Does a monster lurk in global private markets?

The growth of riskier corporate borrowing in financial markets has gained the attention of regulators. Areas such as private credit and leveraged lending have drawn particular scrutiny, as some worry they might be the next sources of financial distress. 

The debate around private markets, particularly private credit, is polarised into two camps. Its champions such as Apollo Global Management, Blackstone and Ares Management tout the tendency for private credit to be in illiquid assets and scrutinise lenders more closely than traditional investment banks. 

They point out unlike banks they will not suffer a bank run on deposits and are less vulnerable to liquidity shortages when bubbles burst. The banks have hit back and said private credits lack transparency and are overleveraged. Who is right?  

The Bank of England’s (BoE’s) most recent financial stability report mentioned private credit 33 times and leveraged lending 11 times, respectively. Even more concerning is how the report describes both forms of finance under the title ‘Global vulnerabilities’. It says they appear “particularly vulnerable”.

There are several trends in these sectors that the BoE identifies that helps explain its uneasiness. One point is that the lack of frequent re-pricing combined with opacity in private credit markets makes them vulnerable to sharp and correlated falls in value. 

Another feature that private credit shares with leveraged loans is their debt tends to be floating and that makes them vulnerable to higher interest rates. 

Any businesses that borrow from these markets are therefore more likely to experience difficulty when they have to refinance.   

Leveraged loans are normally sub-investment grade with a typical maturity of four to seven years at origination. Often, private credit loans are highly leveraged and unrated. 

The numbers 

According to the BoE, the growth of leveraged loans has almost doubled since 2015 to $4.6tn-worth of corporate debt globally. Over the same period, private credit has grown around three to four times and is now worth $1.8tn. Their cousin, high-yield bonds that are sub-investment grade, have grown at a slower pace — 1.3 times — by comparison. They are worth $3.4tn. 

All of these taken together mean that leveraged lending, high-yield bond and private credit markets account for around a quarter of all market-based debt globally. The financial stability report notes that while there is limited data available on the maturity profile of outstanding private credit, 24% of global leveraged loans and 29% of high-yield bonds are due to be refinanced by the end of 2025.  

The BoE adds that the default rate on leveraged loans has increased further since the July financial stability report, from 5.0% to 5.4%, up from 1.8% a year ago.

Reassuringly, the default rate is less than half the peak of 12.2% in the aftermath of the global financial crisis. In contrast, headline default rates in the private credit and high-yield bond markets remain low, despite a slight pick-up in the latter since July.

Sceptics

Haakon Blakstad, chief commercial officer, Validus Risk Management, provides advice and risk management to more than 100 private capital funds globally.

He warns that regulators need to understand private markets better before they deploy rushed regulatory measures. He highlights that private markets have grown in large part due to actions of regulators and policymakers rooted in the financial crisis. 

Quantitative easing, interest rate cuts and the capital requirements imposed on banks created the space for private capital to thrive, private credit in particular.

Some critics of private credit markets have said that there is a bubble growing in this space which he refutes. 

 “What will be important to look at is default rates: if there is an increase in public markets defaults without the equivalent in private markets, then that would be worth looking at. However, this could also be explained by better underwriting standards and/or the benefit of being long-term investors. Illiquidity can be a friend in that regard.”

 “Also if you have artificial valuations across the board, that would constitute a bubble and be a problem. But this is not the case as transparency in the industry is actually higher than a lot of people think. Rating agencies and third-party valuators are also playing an increasingly important part.”

Some rating agencies take a slightly different view to regulators like the BoE on how much concern there should be about private credit. According to S&P’s Global Credit Outlook 2024, even moderate stress could diminish the credit quality of private credit borrowers. 

But the scale of private debt is unlikely to threaten financial stability as it only accounts for 4% of non-financial corporate debt in the US and only 1% in Europe. The outlook also says that after years of strong fundraising, private credit funds have amassed more than $400bn in dry powder globally (as of September), leaving them with cash to deploy.  

At the outlook briefing, S&P Global Ratings head of European credit research Paul Watters said: “Clearly there’s a lot of investor appetite for allocating assets into private credit. 

“And that seems to be continuing in Europe. From our point of view, we’d be more concerned about some of the private credit deals that were financed post-Covid in 2021–2022. 

“That would be where perhaps some of the potential credit vulnerabilities could lie in the sense that those corporates got cheap financing, they might have overvalued assets, and are in a more difficult environment now. All of this may make it more difficult to refinance as and when it’s required to refinance.”

On the other hand, Mr Watters also said that S&P has seen private credit become more disciplined compared to a couple of years ago.

“Back then they might have had a very broad-based approach to sectors they were going to lend to. They’re not lending to all types of companies now,” Mr Watters continued. 

Christoph Gugelmann, chief executive of Tradeteq, says that private credit and leveraged loans account for a very small percentage of overall debt in the world. 

It is for this reason, combined with the long-term nature of private market players, that he is sceptical the sector will be a source of instability next year. 

Mr Gugelmann adds: “The reason [private debt markets] are different to 2007–2008 is back then credit tools were related to more liquid products, founded on short-term funds and had trigger mechanisms. 

“And they required deleveraging otherwise they would break covenants. So they all tried to deleverage at the same time and that is why there was a huge problem.

“Here we are asking someone to finance a bridge or toll road — those investors are not expecting their money back now but in five years’ or 10 years’ time. It is also less speculative; I think private credit brings a tangible benefit to the economy. 

“This is the fundamental difference. There is less short-term speculation here.”

Regardless of how much danger there is in the private debt market, some believe that everyone needs to learn more about it. 

This argument was made by Sarah Boyce, associate director of the Association of Corporate Treasurers, on a Herbert Smith Freehills podcast. 

The podcast was about the law firm’s corporate debt report 2023, on which participants talked about the outlook for next year. 

Ms Boyce said: “At the moment there is a lack of education and understanding about what exactly those credit funds can do, what they offer and who they are.

“The whole area of non-bank finance, whether it is credit funds or other non-traditional sources of finance, are absolutely going to play an increasing role across the market grade investment.”