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Be careful if you own these sectors

Posted on by darion

A problem area on Louis Navellier’s radar… huge growth and huge profits from private lending… warnings are starting… is there a silver lining?

Before we begin, a quick note that our offices, including Customer Service, will be closed on Monday, May 27 for Memorial Day. Regular business hours will resume on Tuesday, May 28.

We will also take a day off here digest but I’ll be back on Tuesday.

On behalf of all of us at InvestorPlace, we hope you have a wonderful Memorial Day weekend with your friends and family. Welcome to summer!

“I don’t want to scare anyone, but if there’s a problem (with this), that’s where it’s going to be….”

This eyebrow-raising comment comes from legendary investor Louis Navellier on yesterday’s Flash Alert podcast in English Growth investor.

Much of the podcast highlighted Nvidia’s massive gains, why the company will be the dominant AI chipmaker in the coming years, and how investors can position their portfolios for AI developments.

But then this warning came when Louis reached for the just-released minutes from the May Federal Reserve meeting:

(The Fed) actually included a little tidbit in the minutes of the Fed, FOMC meeting, talking about the booming private credit sector.

What has happened in America is that we have become like China. We have the official bank lending system, and then we have the unofficial lending system, controlled by the private lending industry.

Now private credit is exploding everywhere. This is what you can buy at Morgan Stanley and almost every broker/dealer and financial advisor.

You can – right now – get a profit of 11%, and you will get the money back in two years. But the question is, “how do they achieve an 11% profit?”

It looks like they are starting to take advantage.

Let’s stop here and fill in a few details to make sure we’re all on the same page.

The rapidly growing private lending industry

“Private credit” is the name given to loans made to individuals or businesses from any lender other than a traditional bank. The largest private lenders include private equity firms (think “KKR”), alternative asset managers (think “Caryle Group”) and insurance companies (think “AFLAC”).

For borrowers, these non-bank lenders offer a way to access funds when traditional banks cannot lend. This may occur because banks face more difficult regulatory hurdles and/or lending standards than non-bank lenders.

For lending institutions, these loans have become big business, providing a reliable stream of income with a high rate of return.

In the wake of the global financial crisis, regulators have tightened the lending practices of large banks. This created space for non-banks to step into the void. And they stepped in, they did.

Private credit has skyrocketed from about $375 billion in 2008 to more than $1.6 trillion in March last year, according to Preqin, a London-based financial data and analytics firm. This is more than a 4-fold increase.

Below you can see how global private sector debt assets under management are growing – and accelerating. Notice the J curve from about 2020 onwards.

Chart showing the growth of global private debt AUM

Source: Bloomberg / Preqin / Brookings

Behind this growth are large profits for investors

Below we look at data from private equity firm KKR from last June. In the case of loan products, we observe different yields to maturity.

Note that direct loans (private debt) offer a yield of 11.6% – more than double the next highest yield of US investment debt of 5.5%.

Graphic showing how the yield on private debt is more than twice that of the next best fixed income product

source: KKR

So lenders enjoy huge returns and borrowers gain access to funds they might not otherwise receive.

It’s a win for everyone, right?

As you might expect, there are growing concerns about the health of the private credit market and its interconnections with the traditional banking system

Lets start with Reuters from the beginning of this month:

For some elite financiers gathered in Los Angeles for the Milken Institute conference, the frenzy of debt in private markets reminds them of the days of risk-taking that predated the 2008 financial crisis.

Last week, in the halls of the Beverly Hilton Hotel and at meetings across the city, I spoke with more than a dozen investors, bankers and fund managers involved in the booming $1.7 trillion private credit market in which investment funds lend money to private equity firms. and other companies. .

Many financiers have worried about the consequences of mounting debt in this market, which operates largely beyond the reach of regulators.

In April, JPMorgan Chase CEO Jamie Dimon noted his growing concern about private lending in his annual letter to shareholders.

He wrote that private credit “is not as transparent as public market valuations. Additionally, private market loans often lack secondary market liquidity and are generally not supported by in-depth market research.

Here are his broader concerns:

New financial products that develop extremely quickly often become an area of ​​unexpected risk in the markets.

Often, weaknesses in new products, in this case private credit lending, can only be seen and exposed in bad markets that private credit lending has not yet encountered.

Next in line to express concern is Federal Reserve Governor Lisa Cook.

FROM PYMNTS:

Cook identified private lending – direct lending to businesses by non-banks – as an emerging gap. Assets of managed private credit funds have grown rapidly in recent years and may be associated with “weak underwriting or excessive risk appetite,” it said…

(Private lending has) increasing links with traditional financial institutions, and an increasing number of banks have their own private lending offerings.

“As a result, I will monitor the contribution of private credit to the overall leverage of the business sector and the evolving interconnections between private credit and the rest of the financial system,” Cook said

Cook’s comments echo what we found in the May Federal Reserve minutes that Louis referenced:

Several participants commented on the rapid development of private credit markets, noting that such developments need to be monitored as the sector becomes increasingly interconnected with other parts of the financial system and that some of its risks may not yet be apparent.

No one is waving the red flag furiously at the moment, but as Louis pointed out, we have to pay attention to leverage

Let’s get back to Reuters: :

In many cases, (new proceeds from debt loans) are collected to pay dividends to investors in these funds, such as pensions and grants, to meet payout demands, say financiers.

It also allows fund managers to ask investors for new money, generating more fee income.

In some cases, the money is used to support struggling portfolio companies or invest in them for growth, as well as to finance new acquisitions.

“Now that we’ve had a real pause in the ability to exit a lot of them (portfolio companies), they’ve had cash flow difficulties,” said David Hunt, CEO of $1.3 trillion asset manager Prudential Financial, PGIM, referring to to private capital companies.

“To deal with this, they are now adding leverage to the fund level. So they have the advantage of leverage.”

“Leverage” at a time when many Americans are struggling to pay off their debts is not a good combination.

If you own shares of any private equity companies, alternative asset managers or insurance companies, it may be worth looking at their exposure to private lending.

You want to make sure they’re not taking on too much, too fast, and with too much leverage.

Louis highlights the positives in this potential problem area…

Let’s get back to him Growth investor podcast:

The Fed is watching (it). If there’s a problem, it’s this one.

But that would actually cause the Fed to cut interest rates – because it needs to save the economy.

So I don’t want to scare anyone, but I want you to know. That was the most interesting thing that came out of the FOMC minutes that came out (Wednesday).

For now, there’s nothing urgent that would require a crazy change in your portfolio. However, our goal is to place potential warning signals on the radar well in advance. And this is something that needs to be monitored.

We will keep you updated here at digest.

Have a good night,

Jeff Remsburg