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Private credit assets lack the price discovery of public markets. Their value is typically assessed quarterly by third-party services, meaning the "marks" on a fund's books can lag significantly behind reality. This creates a hidden risk: in a downturn, the actual sale price could be far below the stated value.
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The catalyst for a private credit crisis will be publicly traded, daily NAV funds. These vehicles promise investors daily liquidity while holding assets that are completely illiquid. This mismatch creates the perfect conditions for a "run on the bank" scenario during a market downturn.
A downturn in private credit can escalate rapidly via a feedback loop. The cycle begins with redemptions and defaults, leading to forced selling of fund assets. This reveals a lack of deep liquidity, causing prices to gap down, which confirms investor fears and triggers more redemptions, creating a self-reinforcing downward spiral.
Private equity giants like Blackstone, Apollo, and KKR are marking the same distressed private loan at widely different values (82, 70, and 91 cents on the dollar). This lack of a unified mark-to-market standard obscures true risk levels, echoing the opaque conditions that preceded the 2008 subprime crisis.
In private markets, there's a perverse incentive for both private equity owners and private credit lenders to avoid marking down asset values. This "mark to make-believe" system keeps valuations artificially high, hiding underlying financial stress and delaying the recognition of losses.
Funds offer investors quarterly liquidity while holding illiquid, 5-7 year corporate loans. This duration mismatch creates the same mechanics as a bank run, without FDIC insurance. When redemption requests surge, funds are forced to sell long-term assets at fire-sale prices, triggering a potential collapse.
The absence of daily pricing in private credit removes an essential discipline. Mark-to-market in public markets acts as an honest, early warning system that forces managers to scrutinize underperforming assets, a mechanism private lenders lack.
Jeff Gundlach argues private credit's attractive Sharpe ratio is misleading. Assets aren't priced daily, hiding risk. When an asset is finally marked, it can go from a valuation of 100 to zero in weeks, exposing the “low volatility” as a dangerous fallacy.
Howard Marks argues that private credit's apparent low volatility during market downturns is not magic but an accounting feature. By not marking to market daily, it mimics the psychological trick of simply not looking at your public portfolio's value, creating a potentially false sense of security for investors.
Private equity funds report lower volatility because they aren't required to mark assets to market daily. Unlike public funds, they can avoid reporting sharp downturns, a practice critics call "volatility smoothing" or "lying." This creates a misleading picture of risk and return.
When facing a downturn or redemption pressures, private credit funds cannot easily sell their troubled, illiquid loans. Instead, they are forced to sell their high-quality, liquid assets, creating contagion risk in otherwise healthy public markets.
