The Rise and Risks of Private Credit

After completing this reading, you should be able to:

• Describe characteristics of private credit, including its typical investors and borrowers, and compare private credit to other types of loans and fixed-income instruments.
• Explain the return profile and growth profile of the private credit asset class, and compare the historical returns of private credit to those of other asset classes.
• Describe and assess the risks and vulnerabilities related to private credit, and explain how private credit can pose risks to financial stability.
• Assess potential policy recommendations that could help mitigate the risks associated with private credit.

Characteristics of Private Credit

Private credit refers to corporate credit provided by nonbank entities through bilateral agreements or small “club deals.” It specifically excludes bank loans, broadly syndicated loans, and publicly traded debt instruments like corporate bonds.

Private credit has evolved significantly, becoming a crucial component of the financial landscape. It serves as an alternative to traditional lending sources, offering bespoke financial solutions primarily to middle-market firms. Its growth is driven by its flexibility and customized terms that are not available in public markets.

Typical Investors

Institutional investors: The primary investors in private credit are institutional investors with long-term investment horizons. These include:

• Pension funds
• Insurance companies
• Sovereign wealth funds
• Family offices

Retail investors (growing segment): In the United States, business development companies (BDCs), which are often publicly traded and open to retail investors, represent a growing segment of the market. In Europe, some funds have adopted more frequent redemption periods to attract a wider investment base.

Typical Borrowers

Private credit best serves borrowers who are often considered too risky or large for bank loans but too small for public debt markets. Key characteristics include:

• Middle-market firms: These firms typically have revenues between $100 million to $1 billion and prefer private credit for its speed and flexibility.
• Highly leverage-supported firms: Often backed by private equity, these firms rely on bespoke credit structures to manage liquidity and solvency, particularly in cyclical downturns.
• Sectors dominated: Technology and healthcare sectors are prevalent among private credit borrowers, highlighting the riskier and innovation-driven nature of these industries.

Key Characteristics

Private credit distinguishes itself through several defining features that offer unique advantages compared to traditional financing methods:

• Customized lending arrangements: The hallmark of private credit is its flexibility in structuring deals. Unlike standardized bank loans or bonds, private credit transactions are highly bespoke and negotiated directly between lenders and borrowers. This allows for tailored covenants, which impose specific restrictions on the borrower’s activities (such as maintaining certain financial ratios or limiting asset sales), thereby providing enhanced protection to lenders and addressing particular risk profiles. This customization enables private credit to serve niche markets and unique borrower requirements that standard financial products cannot fulfill.
• Floating rate loans: Private credit loans typically carry floating interest rates that are indexed to benchmarks like LIBOR or SOFR. This feature protects lenders against interest rate hikes, as rates adjust periodically to reflect current market conditions. Such a mechanism allows lenders to maintain a stable yield relative to the prevailing interest environment, thereby mitigating the risk of inflation diminishing the loan’s value.
• Closed-end fund structures: Private credit is often managed in the form of closed-end funds, which have fixed capital bases and specific investment horizons. This structure permits fund managers to strategically deploy capital over a set timeline without the pressure of redemption calls, thus minimizing liquidity risks. Investors commit their capital for the fund’s duration, aligning incentives and allowing managers to focus on long-term, illiquid opportunities that may offer higher returns.
• Enhanced covenants: Compared to broadly syndicated loans, private credit often includes enhanced covenants that provide lenders with greater downside protection. These covenants can include restrictions on leverage, interest coverage ratios, capital expenditures, dividend distributions, additional debt, and asset sales.
• Long-term capital: Due to the illiquid nature of private credit deals, lenders typically rely on long-term pools of locked-up capital for financing.

Reasons for Borrowing from Private Credit

• Limited access to traditional funding: Weaker firms with low or negative earnings and high leverage may find it difficult to secure bank loans and, therefore, turn to private credit.
• Exclusion from the syndicated loan market: Borrowers may be too small or lack sufficient collateral to access the syndicated loan market.
• Flexibility, speed, and confidentiality: Private credit offers advantages over traditional financing options in terms of flexible deal structuring, faster execution, and greater confidentiality.

Comparison with Other Financing Instruments

Bank loans: Private credit serves companies that are often too risky or large for single bank loans. Bank loans are subject to stricter regulatory oversight and are typically less flexible in terms of loan terms.  

Broadly syndicated loans: Private credit targets smaller companies than those that access broadly syndicated loans. Syndicated loans have a wider investor base and a more developed secondary market, while private credit deals are typically held to maturity. Private credit also offers enhanced covenants compared to broadly syndicated loans.

High-yield bonds: Private credit borrowers are generally smaller and riskier than high-yield bond issuers. High-yield bonds are publicly traded, offering greater liquidity but less flexibility in terms of loan terms. Private credit loans are typically floating rate, while a smaller portion of high-yield bonds are.

Investment-grade bonds: Investment-grade bonds are issued by large, financially stable companies and represent the lowest risk in the fixed-income spectrum. Private credit involves significantly higher risk and targets a different segment of the market.

Yields: Interest rates on private credit loans are typically higher than yields on market-based debt instruments like corporate bonds and leveraged loans, reflecting the higher risk associated with these loans.

Key Takeaways:

• Private credit provides tailored solutions, effectively bridging gaps in the market left by banks and public markets, thus appealing to non-traditional borrowers with unique needs.
• The bespoke nature and strategic structure of private credit attract institutional investors seeking high returns and portfolio diversification.
• Growth in this asset class can be attributed to its capacity for customization, aligning closely with borrower requirements and investor expectations.

Return and Growth Profile of Private Credit

Private credit has increasingly become a significant part of the financial ecosystem, providing tailored debt solutions outside traditional markets. It is characterized by robust returns, relatively low volatility, and rapid growth, making it appealing to a diverse range of investors. Here, we examine its return profile, growth trajectory, and how it stacks up against other asset classes.

Return Profile

• High yields and stability: Historically, private credit has offered some of the highest returns among debt markets, driven by bespoke lending terms that encompass protective covenants and premium interest rates. This makes it attractive for investors seeking enhanced yield compared to traditional fixed-income products.
• Capital preservation: The use of collateral and covenants in private credit loans supports capital preservation, limiting credit losses. During stress periods, such as economic downturns, the presence of these terms can stabilize returns.
• Relative low volatility: Despite catering to riskier borrowers, private credit experiences lesser price volatility compared to high-yield bonds and leveraged loans. This behavior can be attributed to less frequent valuation shifts and the non-marketed nature of these instruments.

Growth Profile

Rapid growth post-global financial crisis: Private credit has grown rapidly since the global financial crisis of 2008. This growth has been fueled by several factors, including:

• Low interest rates, which increased investor interest in alternative investment strategies offering higher yields.
• Post-crisis regulatory reforms that increased capital requirements for banks, making them less willing to lend to middle-market firms.
• Lower capital charges for some end investors, such as insurance companies, for investing in private credit compared to bank loans.

Expansion beyond middle-market: While initially focused on middle-market lending, private credit has expanded its reach to include larger corporate borrowers that previously relied on broadly syndicated loans or corporate bonds.

Regional focus and expansion: Private credit remains primarily concentrated in North America, but other regions, including Europe and Asia, are experiencing similar growth.

Market size: As of 2023, global private credit assets, including both deployed capital and undeployed capital commitments (“dry powder”), reached approximately $2.1 trillion. In the United States, private credit assets are now comparable in size to the leveraged loan and high-yield bond markets.

Growth rates: Over the past five years, assets under management of private credit managers located in the United States have grown at an average annual rate of 20 percent. In Europe and Asia, the annual growth rates have been 17 percent and 20 percent, respectively, although the overall market size is smaller.

Comparison to Other Asset Classes

• High-yield bonds and leveraged loans: Private credit typically offers higher returns compared to high-yield bonds, partly due to the bespoke nature of the terms and comparatively higher credit risks. It also surpasses leveraged loans in yield, while offering similar features like floating rates.
• Private equity: While private equity can provide substantial returns, it involves higher risk and a longer time horizon. Private credit, in contrast, offers more regular income flow with less volatility, making it preferable for income-focused institutional investors.
• Public equities (e.g., S&P 500, MSCI World TR): Compared to public equities, private credit has historically offered lower returns but also lower volatility. However, this lower volatility is, again, partly a function of valuation practices.
• Public debt markets: Compared to public bonds, private credit’s advantage lies in its ability to negotiate terms directly with borrowers, thus enhancing its risk-adjusted returns. It provides an alternative for investors seeking diversified portfolio exposures beyond publicly traded debt instruments.

The higher returns for investors in private credit come at a cost for borrowers. Interest rates on private credit loans tend to be higher than yields on market-based alternatives like high-yield bonds and leveraged loans. This reflects the higher risk profile of private credit borrowers and the illiquidity of the loans.

Key Considerations

• Illiquidity: Private credit investments are illiquid. There is no active secondary market for these loans, making it difficult for investors to sell their positions before maturity. This illiquidity is a key factor contributing to the higher returns offered by private credit.
• Valuation challenges: The lack of a liquid market makes it challenging to value private credit investments accurately. Valuations are typically based on models, which can be subjective and may not fully reflect underlying risks. This can create a false sense of low volatility.
• Dry powder: A significant portion of private credit assets consists of “dry powder,” which refers to undeployed capital commitments. This indicates that there is significant capital waiting to be invested in private credit, which could put downward pressure on future returns if too much capital chases too few deals.

Risks and Vulnerabilities of Private Credit and Implications for Financial Stability

The shift of credit from regulated banks and transparent public markets to the more opaque private credit sector introduces several potential risks and vulnerabilities that could threaten financial stability.

Key Vulnerabilities

• Fragile borrowers: Private credit borrowers tend to be smaller, more leveraged, and have weaker financial profiles than their public market counterparts. This makes them more vulnerable to economic downturns and interest rate shocks, as their loans are predominantly floating rate. Rising interest rates can increase their debt servicing costs, potentially leading to payment-in-kind (PIK) interest accruals, which compound losses if the borrower’s performance doesn’t improve.
• Increased exposure of institutional investors: Pension funds and insurance companies have increased their allocations to private credit and other illiquid investments. This concentration of exposure means that losses in private credit could significantly impact these institutions and their beneficiaries. The lack of transparency makes it difficult for these institutions and their regulators to assess the true extent of these risks.
• Growing share of semiliquid investment vehicles: While most private credit is held in closed-end funds with long lock-up periods, the growth of semiliquid funds, which offer more frequent redemption options, creates liquidity risks. In a downturn, these funds could face increased redemption requests, leading to fire sales of assets and exacerbating market stress.
• Multiple layers of leverage: Although leverage at the fund level may appear modest, the private credit ecosystem involves multiple layers of leverage, from borrowers to funds to end investors. This interconnectedness creates contagion risks. In a downturn, capital calls from funds to investors could strain leverage providers and trigger a cascade of deleveraging, with potential spillovers to other markets.
• Stale valuations: Private credit loans are not publicly traded and are typically “marked to model” by third-party pricing services. This lack of market-based price discovery can lead to stale valuations that do not accurately reflect underlying risks, especially during periods of stress. Fund managers may also be incentivized to delay recognizing losses to maintain their track records. This can lead to a delayed realization of losses and sudden, large valuation markdowns in a downturn.
• Unclear interconnections: The complex web of relationships between borrowers, funds, investors, and leverage providers makes it difficult to understand the full extent of interconnectedness within the private credit market and its links to other parts of the financial system. This opacity hinders risk assessment and increases the potential for unexpected contagion.
• Deteriorating underwriting standards: As the private credit market grows and competition intensifies, there is a risk of deteriorating underwriting standards, including weaker covenants and looser lending terms. This increases the likelihood of future credit losses.
• Increasing retail participation: The growing participation of retail investors in private credit, particularly through BDCs, raises conduct risks. These investors may not fully understand the illiquidity, complexity, and risks associated with these investments.

Systemic Risk to Financial Stability

Private credit’s growth poses potential systemic risks as it becomes a more integral part of the financial system:

• Opacity and data gaps: A lack of comprehensive data on private credit transactions and participants makes it difficult to assess and monitor potential systemic risks. This opacity hampers effective supervision and risk assessment.
• Potential amplification of economic shocks: As private credit markets grow, they may amplify negative economic shocks. The shift from regulated banks and markets to less transparent private firms could lead to a weakened ability to absorb financial turbulences.
• Vulnerability to deteriorating standards: Competitive pressures and rapid growth might lead to decreased underwriting standards and weaker covenants, increasing the risk of credit losses.
• Interconnectedness with other financial sectors: The interconnected nature of private credit with other financial institutions, such as insurers and pension funds, means that disruptions can have wide-reaching effects across the financial system.

Policy Recommendations for Mitigating Risks in Private Credit

The IMF report highlights several policy recommendations to mitigate the risks associated with the growth of private credit and its potential impact on financial stability. These recommendations focus on enhanced supervision, improved data collection, addressing liquidity risks, and strengthening cross-border cooperation.

1. Enhanced supervision and regulation
   • More intrusive approach: The report recommends a more intrusive supervisory and regulatory approach to private credit funds, their institutional investors, and leverage providers. This implies moving beyond a purely principles-based approach to a more rules-based framework, with greater scrutiny of fund activities, investment strategies, and risk management practices.  
   • Focus on leverage: Regulators should pay close attention to leverage within the private credit ecosystem, not just at the fund level but also across the entire value chain, including borrowers and investors. This requires better data collection and analysis of leverage exposures.
   • Consistent asset risk assessments: The report calls for more consistent asset risk assessments across different financial sectors. This would help to ensure that similar risks are treated consistently regardless of the type of institution holding the assets.

2. Closing data gaps and enhancing transparency

   • Improved data collection: A key recommendation is to close data gaps that currently hinder a comprehensive assessment of risks in the private credit market. This includes collecting more detailed data on:
     • Leverage across the private credit value chain.
     • Interconnectedness between different market participants.
     • Investor concentration and exposures.
     • Borrower financial health and performance.
   • Enhanced reporting requirements: The report suggests enhancing reporting requirements for private credit funds, their investors, and leverage providers. This would improve transparency and allow for better monitoring and risk management by both regulators and market participants.
   • Standardized contract terms: Standardized terms for private credit contracts could enhance transparency and facilitate comparisons across different loans.

3. Addressing liquidity and conduct risks in funds

   • Monitoring liquidity risks: Regulators should closely monitor liquidity risks in private credit funds, particularly those with more frequent redemption options (semiliquid funds). This includes assessing the liquidity of underlying assets and the potential for redemption pressures in a downturn.
   • Addressing conduct risks: The report highlights the need to address conduct risks, especially related to the increasing participation of retail investors. This includes ensuring that investors fully understand the risks and illiquidity associated with private credit investments.
   • Implementing FSB/IOSCO recommendations: The report recommends implementing relevant product design and liquidity management recommendations from the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO). These recommendations aim to improve the resilience of investment funds and mitigate systemic risks.  

4. Strengthening cross-border and cross-sectoral cooperation

   • Cross-Border Cooperation: Given the global nature of private credit markets, strengthened cross-border regulatory cooperation is essential. This includes sharing information and coordinating supervisory efforts to address potential cross-border risks.
   • Cross-Sectoral Cooperation: The report also emphasizes the need for cross-sectoral cooperation between regulators of different types of financial institutions, such as banks, insurers, and asset managers. This is crucial for understanding and managing interconnectedness risks.

Specific policy recommendations summarized

• Supervision: Move towards a more intrusive supervisory approach for private credit funds, investors, and leverage providers.
• Data: Close data gaps by enhancing reporting requirements for leverage, interconnectedness, investor concentration, and borrower performance.
• Liquidity: Monitor liquidity risks in funds, especially those with retail investors and more frequent redemption options, and implement FSB/IOSCO recommendations.
• Coordination: Strengthen cross-sectoral and cross-border regulatory cooperation to address interconnectedness and cross-border risks.
• Conduct: Ensure retail investors fully understand the risks and illiquidity of private credit investments.

Question

An institutional investor is constructing a portfolio with a specific mandate to generate consistent income while managing downside risk. Considering the characteristics of private credit and private equity, which allocation strategy best aligns with this mandate?

A) A higher allocation to private equity due to its potential for higher capital appreciation.

B) A balanced allocation between private credit and private equity to maximize diversification.

C) A higher allocation to private credit due to its focus on income generation and lower volatility.

D) A strategic allocation to private equity focused on established, cash-flow generating businesses within defensive sectors.

Correct Answer: C

Private credit aligns well with a mandate to generate consistent income while managing downside risk because:

• Income generation: Private credit investments, such as loans and debt instruments, typically provide regular interest payments, delivering steady cash flows to investors.
• Lower volatility: Compared to private equity, private credit tends to have lower volatility because it focuses on debt, which is higher in the capital structure and less sensitive to equity market fluctuations.
• Downside Protection: Debt investments often include covenants and collateral that reduce the risk of loss compared to equity investments.

A is incorrect: Private equity prioritizes capital appreciation over income and carries higher volatility.

B is incorrect: While diversification is generally beneficial, a mandate focused on income and risk management suggests a greater emphasis on private credit.

D is incorrect. While this strategy may provide some income, private equity still carries higher risk and less consistent cash flows compared to private credit.