The collapse of First Brands demonstrates some of the challenges of private credit, while its use continues to expand.
With standard cash-flow-based lending to corporate borrowers slowing, private equity firms and other private credit lenders are looking to collateral as a financing basis. That collateral, while typically consisting of assets like consumer and auto loans and aircraft leases, now extends to intellectual property rights as well as data center and energy infrastructure.
Consultancy Oliver Wyman estimates that the market for all asset-backed lending in the United States alone is $5.5 trillion, but private credit currently has only a 5% share. To tap the market, credit funds are increasingly partnering with banks. The firm notes that in the last two years, PE firms and major banks have signed at least 10 private credit partnerships, with half of these partnerships focused on opportunities in asset-backed financing (ABF).
That said, the bankruptcy in late September of US auto parts supplier First Brands Group is calling into question some of the assumptions made about private credit’s interest in ABF and indeed about the entire category of nonbank lending.
In fact, the expansion of ABF, based on a borrower’s cash flow from its assets rather than its operations, presents new opportunities and risks for borrowers, lenders, investors, and potentially the financial system. The trend reflects several underlying developments in corporate finance and the broader economy. With growth ebbing in many sectors, so-called “direct,” operating cash-flow lending to corporates, by both banks and credit funds sponsored by private equity firms and others, appears to have reached its peak.
As PE firm KKR put it in “Asset-Based Finance: Hiding in Plain Sight,” a July report, “though today’s addressable ABF market already feels quite large, ABF is where direct lending was a decade ago.”
New Kid On The Block
The latest category of ABF is increasingly taking the form of data centers and other infrastructure that serve as the foundation of the new economy.
Indeed, the boom in artificial intelligence, along with the growing “tokenization” of payments—the use of blockchain technology to settle transactions more quickly and securely—has led to soaring demand for data center capacity, and tech companies are borrowing from private credit funds to expand it despite ample cash coffers.
Meanwhile, the energy transition from fossil fuels to alternatives is driving new electrification projects throughout most of the world, with governments (except that of the US at present) and developers increasingly turning to private sources of capital to finance these projects.
The long-term nature and changing requirements of infrastructure projects, both for power and for digitalization, are widely considered to be better suited to the more flexible and “patient” type of lending offered by private funds in comparison with banks. As Standard & Poor’s noted in a report last June, “Because these early-stage technologies require large up-front capital investments and have long investment horizons, digital and energy transition infrastructure projects are often not a natural fit for traditional sources of funding.” Yet, banks remain involved, often through partnerships with PE firms.
Within this ABF segment, Standard & Poor’s expects global infrastructure funding and financing requirements for data centers to rise 86% to $173 billion by 2028 from $93 billion in 2025, and that global “cleantech” investments—including solar, wind, biomass, green hydrogen, and storage—will need $4 trillion by 2030.
For investors, typically insurance companies, public pension and sovereign wealth funds, ABF provides higher yields and greater diversification than direct lending does, as these assets may not be correlated with those in the public markets.
But as First Brands’ collapse shows, the category is not without risk, as lenders face a need to accurately estimate the residual value of such assets in the event borrowers default, forcing liquidations, and the more unfamiliar those assets become, the harder their residual values are to assess.
Even more traditional ABF deals pose that risk, as evident in First Brand’s failure. Investment bank Jefferies has a $715 million exposure to First Brands’ receivables through a factoring agreement with a fund sponsored by its asset management unit, and the bank says it’s having difficulty assessing its claim on those assets. Swiss bank UBS is also exposed to First Brand’s bankruptcy through its asset management unit, with more than $500 million at stake. Not surprisingly, the stocks of publicly traded PE firms Apollo, Blackstone, and KKR also fell more than twice as far as the Dow Jones Industrial Average in the five days following news reports of First Brands’ failure.
Testing The High
In fact, most deals, whether in the form of direct lending or ABF, have been done in a high-growth, low-interest-rate environment and so have yet to be tested by high rates, an economic downturn, or both. And to the extent that banks are involved, regulators warn that defaults could pose systemic financial risk.
Viral Acharya, a professor of economics at New York University’s Stern School of Business and an adviser to the Federal Reserve Bank of New York, told Global Finance that he worries that the Fed will backstop private credit borrowers because of the possibility of a resulting credit crunch and the risk that poses to the real economy.
“Private credit has not yet been stress-tested,” Acharya says. He worries that, rather than issue more equity in case of credit downgrades, private equity firms will draw down their bank facilities. In that scenario, he says his main concern is that “the risks will play out on banks’ balance sheets.”
That risk may be most acute in data centers, driven largely by compute demand for AI applications developed by big tech firms, or hyperscalers, as the technology has yet to produce significant revenue for them despite already huge investments. And Fitch Ratings in September warned that tariffs on steel and aluminum, sharply rising electricity costs, geopolitical tensions, the end of US federal support for wind and solar power, and a slowing economy all pose increased challenges for data center operators.
Meta Platform’s financing deal last June with PE firm Blue Owl and asset manager Pacific Investment Management is perhaps the most dramatic example of how private credit is financing the trend, as the firms will lead a $29 billion financing for Meta’s data center expansion in rural Louisiana, with all but $3 billion of that in debt. While Meta had $77.8 billion in cash on its balance sheet as of December 31, its capital spending totaled $39.2 billion, and that didn’t include principal payments on finance leases, which are not reflected there.
And the fact that the new data center debt financing also won’t be included on Meta’s balance sheet but will reside in a special purpose vehicle suggests the company is concerned about the risk involved. After all, off-balance-sheet (OBS) financing via special purpose vehicles is designed to securitize the borrowing to shift the risk of default to investors.
Lack of transparency is among the risks facing Jefferies and UBS at First Brands, as the company’s receivables financing was also done through off-balance sheet vehicles. Jefferies said that it was trying to determine if the receivables in question have been factored, or borrowed against, “more than once,” according to an October 10 report by CNBC.
OBS financing only increases the opacity that characterizes private credit in the first place. As the European Central Bank noted in a report in May of last year: “Private funds’ assets are valued less frequently and under more subjective model assumptions, which can conceal potential losses, underlying volatility and the correlation between the returns on private funds with other markets.”
The Bank for International Settlements, an international regulatory institution based in Basel, Switzerland, expressed more fundamental concerns about private credit in a report entitled “The Global Drivers of Private Credit,” published last March: “It remains to be seen whether the expected returns of private credit are commensurate with the risk-taking involved or whether lending standards deteriorate in the face of continued credit expansion—in particular because private credit, being a fairly young asset class, has not yet gone through a full credit cycle.”
The outcome of First Brands’ collapse is likely to shed some light on these issues.
