PGIM – Credit Risks and Deteriorating Lending Standards

I recently listened to a PGIM webinar on credit risks and deteriorating lending standards. It was so good, I wanted to share some of the comments and key take-aways with you. Importantly, PGIM is one of the largest non-bank lenders in the world, so its insights are valuable.

The US panel consisted of three experts and a moderator:

• Jackie Brady, Head of Global Debt Solutions, PGIM Private Alternatives (JB)
• Matt Harvey, Head of Direct Lending, PGIM Private Capital (MH)
• Pinto Suri, Principal & Credit Analyst, PGIM Fixed Income (PS)
• Cameron Lochhead, Global Head of Institutional Relationship Group, PGIM (Moderator) (CL)

Key take-aways

1. The end of the economic cycle may be near, and the market is experiencing some terms erosion due to tight loan supply. Investors should also be mindful of hidden leverage given the complexity of the current lending system. The market’s complexity, as well as rapid growth in private credit, creates a challenging regulatory picture as leveraged loan activity shifts from banks to long-term investors.
2. Lenders across the credit universe will benefit from remaining disciplined in an uncertain risk environment.
3. Volatile credit cycles can unlock equity upside in mezzanine financing.
4. Origination capability is the biggest differentiator between participants. Selectivity is so important as is the power to pass.

Below are select, abbreviated parts of the discussion.

Also read: Uncertainty is Non-Linear

Moderator – How are credit risks today compared to 2007/8?

JB – Risks are quite different, commercial real estate (CRE) pre GFC was lending based on income to come, but not in place. Leverage was higher and there was a sizeable Collateralized Loan Obligation (CLO) and Commercial Mortgage Backed Security (CMBS) market. Following the GFC, the market was more restrictive and money relatively cheap. Excess leverage transferred to lower leverage and higher interest rates. There’s lower debt service coverage now.

MH – There’s been a sense of a crescendo in private corporate credit and buying assets underpinned by demand moving from liquid to illiquid. Private credit was in the banking system and now it’s outside it. We’re seeing late economic cycle risks.

PS – In regards to the REITS, we are seeing the same trends as in the GFC, but with more discipline. There is going to be some cleansing out.

Insurers take risk out of the economy and put it on their own balance sheets. As risk absorbers especially on the life insurance side, what’s taking my eye is this notion of financial engineering. Insurers are already complex entities. Complex being where models don’t yield consistent results, there are multi variate solutions. That complexity is taking more financial engineering risk, as we are starting to see in memory of the GFC. All of those complex products that kept hiding leverage is a concern to watch. Not material right now but emerging and has the potential to grow.

Moderator – Why are regulators concerned about lending standards now? I note there’s US$1.2 trillion of covenant-lite loans?

MH – Most of the syndicated and HY loan markets are covenant lite now and that is a distinction from pre GFC.  What we’re doing in private credit right now is trading liquidity for an asset that we think generates an illiquidity premium and that we therefore have more control over at the fundamental asset level. We can’t trade it out to seek value.

1. The asset class has grown dramatically in last 10 years from banks and CLOs to private credit vehicles, that’s going to attract attention form the regulators full stop.
2. Who holds the assets? Now in the hands of long term asset owners such as pension funds where previously it was the banks.
3. The regulators are focused on policy holder integrity and do the assets match the policy risks?
4. Banking regulators are focused on contamination and potential for systemic risk.
5. Retail, more assets are in retail oriented vehicles first focused on credit investors and HNW. The focus is on transparency and illiquidity and is it properly understood? Proven managers use covenants and origination tools to convey transparency to price. They use repeatable processes.

JB – CRE is an asset backed loan and we have an actual mortgage so is differentiated from the process you would see in cash flow covenant lending. Leverage levels have returned. Structurally, loans have declined, there is more interest only deals. What downside tools are there in the toolkit to help us get out on the other side?

The market is highly differentiated – US CMBS, Insurance, Banks, Freddie Mac and Fannie Mae. A wide diversity of lending sources of capital.

PS – Credit rating agencies are not looking at the same issues as we are at PGIM. The issue of CMBS and structured credit is a watch point. I am less clear the regulators are understanding the level of financial engineering we are starting to see on the insurance side. You take a loan and are self securitising and pumping that through, a single B credit showing up as a AAA at different levels of your insurance enterprise.

It gets to a point when you already have a complex industry and are layering in more complexity, what’s going to happen when there is stress?

Moderator – What questions do you ask and what due diligence do you do?

JB – What work out experience do you have? What restructuring experience do you have and how have those lessons changed your business? How have lessons learned migrated into business today? PGIM like amortising loans, where debt declines over time.

Office real estate is capital intensive, do you demand reserves or let loans go without reserves?

Where do asset managers draw the line?

MH – Three suggestions:

1. Origination – What percentage of your deals are you the sole or lead on the deal? 80-85% gives better oversight. Otherwise, you are just paying fees for someone else’s book.
2. Covenants, a fundamental of private credit. Need enforcement ability to control a work out situation and protect loan value. Not just financial covenants, but all the other terms and conditions to protect your collateral, ask to see the credit agreement.
3. Track record attribution, including beta (how performance compares to the market) returns over public market, illiquidity premium. Also alpha, selection and portfolio management and the ability to avoid losses.

PS – Risk culture, try and research from multiple angles – deals, structures and what went wrong and how that was dealt with.

Moderator – Best ideas?

JB – The regional banking system is selling assets at discounts. They are restructuring balance sheets and selling good assets because the balance sheets are feeling the pinch.

PS – There’s an opportunity in REITS, elevated short interest is depressing the market. There are good assets but with weak owners, assets will move into stronger hands.

MH – In private credit you get paid to invest where markets are less crowded. Two areas I would focus on:

1. Non sponsored direct lending
2. Mezzanine, debt with upside equity potential. Rescue and financing solutions that help rehabilitate capital.