The Private Credit Paradox: A Canary in the Coal Mine?

The recent actions of JPMorgan Chase and a group of banks to cut their exposure to KKR’s troubled private credit fund, FS KKR Capital Corp., raise more questions than answers about the health of the private credit market. On one hand, lenders are mitigating potential losses by reining in their credit lines and increasing interest rates on remaining facilities. However, this decision also suggests a deeper concern: that the market is experiencing a growing disconnect between asset values and underlying fundamentals.

The fund’s performance over the past year illustrates this dynamic. FS KKR Capital Corp.’s shares have plummeted by nearly half, with the company’s net asset value falling by 10%. Meanwhile, loans in the portfolio are no longer generating income due to defaults on payments from software maker Medallia and dental services firm Affordable Care. These losses amount to a staggering $560 million, or $2 per share.

The lenders’ decision to cut their exposure rather than exit entirely suggests growing unease about potential further losses. This raises questions about whether the private credit industry is truly “conservatively capitalized and structurally designed to mitigate, rather than transmit, risk to the financial system,” as Will Dunham, CEO of the American Investment Council, has claimed.

The situation at FS KKR Capital Corp. bears an unsettling resemblance to that of mortgage-backed securities before the 2008 financial crisis. While proponents argue that private credit is less concentrated and more dispersed than traditional banking risks, the parallels between the two are striking. Both involve complex, opaque instruments with embedded risk created by leveraging low-quality collateral. And both have shown a propensity for blowing up in spectacular fashion.

Not everyone agrees on this assessment. Prominent investors like Jeffrey Gundlach have sounded the alarm about private credit’s potential to cause the next financial crisis. Their warnings are worth taking seriously given the growing evidence of systemic risk. The fact that KKR is now injecting $300 million into FS KKR Capital Corp., along with authorizing a separate share repurchase program and waiving its own incentive fees, only adds to this concern.

The JPMorgan-led group’s decision to cut their exposure and increase interest rates on remaining facilities suggests that more investors will pull back from the market. This could lead to a significant reduction in new investments, as well as a focus on supporting existing portfolio companies rather than taking on new risk.

Regulators should take a closer look at the sector’s structural design and capitalization given the parallels with mortgage-backed securities. While proponents argue that losses are dispersed across investors rather than concentrated inside the banking system, this assumes that investors will ultimately bear the brunt of any losses. However, as seen in the case of FS KKR Capital Corp., even the largest and most sophisticated players can be caught off guard by sudden defaults.

Ultimately, the recent actions of JPMorgan Chase and other lenders are a clear signal that something is amiss in private credit. Rather than celebrating the sector’s “conservative capitalization” and “structural design to mitigate risk,” we should be taking a harder look at the underlying fundamentals. As investors, regulators, and policymakers, it’s time to acknowledge the risks inherent in this market and take steps to address them before they blow up in our faces.