic conditions. Zito argued that private equity deals completed between 2018 and 2022, particularly in the software sector, were often executed at far higher valuations than comparable public companies. If those businesses run into trouble, he suggested recoveries on the associated loans could fall somewhere around twenty to forty cents on the dollar. He was even more blunt about valuation practices across the industry, saying he believed many private equity marks were simply wrong and that firms risk losing investor trust if they refuse to adjust them.

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All of this is happening at the same time the economy is finally starting to feel the effects of positive real interest rates. For most of the past decade credit markets operated in an environment where money was essentially free. That allowed questionable lending models to flourish because refinancing risk was minimal and investor demand for yield was enormous. Once rates rise and liquidity tightens, the underlying quality of the loans suddenly matters again.

In my opinion that is exactly what we are starting to see. The combination of stress in buy now pay later lending and growing redemption pressure in private credit funds looks like an early reminder that the credit cycle has turned. Investors still appear remarkably comfortable with firms like Blue Owl Capital, Ares Management, and the broader universe of BDCs, along with BNPL lenders and even some regional banks that have meaningful exposure to these areas. Personally I still think most of that space is worth avoiding.

Looking ahead, my expectation is that stress will accelerate across both BNPL and private credit as the effects of higher interest rates continue working their way through the system. One area that could easily be next is commercial real estate, where property valuations still look suspiciously optimistic given the current financing environment.

Eventually the Federal Reserve will almost certainly step in and engineer some kind of liquidity backstop if the situation deteriorates far enough. The playbook is pretty well established at this point, and policymakers have never shown much hesitation about stabilizing credit markets when things start breaking. But historically those interventions tend to arrive only after markets go through at least a brief period of forced deleveraging. If that process has started in fintech lending and private credit, the awkward phase where investors rediscover what their assets are actually worth may still lie ahead. And that is usually the part nobody enjoys.

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