Wall Street doesn’t know whether it should love or be afraid of private credit. By the time it finds out, it might be too late.

Since its popularization after the pandemic, institutional investors‘ new favorite asset class has had quite the splash. Dozens of investment firms have made a modest fortune cutting out banks and offering an alternative directly to both borrowers and lenders. Only, the riskier profile of private credit has proven to be a quarrelsome thing.

As “shadow banks” are not restrained by the same regulations as actual banks, many have turned up risk and shrugged off rigorous underwriting in search of deals — many of which are being sold to other investors for a healthy fee. The result has been some pretty fantastic failures. That’s especially the case in the auto industry, where a number of high-profile failures shook up the financial sector in November. The failure of First Brands Group, for example, cost non-bank lenders over $1 billion.

Those risks were cast aside in January as CNBC reported that many non-bank lenders raised multi-billion-dollar follow-on rounds. Perhaps, in their mind, the risk was one of the features of a private credit vehicle. It’s easy to say that when you think you can get your money back. As some investors in Blue Owl Capital Corp II (OBDC II) are finding right now, that’s not always a given.

Blue Owl suspends withdrawals

On Wednesday, the $1.7 billion investment vehicle permanently restricted withdrawals from OBDC II, a private credit investment vehicle which primarily focused on “US middle-market companies.” It primarily did this by originating senior secured, floating-rate credit to software and tech firms.

The decision comes after the ailing fund faced over $150 million of redemption requests over nine months, during which the firm is alleged in one class action lawsuit to have misled investors about risks to its asset base, stressing that there was “no meaningful pressure.”

In reality, there were. The firm then controversially attempted to roll the struggling OBDC II into a larger, publicly traded fund operated by itself. However, shareholders revolted as they realized they would take a 20% haircut. That proposal was quickly shelved, while the firm continued to allow withdrawals.

But with redemptions rising, exacerbated in part by fears that AI will consume the sort of imperiled businesses that shadow banks lent to, Blue Owl has pressed the pause button and will now pursue a full liquidation of the fund.

It took a step towards winding down OBDC II by selling $600 million in assets from OBDC II, about 30% of the fund’s worth. Those investments were sold, per the Financial Times, for roughly what they were worth. And while that’s sure to settle some fears that the private credit risk rooster is coming to roost, there’s little consolation for anybody, bar maybe the borrowers who got cash for their business (and the companies charging the fees for access to the credit, of course).

Risks may vary

For lenders, a liquidation isn’t going to make up for the pittance of performance. Reuters’ Jonathan Guilford likened the situation to the fall-off in nontraded REITs after the pandemic. Those assets, to this day, have not recovered to their former levels.

But one fund is still one fund, so to generalize the problem with Blue Owl (which is having problems across more than this one fund, but has continued to examine big data center-focused deals with Meta and Oracle, for example) might be a little preemptive. At a minimum, it points to some serious liquidity issues.

If we get to the core of the problem here, what’s at stake is whether shadow banking offers the benefits it says it does. If lenders (who provide the money to the investors to invest) don’t get great returns or have worries about the sector, that could end up being a problem which compounds.

How Did the Market React?

Private credit flubs generally invite reappraisal of the sector and whether or not the gravy train will continue to print. That is, if the risk is worth the returns.

Today, that question is stoking carnage among the private credit crop: Blue Owl fell over 9% intraday, joined by declines from other alternative investment managers like Blackstone, Apollo Global Management, KKR, and Carlyle.

But is it an existential problem? While economist Mohamed Aly El-Erian is making headlines warning about a “canary-in-the-coalmine” situation in private credit similar to Aug. 2007, it feels too early to decisively say whether the scale of the problem will be disruptive enough to shake the entire economy.

There has been a concentration of private credit failures in the auto industry, for instance. However, those issues have not been systemic enough to cause non-banks or other financial institutions to fail. Instead, portfolios have taken the hit, offering the industry a lesson about underwriting. Of course, you have to remember that a feature of private credit funds is risk; these “cockroaches”, as they call them, might just be part of the product.

Ultimately, it remains to be seen if these issues are more pervasive and far-reaching than with this one fund. If, for example, the problems with this $1.7 billion investment vehicle were representative of the whole private credit industry?

Well, then we might have a problem.