A staggering 70% of private credit managers have less than a decade of experience, meaning their entire careers have been in a low-rate, bull market environment. This lack of cycle-tested experience poses a significant systemic risk as market conditions normalize and stress appears.
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The term "middle market" is too broad for risk assessment. KKR's analysis indicates that default risk and performance dispersion are not uniform. Instead, they will be most pronounced in the lower, smaller end of the middle market, while the larger companies in the upper-middle market remain more resilient.
Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.
During periods of intense market euphoria, investors with experience of past downturns are at a disadvantage. Their knowledge of how bubbles burst makes them cautious, causing them to underperform those who have only seen markets rebound, reinforcing a dangerous cycle of overconfidence.
The most imprudent lending decisions occur during economic booms. Widespread optimism, complacency, and fear of missing out cause investors to lower their standards and overlook risks, sowing the seeds for future failures that are only revealed in a downturn.
While default risk exists, the more pressing problem for credit investors is a severe supply-demand imbalance. A shortage of new M&A and corporate issuance, combined with massive sideline capital (e.g., $8T in money markets), keeps spreads historically tight and makes finding attractive opportunities the main challenge.
Centerbridge initially sought investors equally skilled in PE and credit, a "switch hitter" model they found unrealistic. They evolved to a "majors and minors" approach, allowing professionals to specialize in one area while gaining significant experience in the other. This fosters deep expertise without sacrificing the firm's integrated strategy.
Judging investment skill requires observing performance through both bull and bear markets. A fixed period, like 5 or 10 years, can be misleading if it only captures one type of environment, often rewarding mere risk tolerance rather than genuine ability.
The era of generating returns through leverage and multiple expansion is over. Future success in PE will come from driving revenue growth, entering at lower multiples, and adding operational expertise, particularly in the fragmented middle market where these opportunities are more prevalent.
The career arcs of venture and buyout investors differ starkly. VCs rely on networks relevant to young founders, leading some to retire by 45 as connections become stale. In contrast, buyout investing is an apprenticeship business where age and experience are increasingly valued.
For young professionals in finance, market downturns are the ultimate training ground. Free from portfolio responsibility, they can observe how senior leaders navigate crises and absorb crucial lessons about risk and psychology that are unavailable in bull markets.
