The IMF is worried about private credit. Well, join the club.
Over the past 15 years, alternative asset managers have increased lending exponentially to exactly the smaller, riskier and highly leveraged corporate borrowers that – due to enhanced regulation – banks stepped away from after the global financial crisis of 2007/08.
In the subsequent long period of rates repression and low defaults, investors made good money lending to unrated companies that were too risky for the banks and too small for the public bond markets. Thanks to this, private credit fund managers then raised so much money that they also began to compete with banks in the broadly syndicated loan and high-yield bond markets, financing larger companies, often at the moment private equity sponsors took them private.
Suddenly, private credit, when you include funds raised but not yet deployed, is a $2.1 trillion global market. That is comparable in size to the US high-yield bond market and the leveraged-loan market.
On the surface, it looks stable and resilient. Most direct lending is provided through closed-end funds to which pension funds, insurance companies and sovereign wealth funds make long-term capital commitments. Those investors can’t suddenly yank their money out during a sharp but short-lived credit downturn in the kind of knee-jerk reaction that might otherwise force managers to sell good assets to meet redemptions and so push credit funds into a doom loop.
There is no maturity transformation going on here and no risk of deposit flight. This is a buy and hold market, not an actively traded one, which logically should offer an illiquidity premium to investors providing negotiated, bespoke loans to private mid-market companies.
But the fact that private credit funds are charging more for loans to smaller, risker corporates that regulated lenders won’t touch, but then reporting smaller drawdowns during period credit panics – the pandemic lockdowns, the invasion of Ukraine, rising rates – raises an important question.
Is all this too good to be true?
The Lincoln index
This matters because this modern form of non-bank private credit, which sprang up first in the US 30 years ago, has expanded into Europe and is growing rapidly from a low base in Asia.
Lincoln International is an investment bank that specializes in advising leading private-equity firms and their portfolio companies. Each quarter, it values over 5,000 private companies primarily owned by over 150 alternative investment funds. These companies are levered via borrowings from the direct-lending market. Lincoln uses its valuations of performing loans held by investment-fund clients to construct US and European senior debt indices, charting yields, total returns and present fair values in US and European direct lending.
It most recently published a new European senior debt index (ESDI) which, for the five years from 2019 to 2023, shows a compound annual growth rate of 8.2%, compared with 4.4% for the public Morningstar European leveraged loan index but with much lower volatility: a standard deviation of just 1.1% on direct lending, versus 5% for leveraged loans.
Rates have risen far and fast over the past two years. Shouldn’t that be hurting smaller, risker borrowers by now? And if default rates and credit losses are not rising in private credit, could it be that non-bank lenders and borrowers are somehow disguising the true extent of distress?
This is an opaque and less-regulated market than for syndicated bank loans. Direct lenders say that they experience lower loss given default than public markets thanks to seniority in the capital structure, covenant protections and injections of capital from private equity owners into portfolio companies.
New risk?
The IMF admits that it simply doesn’t have the data to judge what lurks beneath the surface calm. But it is concerned about the increased exposure of pension funds and insurers, especially those taken over by private equity sponsors, to the asset class; as well as about the potential for multiple layers of hidden leverage, stale valuations based on mark-to-model, and unclear interconnections between participants.
Taken together, all that might make private credit a new source of systemic risk.
And so, the IMF recommends in chapter two of its April 2024 Global Financial Stability Report that countries should now consider “a more intrusive supervisory and regulatory approach to private credit funds, their institutional investors, and leverage providers”.
The IMF might well be crying wolf here over a market that has delivered clear social and economic benefits by channelling funding to small and mid-market companies that regulators have made it uneconomic for banks to support.
The IMF figures it is worth calling the alarm, even if it turns out to be a false one. But policymakers might be well advised to think about a different question: how to ensure that a broad array of smaller credit managers keep funding available to the new, small companies that keep economies growing.
Sure, it may be a risky business. But if it generates a sustainable return per unit of risk, let’s not regulate it out of existence.
