Scott McMunn is the chief executive officer of the Loan Market Association
Whenever an asset class posts stellar growth, warnings of bubbles or unforeseen risks follow. So it is with private credit: UK regulators, US policymakers and even large banks have voiced concerns that private credit is creating risks for the financial system.
Private credit has certainly grown fast: global assets under management rose from $436bn in 2013 to $1.6tn in March 2023. That compares with the $1.4tn US high-yield bond market.
Furthermore, there is every sign that this trend will continue. A recent Mercer survey of the world’s 60 largest asset owners found that 39 per cent plan to increase their exposure to private credit, while Private Debt Investor’s LP Perspectives 2024 Study found that 51 per cent of investors it surveyed do so too.
Transparency concerns
There are legitimate concerns about the transparency of private credit portfolios and how assets are valued; some US managers have a structured and formal approach to disclosure for each investment, but valuations are derived more from agreed approaches than observed trades and differ between managers.
However, there have also been a number of secondary fund trades recently with prices for specific funds varying depending on the manager, vintage, strategy and portfolio composition. This shows that market discipline is still at work and that some valuations are being challenged by secondary fund investors. The onus is clearly on limited partners, or the end investors in these funds, to ensure rigour in managers’ valuation disclosures.
Research showing that different managers are valuing the same assets differently is naturally a concern — and this lack of consensus may conceal some degree of underperformance. But how funds value assets isn’t a critical issue from a systemic risk perspective since few managers have mark-to-market triggers that would require them to offload assets if prices fell below a certain point.
Resilience over risk
Talk of systemic risk reflects concerns that the entire financial system is under threat — possibly leading to a 2008-level failure that cascades across asset classes and institutions. Yet there are three main reasons why I believe private credit is a source of support for the financial system, rather than a systemic risk.
First, it’s wrong to assume private credit is inherently risky. For that to be true, it would have to involve greater leverage, looser covenants or less security than other lending. It doesn’t. Private credit encompasses a wide spectrum of credit strategies and much of its recent growth has come from the refinancing or replacement of traditional leveraged loans.
Second, the risk of contagion reaching the public capital markets is reduced because credit funds do not hold public securities and forced liquidations are unlikely. Most private credit funds have a closed-end structure and typically lock up investors’ capital for five to 10 years.
Third, it’s important to remember that private credit de-risks the banking system. It shifts exposure to higher-yielding credits away from deposit-taking institutions to funds that use less leverage and are funded by committed long-term capital.
Most private credit funds have no borrowings or derivative exposures that could cause contagion, and do not operate with mark-to-market calls. Those that do use leverage are restricted from taking on excessive debt by their mandates.
When you consider that major banks hold assets totalling more than 10 times their Tier 1 capital, it’s hard to see private credit as an additional risk. It’s no wonder the US Federal Reserve concluded last year that “financial stability vulnerabilities posed by private credit funds appear limited”.
An established asset class
Private credit is now established as an asset class in its own right, commanding dedicated and growing allocations from institutional investors, as well as providing a permanent and valuable addition to the range of financing options for borrowers.
While greater transparency is needed in asset valuations, the market also creates the kind of risk transfer mechanism that is essential in enabling lenders to manage their credit risk exposure.
As ever, providers and users of capital are finding a way to connect. We should welcome that, while making every effort to ensure the market develops in a sustainable way.
