First the private credit firms came for the banking industry’s lucrative corporate loan business. Now they’re grabbing a chunk of their consumer-lending work. The pressing question for this thriving multi-trillion dollar industry is whether it has timed its latest incursion badly.The likes of Fortress Investment Group, KKR & Co and Carlyle Group Inc 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, firms 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” 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 last year, says Patrick Lo, partner and co-chief investment officer at Waterfall Asset Management. New York-based Fortress inked a deal this summer to provide £750mn ($956mn) for a British provider of dental loans. Fellow US asset manager Castlelake LP last week agreed to buy up to $1bn in consumer loans initially created by Pagaya Technologies Ltd, whose business model is to use artificial intelligence to help vet consumer borrowers. It’s done similar with Upstart Holdings, another AI-based fintech. KKR launched a €40bn vehicle last year to buy current and future BNPL loans originated in Europe by PayPal Holdings Inc. Rivals such as Blue Owl Capital Inc are looking to expand into consumer finance via acquisitions. It’s all part of a plan to build so-called asset-based finance businesses, providing funding to both companies and individuals. Fund managers at these firms say they’re 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 also make it harder for them to honour debts. “Even if you have some deterioration driven by the higher unemployment rate, we think we have enough of a cushion in the structure to absorb this,” says Dominick Ruggiero, co-CIO of Fortress Lending Funds. “That said, we need to constantly reevaluate our assumptions. Higher unemployment is going to drive more volatility, especially on the subprime consumer.” Others point out that although asset-based finance is usually secured by real things such as property when lending to companies, it often isn’t 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 hasn’t been fully felt yet, experts warn. According to a Bloomberg News survey done by Harris Poll, some 43% 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. A senior manager at one of the largest private-market firms, who asked to remain anonymous when discussing commercial matters, says the risk from subprime consumer loans has increased as pandemic monetary stimulus fades. His firm is doubling down on backing loans to consumers who have equity in their homes, he adds, rather than exposing itself to unsecured lending. 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,” says Marco Folpmers, a partner for Deloitte’s financial risk management team. “BNPL platforms in particular are struggling to make a profit.” Worries over the global economy spiralled this month after a worse-than-expected US unemployment report triggered a brutal market selloff. Goldman Sachs Group Inc economists increased the chances of an American recession in the next year to 25% from 15%, 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’s 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 startups, such as BNPL providers, who don’t 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,” says 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. James Ruane, London-based managing director for capital solutions at investment firm Caisse de Depot et Placement du Quebec, says his employer tends to focus on relationships with bigger lenders to mitigate such dangers. “Banks have a large apparatus for monitoring risk and have the teams and budgets to do that,” says 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 $900bn in the next few years from $350bn currently, according to research by Atalaya Capital Management, a specialist in such investments. “Our view is that private credit investing in consumer finance is a growing secular trend,” says David Aidi, a partner at Atalaya. “This type of financing activity is moving outside of the banking sector, similar to how corporate loans have already moved.” Isaiah Toback, a Castlelake partner, agrees that even though he “doesn’t think there’s as much of a safety net for the consumer as in times past,” there are still plenty of decent opportunities around for firms like his, and a chance to bring their expertise to parts of the loan market where it may be lacking. “I’ve a nuanced view of this in that it’s interesting to see innovation,” Folpmers concludes. “But this needs more guardrails.”
