Frankenstein’s Monster in Your Portfolio?

I asked for my money back once. Not from a fund. From a friend who owed me $200.

He said sure. Then he paid me $40. Then he explained that the other $160 was still good, still coming, still worth full value. He just couldn't give it to me right now.

That's what's happening in private credit right now. Except the friend manages tens of billions of dollars.

Here is the setup. Over the last few years, ordinary investors poured money into a product called a non-traded BDC. A business development company. You put cash in. The fund lends it to mid-sized private companies at high rates. You collect a fat yield. The pitch was simple: bond-like safety, equity-like income, low drama.

The product grew into a $2 trillion industry. Then people started asking for their money back.

And the funds said no. Not all of it. Not now.

These funds cap withdrawals at 5% of the fund per quarter. It's written into the rules. So when 17% of investors in Cliffwater's flagship lined up to leave in the second quarter, the fund paid out 5% and told the rest to wait. Everyone who asked got back about 29 cents on the dollar they requested.

Blackstone's big fund saw 10% of investors try to leave in the same quarter. It capped them at 5% too.

The managers call these caps a feature, not a bug. They're right, in a way. The caps stop a fire sale. But they also tell you something. A fund only needs a gate when too many people want out at the price on the screen…

So the question becomes the whole story. Is that price real?

That's what worries me. The number these funds report is called net asset value. NAV. It's what your statement says your shares are worth. But it's not a market price. Nobody bids on it. The manager calculates it. And right now there's a growing gap between what the statement says and what a buyer will pay.

We've tracked the edges of this for months. This week it moved to the center.

Let me show you the gap.

There's only one honest way to learn what something is worth. Try to sell it.

In February, a hedge fund run by Boaz Weinstein did exactly that. His firm, Saba, offered to buy shares of several non-traded credit funds directly from investors who wanted out. The price he offered tells you everything.

For one Blue Owl fund, Saba bid $3.80 a share. That was about 35% below the value the fund itself reported. He has said he's willing to buy across the sector at discounts of 30% to 40% or more.

The fund's board pushed back. It said investors would do better waiting for scheduled payouts. Maybe. But a real bid landed on the table, and it landed far below the statement value.

Weinstein went further on social media. He called the private credit market "Frankenstein's Monster." So a man who made his name pricing complex credit is now buying these funds at a third off. That's the tell.

And here's where it spreads. The high yield that drew people in rests on a quiet accounting choice.

When a borrower can't pay cash interest, many of these loans let it pay with an IOU instead. The interest gets bolted onto the loan balance. The lender still records it as income. Investors still get a yield on paper. No cash changes hands.

It's called payment-in-kind. PIK, for short. In small doses it's normal. In large doses it hides stress.

Look at the numbers. Across 46 of these funds, the median dividend was barely covered by income at all in the first quarter. Strip out the PIK paper income, and coverage dropped to 0.89 times. Below one. The cash coming in didn't cover the cash going out.

So the dividend looks sturdy. The cash behind it is thinner. Fitch has warned this can drain a fund's liquidity if too many borrowers lean on the IOU option at once.

When the income is partly an IOU and the exit is partly closed, you're holding less than the statement says. That's the same problem, seen from a different door.

Meanwhile, the squeeze didn't stay put.

Early in June, the Swiss manager Partners Group said it was limiting withdrawals from one of its European private equity funds. Then it said it might restrict more of its funds. It warned the wave of withdrawal requests was moving from private credit into private equity.

That's the part I keep coming back to. These are different products. Private loans. Private companies. Private real estate. But they share one design. You can put money in easily. You can only take it out slowly. And the value you see is the value the manager assigns.

When investors lose faith in one, they reach for the exit in the others. In Canada, roughly $30 billion in private real estate funds — about 40% of that market — already sits gated.

One door closing makes people test the next one. So the question isn't whether the loans are good. It's whether everyone can leave at the price on the screen. They can't. They never could.

Three more things worth keeping track of.

Japan's longest bonds woke up. In January, the yield on the 40-year Japanese government bond crossed 4% for the first time in over thirty years. Japan was the world's cheap-money anchor for a generation. Its big life insurers, sitting on huge unrealized losses, are pulling back from the longest bonds and rethinking what they hold abroad. When the anchor moves, the rope tugs on everyone tied to it.

Subprime car loans hit a record. In January, 6.9% of subprime auto borrowers were at least 60 days behind. That's the worst reading in the 32 years Fitch has tracked it. Prime borrowers are fine, near 0.4%. A car payment is the last bill most people skip, so this gap shows you exactly which households have run out of room.

Software loans sit at the center of the credit books. Moody's found software makes up about 25% of the median private-credit fund's loans. The maturity wall for those loans doesn't arrive until 2028 and 2029. So the stress is a slow build, not a sudden break. For now. We'll see.

Wall Street has a trick it loves. Take something that's hard to sell. Wrap it in something easy to sell. Then tell everyone the wrapper is safe.

It's doing it again right now.

Banks are taking pools of private loans — the same kind of loans made to mid-sized companies — and bundling a hundred or more into one structure. Then they slice that structure into layers. The top layer gets paid first, before any of the layers below it lose a penny. Because it's first in line, the rating agencies stamp it AAA. The highest grade there is.

Then they put that top layer inside an ETF. A fund you can buy and sell on your phone, any second the market is open. About $13 billion flowed into these funds over the past year.

Look at what just happened.

The underlying loan didn't change. A company in one of these pools is just as slow to repay, just as hard to value, as it was the day it was made. But the wrapper says daily liquidity. The rating says AAA. The yield says 4.8%.

The sellers lean on one fact. A AAA layer of this kind of structure has never taken a loss in thirty years. That's true. It survived 2008. The buffer underneath it is thick.

But I've heard "it survived the last one" before. In 2007, the safest thing on the board was a AAA slice of a mortgage pool. Same idea. Take loans nobody could price one by one, pool them by the hundred, and stamp the top slice AAA. The buffer was thick there too, right up until the loans underneath all went bad at the same time.

The danger then sat in the slice everyone agreed was safe. The slice nobody stress-tested for everything failing at once.

I'm not saying these funds are 2008. The loans are different. The buffers are real. The managers can swap out bad names while there's still a market to swap into.

But the move is identical. We took an asset whose whole problem is that you can't sell it quickly at a known price. And we sold it as something you can. The promise of instant cash now sits on top of loans that pay some of their interest in IOUs.

A wrapper can't make an illiquid thing liquid. It can only hide the seam until everyone reaches for the exit on the same morning.

I have no idea when that morning comes. So we watch the seam. We'll see.