Bankruptcies are a routine event for companies relying on large amounts of high-yield debt for their capital. Investors reserve much of the high income they receive in good times for the inevitable losses in bad times. What is not routine is companies collapsing suddenly amid allegations of massive fraud, and in ways that destroy business operations, inflicting losses on employees, customers and suppliers as well as investors.
Like the first swallows of Spring, these collapses can be the first sign of a major financial meltdown, often brought on by a combination of excessive leverage, draining liquidity and misguided valuations.
In the mid-1990s, toxic mortgage securities were at the heart of the crisis; in the late-1990s and early-2000s, it was dicey revenue-recognition and derivative accounting; in 2007, it was financial institutions and complex credit derivatives; and in 2023, it was crypto. In 2025, attention is turning to the $1.7 trillion private credit industry and its explosive growth since the financial crisis.
In the last month, we’ve seen auto-parts supplier First Brands Group fail amid lender claims of “widespread fraud” and the disappearance of billions of dollars; lender Tricolor Holdings collapse with its bankruptcy trustee probing fraud of “extraordinary proportion”; and remodeling company Renovo Home Partners shut without warning and file for Chapter 7 (liquidation) rather than the usual Chapter 11 (reorganization) bankruptcy that preserves business operations.
Renovo collapsed so suddenly that employees were sent emails terminating their employment the same day, with their health insurance ending two days later. They may well not get their final paychecks. Customers were left with unfinished jobs and no one answering the phone. They may well lose their deposits and be left with demolition but no construction.
This kind of disruption should never occur due to an inability to make interest payments. It’s in everyone’s interest — creditors, customers, suppliers and employees — to keep economically sound but financially overextended businesses in operation. That’s what Chapter 11 bankruptcy is designed for. Only fraud or incompetence can explain destroying going concerns due to financial problems.
“My antenna goes up when things like that happen,” JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon told analysts recently. “I probably shouldn’t say this, but when you see one cockroach, there are probably more. Everyone should be forewarned on this one.” And that was before the Renovo news hit.
Dimon is not the first to make this point with a colorful analogy. Back in 1993, when high-yield debt was free-falling, Warren Buffett famously remarked, “You don’t find out who’s swimming naked until the tide goes out.”
And in 1955, John Kenneth Galbraith, writing about the Great Depression, introduced the concept of the “bezzle” — the aggregate amount of money that has been embezzled but not yet discovered. He pointed out that the bezzle adds to the money supply, because both the embezzler (correctly) and the embezzlee (incorrectly) believe they have the same assets. When economic times start to turn bad, the bezzle disappears as frauds are uncovered and the sudden contraction of money supply can turn a mild downturn into a sudden crash.
One new aspect in 2025 is the existence of publicly traded private credit funds, popularly known as business development companies.
Traditionally, most debt was held by private lenders such as banks that were heavily regulated with large capital buffers to absorb losses. Loans were accounted for in a “banking book” that did not mark them to market. Instead, banks estimated a loan loss reserve for expected losses. Public debt, with extensive disclosure requirements, is marked to market by prices in arms-length transactions. While both sectors have had plenty of disasters, substantial safeguards are in place as well.
Publicly traded private credit funds have no capital buffers, are lightly regulated, don’t mark to market effectively and have minimal disclosure and few arms-length transactions in their underlying positions. They rely almost exclusively on the oversight of their managers to prevent a credit meltdown with possible contagion.
BlackRock TCP Capital Corp. was the largest holder of Renovo debt, and it valued it at 100 cents on the dollar as late as Sept. 30 — meaning fund investors were paying management and performance fees as if the debt retained full value.
Meanwhile, a significant and unusual gap has opened between how different private credit funds value a loan to software provider Medallia Inc. An Apollo Global Management Inc. fund deemed the loan worth 77 cents on the dollar at the end of September, a level typically considered distressed, while a rival fund co-managed by Future Standard and KKR & Co. put it at 91 cents, Bloomberg News reports.
The failure of institutions to mark instruments to market can disguise small downturns, but they lead to sudden collapses when the difference between the official valuation and economic value gets too large. The combination of high leverage (publicly traded private credit funds often have $2 of debt to $1 of equity, and the $3 is invested in debt of highly levered companies), low liquidity and untrustworthy valuation is the trifecta underlying many a financial disaster.
Of course, investors in these funds know — or should know — all this. They may rationally choose to accept the danger of working without a net to save the expense of safeguards; and to allow presumably expert managers to maximize the value of positions without fetters or publicity. But given the sometimes catastrophic effects of credit meltdowns, when even small-money losses in a narrow sector can shake confidence and infect other markets, it’s less clear that the financial system as a whole is better off with these funds.
It remains to be seen whether this episode will snowball into a full-fledged credit crunch. The total dollar amounts to date are not significant compared to the overall economy, but neither were the subprime mortgage losses in 2007. What matters is the size of the bezzle.
If we’ve seen the worst of it, this could be a minor hiccup for everyone not working for, dealing with or investing in the stricken companies. But if it’s only the tip of the iceberg, it could be time for women and children to head for the lifeboats and the band to strike up Nearer my God to Thee.
A message from Advisor Perspectives and VettaFi: Discover something new! Click here to register for our upcoming webcasts.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
Read more articles by Aaron Brown
