Over the past decade, the private credit industry has ballooned from arcane financial solution to a core pillar of asset management. But recent tremors in corporate debt markets have led several economic institutions to warn of its risks to the global economy. Ali Lyon asks: how worried should we be?
What kept you awake at night this Halloween?
Readers who indulged in a fancy dress party might be minded to point to one of the scarier outfits they witnessed on Friday night. Those with young children will surely look closer to home – at their own little terror – for the root cause of their chronic sleep debt.
For International Monetary Fund (IMF) head Kristalina Georgieva, though, the spectral, shadowy force robbing her of a full eight hours is bigger. About $4 trillion bigger.
In an eye-catching set of remarks at the organisation’s jamboree in Washington last month, the Bulgarian economist voiced her continued unease over the untrammelled rise of private credit, urging regulators and the media to shine a light on its more opaque practices.
“This is why we are urging more attention to the non-bank financial institutions,” she told reporters in a press conference. “You are asking the question that keeps me awake every so often at night.”
Steve Schwarzman’s Blackstone is one of the biggest players in private credit
What is private credit?
The proliferation of corporate lending by so-called non-banks – or, to use their more sinister moniker, ‘shadow banks’ – has been one of the financial mega trends of the last decade.
Since the Global Financial Crisis, it has rapidly ascended from an arcane element of finance – almost solely renowned for venturing to the dark, distressed corners of the corporate world where banks and bondholders dared not tread – to a core component of the asset management ecosystem.
As regulators bore down on traditional banks’ riskier pre-crisis behaviour – foisting big capital requirements on them to prevent a similar crisis from ever happening again – private lending took off, sating the underserved corners of the credit market with relish. Its private equity-like model – where a closed-end fund would lend to multiple companies over a multi-year cycle – was attractive to both borrowers and investors.
Robbed of their consistent six per cent yield for investment-grade corporate loans by a decade of paltry interest, debt investors loved it. For family offices, sovereign wealth funds and insurance companies that think in decades, not quarters, the promise of double-digit yield in exchange for what they calculated to be only marginally more risk was too good to turn down.
Meanwhile companies – often mid-sized firms struggling to convince risk-averse post-GFC banks of their unimpeachable reliability – suddenly found they had another avenue for capital.
Fears grow over systemic risk
To many, that route was also more appealing than from debt from a bank or a public debt issuance to corporate bondholders. The prospect of being on the hook to just one lender, not hundreds spread across the world, felt clean, allowing a bilateral, trusted relationship. Crucially, rather than airing any dirty laundry in public – to multiple bondholders with conflicting interests – hiccups could be ironed out in private, without investors, staff or even regulators knowing.
And yet, as it has moved into the financial mainstream, fears around the systemic risk it poses to markets – and the real economy – have grown. In a foreshadowing of her comments last month, Georgieva’s IMF devoted a full chapter of its 2024 Global Financial Stability Report to its concerns about the fledgling industry. The sector – officials wrote – “creates significant economic benefits”, yet its astronomical growth was also likely to lead to a lowering of underwriting standards that, in a downturn, would “become macro-critical and amplify negative shocks”.
Andrew Bailey said private credit had echoes of the subprime crisis of 2007
How risky is private credit?
The IMF isn’t alone. Fears around the direct, private nature of the lending has led to a gradual rise of regulatory scrutiny of an industry that, up until then, had largely been left to its own devices by watchdogs and lawmakers. In the last year, the banking regulators for both the UK and Eurozone carried out their first major assessment of traditional banks’ exposure to the sector. Meanwhile the House of Lords’ widely respected Financial Services Regulation Committee chose to include lending practices in its ongoing inquiry into the rise of private markets.
“Private credit has replaced a big stack of what the banks used to do,” says Vivek Raja, an analyst at Shore Capital. “That IP [intellectual property] has gone from the banks into private hands, and the regulators have tacitly sanctioned it… they were happy for it to lurk in the shadows without holding the economy to ransom in the way sections of traditional banking system leverage might.”
But last month, that speed of that change – and the scrutiny that was coming with it – accelerated dramatically, after a triumvirate of credit-related corporate failures spooked markets. Initially, car parts maker First Brands collapsed, drowning in tens of billions of dollars of debt. Then, the auto lenders Tricolor and Primalend – which specialised in car sales and finance to so-called ‘subprime’ customers – both hit the skids in the space of weeks amid an uptick in defaults.
Cockroaches..?
Fingers immediately pointed to the role private credit might have played, and speculation over whether the failures were an early portent of a wider crisis went into overdrive. In remarks that have since been repeated ad nauseam, Jamie Dimon told an analyst call that “when you see one cockroach, there’s probably more”; as thinly veiled a barb at some of the laxer private credit lending practices as is possible to conceive.
Days later, those warnings migrated across the Atlantic, when Bank of England governor Andrew Bailey told peers that the industry had begun to look eerily similar to the subprime loan crash that foreshadowed the GFC.
“We certainly are beginning to see, for instance, what used to be called slicing and dicing and tranching of loan structures going on,” he told peers on the aforementioned regulation committee. “And if you were involved before the financial crisis, then alarm bells start going off at that point.”
Executives from Blackstone, Apollo and Ares Management at a recent committee hearing
Shadow banks showing ‘Ponzi scheme-like behaviour’
According to Raja, central bankers and regulators are right to be on guard. As shadow banking has grown – and built up a track record of outsized returns – it has sucked in ever larger amounts of so-called institutional money, be it from pension funds, insurance firms or major asset managers.
“I do worry because some pension funds have piled in, which starts to speak to pension pots of moms and pops,” he says. “And when I started getting really worried – or pretty cynical – was when, led by this US administration, people started saying retail is fair game, too.”
Until recently, retail investor involvement in private credit had been practically non-existent. After all, the industry’s eight- to 10-year cycles and closed-end nature should largely prohibit people trading their own money, almost by definition. And yet – much like its equity sibling – there has been a congestion, caused by fewer deals to take place to allow investors to exit, that forced some funds to seek out new avenues for capital.
“It looks more and more like a Ponzi scheme,” Raja says. “Because you’ve got this stack of assets under management, but they’re not realising any assets. Their inflows [from new avenues like retail investors] are – in a way – providing liquidity to people who don’t want to roll on, which is kind of quite Ponzi-like.”
The industry has mounted an aggressive rearguard action against charges like those levelled by Raja, Dimon and Bailey. In a fiery interview at a recent investment expo, Marc Lipschultz, the co-founder of Blue Owl and global luminary of private credit, accused Dimon and traditional banks of having a commercial interest in seeing their newfangled competitor fail. “There are people who have meaningful, parochial interests in the industry not continuing to grow and succeed,” he told delegates.
It looks more and more like a Ponzi scheme. The inflows are, in a way, providing liquidity to people who don’t want to roll on.
In the UK, those sentiments were echoed at an evidence session last week, when peers grilled executives from three giants of shadow banking: Apollo, Blackstone and Ares. Probed on the systemic risk their activities posed to the wider economy – and prodded on whether regulation on them should be brought in line with regular banks – they leapt to the defence of their vocation.
They argued that banks are obliged to return their customers money as and when they want, making them more vulnerable to so-called contagion. On the other hand, their eight-year cycles and bilateral relationships meant they would hold up well against such shocks, they submitted. If anything, Blackstone’s Daniel Leiter submitted, they act as an important bulwark to the often flaky relationship between customers and their banks.
“In periods of stress, our investors like us to deploy even more capital – it’s countercyclical,” he said. “That’s the key point of what we really do… in periods of stress, our investors like us to deploy even more capital.”
Leiter and Tristram Leach, who heads up direct lending in Europe for Apollo, even submitted that the succession of collapses that set off this most recent – and sustained – bout of scrutiny had few links to their industry; if any. It was, in fact, banks that owned the majority of Primalend, First Brands and Tricolor’s swollen debt piles.
So are Georgieva and Bailey right to toss and turn over the spectre of a shadow bank precipitating the next financial crisis? The beauty of private credit is we might never know.