Since the financial crisis of 2008, policymakers have been cracking down on leverage at banks. As a result, banks cut back on any lending that didn’t seem profitable enough if it wasn’t juiced by leverage.
The result was a big opportunity for fund managers: a private credit market now estimated to be worth some $1.6 trillion and forecast to double in the next five years. Bankers and bond investors have started to complain and to issue warnings about looming risks. Policymakers are asking questions.
Regulators should resist pleas to impose new rules on private credit, but they should seek ways to track its evolution and monitor potential risks.
Private credit funds pose less of a threat to financial stability than banks because, unlike depositors, their investors — largely pension funds, insurance companies and wealthy families — don’t expect to be able to withdraw their money whenever they want. They can also withstand losses if some of the loans default. Bank depositors, as demonstrated earlier this year, aren’t prepared to do the same.
It’s true that private credit funds mostly make loans to risky companies. But so far they’ve tended to do so carefully, writing terms into the contracts that require borrowers to meet certain tests of financial health and prohibit them from moving assets or transferring intellectual property to subsidiaries outside of the lenders’ reach. They also make floating-rate loans, which has benefited investors in a rising rate environment. By contrast, in recent years investors in the types of widely syndicated bank loans that finance large takeovers have been getting reduced protections and little opportunity to negotiate.
Double-digit returns in private credit have attracted more money from investors. And the substantial fees earned by the funds — about $7 billion for the six largest managers in 2022 — have attracted more competition. As is often the case with hot financial products, however, success can carry the seeds of trouble.
To compete, some funds are already giving up on some of the protections they once demanded. Meanwhile, companies that took out loans just a couple of years ago are feeling the impact of higher rates. Losses are, of course, a consequence of risk-taking. But regulators should know if those losses start spreading beyond the funds and their institutional investors.
For instance, some private credit funds are now being pitched to retail investors. Insurance companies, often working in tandem with asset managers, are putting more of their annuity holders’ money into illiquid private credit. Banks are increasing their exposure in a variety of ways — making loans to private credit funds, building their own or teaming up with third parties to start new funds.
Much of this lending lacks transparency. Federal and state banking and insurance regulators will need to make sure they’re gathering the right information and sharing it with each other, watching for signs of risk concentration. Asset managers, seeking to expand the market further, may find it’s in their interest to share more information about their loans and default rates with rating companies and regulators.
With risks attended to, a diverse ecosystem of credit providers should benefit the broader economy — and policymakers should see that there’s nothing to fear.
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