First Brands flop tests shadow banks' flashlights

By Stephen Gandel

One of the big questions about the private credit boom is how lenders perform in a crunch. The collapse of First Brands, which filed for bankruptcy last Sunday, is especially revealing.

The U.S. auto parts firm appears to have racked up more than $4 billion in opaque debt by tapping a fragmented group of non-bank lenders, including private credit firms, securitized debt funds, and factoring companies. While the losses could be large, they are widely distributed. But if lax financial controls and hidden liabilities prove more common, investors may need to reconsider whether private lenders are properly compensating them for the risks.

First Brands, formed through a series of mergers, owned several mechanic-favorite auto parts brands. Its creditors include at least 517 collateralized loan obligations (CLOs), Cantor Fitzgerald’s private credit arm, and trade finance firms like Raistone, which is laying off dozens of employees due to exposure, Bloomberg reported citing people with knowledge of the matter. Rating agencies have slashed First Brands to a deeply distressed CCC. Many lenders were likely unaware of the true scale of the company’s liabilities. A balance sheet circulated in August showed $5.6 billion in corporate debt; the firm's bankruptcy filing now estimates liabilities between $10 billion and $50 billion. Much of the previously unknown debt appears tied to off-balance sheet loans backed by assets. The existence of those claims could reduce what First Brands' primary lenders recover in bankruptcy.

In one sense, private credit and debt markets appear to have absorbed the hit. VanEck’s CLO ETF, which tracks debt tranches and has over $1 billion in assets, is up 4.4% this year, though it dipped slightly in recent days. CLO watchers say First Brands' failure has done little to stall the broader private debt market. According to Fitch Solutions, the 379 U.S. CLOs holding First Brands debt had an average exposure equivalent to just 0.51% of fund assets. The 138 European CLOs had slightly higher exposure at 0.71%. Cantor’s O’Connor, one of the largest creditors, is owed $116 million — a small fraction of the $16 billion in assets it reported managing earlier this year.

The bigger question is how at least $4 billion in debt — possibly much more — escaped the notice of hundreds of lenders and investors. That's where the private credit market failed. The industry's proponents argue their funds assess risk better than banks. But CLOs, which have grown alongside private credit, are broadly diversified and often prioritize portfolio performance over scrutiny of individual loans. What's more, as money floods into private credit funds, some managers may be more focused on deploying capital than assessing creditworthiness.

Diversification can absorb failures, but it can also obscure them. If First Brands is an outlier, investors may be safe. If not, private credit may be underpricing risk it should be weeding out.

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On September 28, Cleveland-based auto parts maker First Brands filed for Chapter 11 bankruptcy protection. The filing listed a number of private credit funds among First Brand's top creditors, including an arm of Cantor Fitzgerald and London-based Pemberton Asset Management.

In total, First Brands owes borrowers between $10 billion and $50 billion, according to the filing, and has as little as $1 billion in assets. A failed offering in August listed the company's debt at $5.6 billion.