Private finance can overlap with banks in ways regulators are still assessing. Global private finance, which includes both private equity and private credit, has seen a rapid expansion, with annualised growth of nearly 18 per cent since 2017, according to the International Organization of Securities Commissions’ September 2023 report, Emerging Risks in Private Finance.
This growth has occurred as banks have retrenched from the credit arena following the tightening of banking regulation.
The private credit industry praises its ability to offer credit during periods of market stress. “The industry provides distressed or special situations debt to struggling or complex businesses that traditional lenders may avoid,” states a note from the American Investment Council, an industry group.
However, it is unclear to what extent the industry is interconnected with banks and the financial stability risk that leads to in the current high interest rate environment.
In January, the European Commission published a report on the macroprudential review for credit institutions, indicating it will run a consultation in 2024 to collect insights on the interconnection between banks and non-bank financial institutions.
“The strong growth of these activities, the inherent opacity in these markets, the amount of leverage used in this sector, and its interconnectedness with the broader financial system and the real economy are reasons to be concerned about these activities,” says Jean-Paul Servais, chair of Iosco.
Interconnection with banks
While banks do not seem to have a material exposure to private credit in aggregate, some lenders may have concentrated exposures to the sector, found the IMF in its April 2024 Global Financial Stability Report.
Particularly in Europe, the direct lending market still has fairly strong bank involvement, with local banks still funding direct lending, according to Ruth Yang, global head of private markets analytics at S&P Global Ratings.
The overlap between the bank and non-bank sectors is unclear as investment banks play a role in many phases of leveraged buy-out and private credit transactions, primarily through the provision of leverage, explains Iosco’s report.
Banks themselves are establishing their own private credit operations or partnering with non-banking partners to offer clients access to significant pools of additional and less-regulated liquidity.
However, in a potential downturn, banks could curb lending to private credit funds, exposing private credit funds and their investors to liquidity problems. Interconnectedness could affect public markets, with the possibility of insurance companies and pension funds being forced to sell more liquid assets.
Financial stability risks
The “private” element of the private credit industry makes mapping risk transmission challenging.
“We didn’t find there’s an imminent financial stability risk but we could not rule it out either, given the numerous potential issues whose impact taken together is difficult to measure,” says John Wennstrom, senior policy adviser at Iosco.
Issues include the refinancing of existing debt in the context of higher rates, valuations, risk management approaches, liquidity and leverage.
Liquidity mismatches, often a cause of pain in the banking industry, seem less of a problem in the private credit industry, as private credit funds use long-term capital lock-ups due to the illiquidity of their underlying assets.
“Today, most capital is locked up and we find it unlikely that somebody might be able to create huge pools of illiquid assets that have a daily dealing element to them like banks’ deposits,” explains Jiří Król, deputy CEO of the Alternative Investment Management Association.
“Nobody runs or wants to run an unstable model like that. The investors [of this asset class] understand how liquidity works and [they] don’t need liquidity in the same way as banks’ depositors.”
Still, new funds targeted at individual investors may have higher redemption risks and these have not been tested in a severe run-off scenario, warns the IMF.
The leverage concern relates to the risk that if leverage is withdrawn, market operators might be forced to dump assets into the market, creating pricing issues. “But private credit is an untraded market,” adds Król. “Even if somebody tries to sell a loan that nobody else trades or if they sell it at a big price discount, what does it matter to the rest of the market? The market is not getting impacted or priced from that single deal [in] the same way as ... with equity or bonds.”
There has been a meaningful rise in leverage ratios. S&P Global Ratings reports that the median corporate debt ratio rose continuously between 2003 and 2021. Debt-to-equity ratios increased in the US from four to six times, and in the EU, from four to seven times.
There is also general concern around valuations in the sector. Private market loans rarely trade, and therefore can’t be valued using market prices and may suffer from subjective valuations, according to the IMF report.
The decade of low interest rates has pushed valuations of assets high with a huge number of private equity-owned businesses relying on a never-ending flow of financing opportunities. “If this credit all of the sudden dries up, there might be a potential significant impact on the real economy,” says Wennstrom.
Many funds are sitting on significant amounts of uncommitted capital, which they may rely on to weather short-term issues with their portfolio companies. “But then when the refinancing walls appear, around 2025 and 2026, the industry may start to experience issues. We also don’t have clear insight into the quality of this lending,” says Wennstrom.
Private equity fundraising has already slowed and regulators are concerned about where difficulties will arise in this changing market. “If the wheels fall off the bus, will this impact banks and the larger financial system? And if that doesn’t happen, where are the pain points with institutional investors such as pension funds or insurance companies?” asks Yang.
Regulation so far
“There’s a particular interest in private credit at the moment — a relatively new area compared to private equity. However, we are not yet making any policy considerations,” says Wennstrom.
Still, things are moving in some jurisdictions. Last August, the US Securities and Exchange Commission adopted new reporting requirements for private funds while the UK Financial Conduct Authority announced in March its intention to review valuations in these markets.
Meanwhile in February, the European Council, which groups EU governments’ ministers, adopted new rules for private debt funds with the introduction of leverage limits: 175 per cent for open-ended and 300 per cent for closed-ended funds.
However, these rules may not fully restrain the leverage issues as they only capture leverage at the level of the fund rather than the portfolio company, which is itself being heavily leveraged, notes Samuel Brewer, partner at law firm Travers Smith.
It is the same case in other jurisdictions where the reporting frameworks do not necessarily capture all forms of indirect leverage of private funds via portfolio investments, found the Financial Stability Board in its 2023 Global Monitoring Report on Non-Bank Financial Intermediation.
Zach Milloy, partner at law firm Paul Hastings, wonders “whether the leverage limits put EU sponsors at a competitive disadvantage compared to their non-EU counterparts, particularly against sponsors in the US who aren’t subject to the same restrictions”.
It seems unlikely that the UK will implement such restrictive rules. “I think the UK is going to make some changes to the Alternative Investment Fund Managers Directive but not for a few years, and we don’t know what form it will take. I’d be very surprised if we ended up with something particularly similar to where the EU has gone,” says Brewer.
“As we’re seeing how in other areas like ESG and AI regulation, the UK post-Brexit seems to be adopting a bit more of a ‘wait and see’ approach rather than rushing to regulate in great detail,” he adds.
The strongest argument against regulating the alternative asset management sector in the same way as banks rests on the idea that it is only institutional investors’ money at stake rather than broader systemic risk. This is despite private finance products also being increasingly offered to high-net-worth and retail clients in a market still dominated by institutional investors, notes the FSB.
“The idea is that if a private equity house goes down, it shouldn’t take the investor money with it. However, with these sorts of rules, it’s only after a crisis that you see how effective they were,” adds Brewer.
