Private credit wonder drug works in limited dose

Private credit is big and getting bigger. The practice whereby companies borrow directly from specialised funds, bypassing banks and the bond market, has exploded in recent years. That breakneck growth is making global watchdogs fret over risks to financial stability. A more fundamental question, however, is whether it promotes or impedes the ultimate purpose of the financial system: to support real economic growth.

Once upon a time companies that wanted to borrow money went to a bank. By the early twentieth century, the largest and most creditworthy corporations began to mimic governments by selling bonds to investors. In the early 1990s, entrepreneurial financiers took advantage of the crisis in the U.S. savings and loan industry to open the public debt markets to smaller and riskier companies. Today, high-yield corporate bonds are a $3 trillion global asset class.

Private credit is a more recent innovation. The practice emerged around the turn of the millennium as a source of finance for companies seeking more than a commercial bank loan, but too little to justify tapping the bond market. The global banking meltdown of 2007-2008 gave this source of financing a big boost. The IMF estimates it has ballooned from less than $0.5 trillion a decade ago to $2.1 trillion last year. JPMorgan analysts put the total even higher, at more than $3.1 trillion. More than 85% of private credit transactions, meanwhile, are now bigger than $1 billion.

The IMF recently laid out the potential risks from this rapid growth. The creditworthiness of borrowers is one issue. On average, companies using private credit have more leverage than their public market counterparts. They are also more highly exposed to gyrations in interest rates, because private credit is generally lent at floating rates. Private credit funds themselves often borrow from banks, too. Then there is the question of accurate and timely valuation. As with all private assets, the lack of a transparent secondary market means investors can face large and abrupt losses.

It is not all doom and gloom. The IMF concedes that private credit funds pose fewer liquidity risks than in some other asset classes. They typically lock up investors for longer periods, matching the terms of the underlying loans. Retail funds which give customers faster access to their money remain rare.

A bigger systemic risk is the interconnectedness of private credit with other illiquid asset classes. In 2008, the direct economic damage from toxic subprime mortgages was minor, but sparked a fatal contagion because they were intermingled in so many investor portfolios. Similarly, losses in private credit funds could shock the financial system indirectly by rebounding on capital providers. Four-fifths of private credit vehicles are managed by firms which are also active in private equity – suggesting trouble in one of today’s go-go asset classes could easily infect the other.

It’s possible that the IMF, traumatised by its misplaced confidence in financial innovation before 2008, is being excessively wary. Its 2006 proclamation that the rapid growth of securitisation had “helped make banking and the overall financial system more resilient” is an infamous cautionary tale. Yet any assessment of risks depends on weighing up the offsetting benefits which private credit brings.

The positives have so far been obvious for providers and consumers. Between 2001 and 2023, private credit funds generated an annualised total return of around 9.5% to investors, beating the 6.5% earned by global listed equities and with lower volatility. For corporate treasurers, meanwhile, these funds have proved an inventive source of capital, ready to lend against novel kinds of collateral and on unconventional terms.

The private credit boom may mostly have replaced rather than augmented overall lending. Total credit to non-financial corporates in the United States has risen only modestly, from 72% of GDP in 2007 to 79% of GDP today. But like the flourishing of high-yield bonds, private credit does seem to have matched previously segregated savers and borrowers.

Indeed, some go further and argue the growth of private credit is reducing the fragility of the financial system by directing credit, interest rate, and liquidity risks to those best able to bear them. Huw van Steenis, the veteran analyst and vice chair of consultancy Oliver Wyman, suggests private credit is just the latest iteration of the periodic process where banks recycle excess risk from their balance sheets into the capital markets. He compares it to the new anti-obesity drugs developed by Novo Nordisk NOVO_B and Eli Lilly LLY and argues that anyone interested in keeping the banking sector lean and mean should approve.

Even if this analysis proves accurate, however, it will be important to ensure that the new weight-loss plan does not starve the banks to death.

Unlike intermediaries in capital markets, banks create the money which they lend. This flexibility of banks’ balance sheets – ultimately backstopped by the central bank – is a feature of the financial system rather than a bug. It enables the banking sector to absorb the unexpected shocks to credit demand that are an intrinsic part of a capitalist economy.

Finance provided by capital markets, by contrast, is not designed to pull off this trick. These intermediaries merely lend out prior savings they have gathered from others. A financial system which depended entirely on capital markets might indeed enjoy a highly efficient allocation of risks at a particular point in time. Without the support of a sufficiently sized banking sector, however, it would be disastrously brittle.

With private credit, as with miracle weight-loss drugs, therefore, it is important not to exceed the stated dose.

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(Felix Martin is a Non-Resident Senior Fellow of the Center for Global Development, and Chair of the Cost Benefit Analysis Panel of the UK Financial Conduct Authority. He writes in a strictly personal capacity.)