Private credit’s meltdown will hurt Gulf SWFs and family offices

Matein Khalid

The past eight weeks have seen a multi-trillion-dollar market cap meltdown. Wall Street developed a sudden aversion to software companies, viewing them as victims of the AI revolution. At the same time, the war in the Gulf has led to a sharp rise in the Volatility Index, the US dollar and US Treasury bond yields.

These are macro headwinds for high-beta Nasdaq sectors, including software, and have cast financial storm clouds over even large, established businesses in the US, Europe and Asia.

While it is premature to conclude that enterprise software firms will share the fate of horse-drawn buggies and black-and-white TV, the fact remains that technological obsolescence is a recurrent, even traumatic, theme in the Digital Age.

The private credit industry’s perma-bull cheerleaders lambasted JP Morgan chairman Jamie Dimon when he warned about credit “cockroaches” in their opaque, illiquid, $1.7 trillion alternative funding market. His comments followed two spectacular US corporate failures last autumn – subprime auto lender Tricolor and car parts maker First Brands.

However, Dimon’s pessimism has been vindicated by clear evidence of a liquidity crisis. Institutional investors have not been able to redeem their investments even in some of Wall Street’s largest bellwether private credit funds, where credit exposure to the software/IT services sector can range from 45 to 60 percent.

The problems in the software sector are likely to get worse if $100 Brent forces the Federal Reserve to raise interest rates in order not to violate its inflation mandate at a time when the global economy is stressed by war and the greatest oil supply shock since October 1973.

If this happens, rising defaults in the software sector may trigger cross-asset contagion and pose a systemic headwind for the US central bank at a time when the capital markets will surely test Kevin Warsh, the incoming chairman.

Yet the sudden bankruptcies of Tricolor and First Brands were just the tip of the credit risk iceberg. Real systemic cockroaches have now emerged in the global software business, which Silicon Valley wunderkind Marc Andreessen once boasted would eat the world.

Instead, software is now in danger of being eaten alive by AI’s crown jewel disruptors. Anthropic proved this with a vengeance in early February, when its AI-powered legal research tool gutted the valuations of Thomson Reuters and LegalZoom by 25 percent in a single trading session.

The wolves are now also circling private equity amid a tsunami of investor redemptions and as failed buyouts devastate the shares of the bluest-chip Wall Street alt asset managers.

Blackstone, KKR, Carlyle, Apollo, TPG and Ares manage the largest private credit exposures from the Gulf – at least $100 billion in private credit allocations from the GCC’s biggest sovereign wealth funds, ultra-high-net-worth investors and family offices.

Their shares have fallen from 45-60 percent on the New York Stock Exchange as the macro storm clouds darken in both private and public capital markets.

Private credit was previously a niche $300 billion industry that emerged as a result of the restrictive Dodd-Frank banking regulations enacted in the immediate aftermath of Lehman Brothers’ failure in 2008. Then, money centre banks such as Citigroup, Merrill Lynch, Morgan Stanley, UBS and RBS barely survived the global financial crisis without explicit or implicit taxpayer-funded government bailouts.

In return for the bailouts, global banks were forced to abandon the high-yield, unregulated, middle-market direct-lending segment. This left the field open for a new breed of leveraged, unregulated asset managers who claimed to have discovered a secret sauce to generate 300-500 basis points higher annual returns than those available in equities or high-yield bonds.

Sadly, the senior executives of the Gulf’s sovereign wealth funds, pension funds and family offices bought the Yale endowment model ideology peddled by Wall Street’s private credit merchants of debt.

The executives ignored the fact that the endowment model seriously exposes a financial institution to credit risk in illiquid markets.

US private credit’s exposure to software and IT services now imply an unexpected debt shock at the pinnacle of GCC finance – at a time when the Iran war could mean unexpected demand for liquidity in even sovereign wealth funds. Once again, hubris on Wall Street could mean nemesis for GCC capital allocators to US private credit.

Swiss megabank UBS estimates that private credit defaults will rise to 13 percent due to AI disruption, against only 4 percent in the US high-yield debt market. Software services is another danger zone as the freefall in the shares of Accenture, IBM, Tata Consulting Services and Infosys suggests.

This is beyond just routine credit risk. It is existential and the Gulf must brace for an external debt crisis on the scale of Latin American sovereign debt in the 1990s, mortgage derivatives in the 2005-07 credit bubble and the systematic destruction of China’s property developers over the past decade.

I was aghast when I saw GCC-based commercial banks in even the Northern Emirates sell 10 times leveraged notes on high-risk products like Asian high-yield funds, which blew up when China’s ultra-prime property developers defaulted and the biggest real estate bubble in human history was destroyed by President Xi’s Politburo.

A 13 percent default rate in US private credit means hundreds of billions of dollars will have to be written off worldwide by lenders whose loan covenants simply cannot price the scale of value destruction we have seen.

If the shares of global software colossi such as Microsoft, Adobe and Salesforce can lose 30-50 percent since last summer, what hope is there for the thousands of private software/services firms backed by alternative asset managers who routinely market their funds to elite GCC investors?

The lack of regular reporting by private credit funds means it will take some time before the cockroaches trigger a bottom-line bloodbath – but it will happen.

This debt crisis has the potential to cause a global recession and end the asset market euphoria of the Roaring Twenties.

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