## CHAPTER 2 — The Rise and Risks of Private Credit ## Source details **Canonical URL:** [CHAPTER 2 — The Rise and Risks of Private Credit](https://www.imf.org/-/media/files/publications/gfsr/2024/april/english/ch2.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2024/april/english/ch2.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2024/april/english/ch2.pdf.json) --- ### Overview and purpose - Assesses vulnerabilities and potential risks to financial stability in corporate private credit, a rapidly growing asset class traditionally focused on providing loans to midsize firms outside commercial banks or public debt markets. - Focuses on performing corporate credit rather than distressed assets, infrastructure, and real estate. - Notes that private credit has provided significant economic benefits by offering long-term financing to firms too large or risky for banks and too small for public markets. ### Size, growth, and structure - Private credit assets grew to approximately $2.1 trillion globally in combined assets and undeployed capital commitments in 2023. - Private credit has grown exponentially over approximately 30 years and expanded markedly over the last 5 years. - Typical structure and market shares: - Closed-end GP/LP funds with capital call structures and limited life cycles dominate; closed-end funds account for approximately 81 percent of the total market. - Business development companies (BDCs) account for 14 percent of the market. - Specialized collateralized loan obligations (CLOs) constitute an additional 5 percent of the market. - Geographic and scale statistics (as of June 2023 unless otherwise noted): - Assets under management (deployed and committed) of private credit managers located in the United States reached $1.6 trillion, growing at an average annual rate of 20 percent over the last five years. - In Europe, private credit increased at an average rate of 17 percent per year over the same period and accounts for 1.6 percent of corporate credit. - Private credit now accounts for 7 percent of the credit to nonfinancial corporations in North America. - Asian private credit accounts for about 0.2 percent of credit to nonfinancial corporations and has grown at 20 percent annually over the last five years. - Manager focus by region: North America–focused managers $1.1 trillion; Europe focus $460 billion; Asia focus $114 billion; Other focus $59 billion. ### Economic role and investor base - Advantages: flexibility, speed of execution, confidentiality, and tailored repayment and collateral arrangements; typically more expensive than bank loans. - Managers claim stronger workout resources, enabling fewer sudden defaults and smoother restructurings relative to banks or public markets. - Funding predominantly from institutional investors: pension funds, insurance corporations, sovereign wealth funds, family offices, and high-wealth individuals. - Managers active in private equity hold more than three-quarters of private credit assets; about 70 percent of private credit deals have private equity sponsors. ### Main vulnerabilities and channels to financial instability - Opacity and data gaps: - Private credit loans are unrated, rarely traded, typically “marked to model” by third-party pricing services, and lack standardized contract terms. - Rising risks may be difficult to detect in advance due to opacity and data gaps. - Key vulnerability categories: - Borrower fragility: borrowers tend to be smaller and riskier; loans are typically floating rate and cater to relatively small borrowers with high leverage. - End-investor exposures: increased exposure of pensions and insurers to private credit and other illiquid investments could produce significant capital losses if credits are dramatically rerated. - Liquidity mismatches: growth of semiliquid and retail-facing funds increases redemption and first-mover risks despite most private credit funds posing little maturity transformation risk today. - Leverage and interconnectedness: multiple layers of leverage across borrowers, funds, leverage providers, and end investors; modest fund-level leverage today could still lead to significant capital calls in a downside scenario. - Valuation opacity and stale marks: lack of price discovery, incentives to delay realization of losses, and reliance on models could produce deferred loss recognition followed by large markdowns. - Conduct risks from retail participation: retail investors may not fully understand risks or redemption constraints. - Cross-sector spillovers: high exposures (for example, private-equity-influenced insurers) can create contagion channels; data constraints hamper supervisors’ ability to assess exposures and spillovers. ### Current risk assessment and adverse scenarios - Present assessment: - Financial stability risks from private credit appear contained at present due to largely long-term funding and modest observed leverage. - Liquidity and interconnectedness risks appear modest at present. - Stress scenario concerns: - The sector has never experienced a severe downturn at its current size and scope; an adverse scenario could produce delayed realization of losses followed by a spike in defaults and large valuation markdowns. - Rapid growth and increasing competition (including from banks on larger deals) may degrade underwriting standards and covenants, increasing future credit loss risk. - Continued exponential growth with limited prudential oversight and opacity could make vulnerabilities systemic and amplify negative shocks to the economy. ### Characteristics of private credit borrowers and loan structures - Borrower scale and sectors: - Typical borrowers: highly leveraged middle-market companies smaller and riskier than leveraged-loan and high-yield bond issuers. - Median firm size comparisons: - Private credit: Median firm size: $0.5 billion - Leveraged loans: Median firm size: $4.6 billion - High-yield bonds: Median firm size: $4.5 billion - Investment-grade bonds: Median firm size: $16 billion - Sector composition: Information technology 41%; Healthcare 14.5%; Consumer discretionary 11.5%; Industrials 8.5%; Raw materials and natural resources 8.2%; Telecoms and media 6.1%; Financial and insurance services 5.8%; Other 4.5%. - Loan features: - Private credit borrowers almost exclusively use floating rate loans. - Private credit loan interest rates are typically higher than yields on market-based debt instruments. - Only about 29 percent of high-yield corporate bond issuers’ total debt is variable rate; sample average for 518 North American and 157 European high-yield issuers: 29.4 percent (end of 2022). - Payment-in-kind (PIK) interest: share of PIK interest in BDC interest income has doubled since 2019. - Most private credit loans are secured; collateralization can be lower in some sectors (for example, software), where unitranche and mezzanine loans are more common. ### Credit performance and cyclicality - Credit losses: - Despite higher-risk profiles, private credit credit losses have not historically exceeded losses in high-yield bonds and are comparable to leveraged loans. - Headline default rates for private credit indices tend to be relatively high because they include covenant defaults that often lead to renegotiation rather than payment defaults. - Sponsor effects: - Private equity sponsorship mitigates private credit risks; private equity sponsors may inject capital if stress is expected to be transient. - Evidence from leveraged-loan markets shows sponsored firms have lower default rates during stress than nonsponsored firms. - Cyclicality and resilience: - Private credit lending did not “dry up” in March 2020 and was more stable than similarly floating-rate leveraged loans during the COVID-19 period. - Private credit activity is less responsive to sudden credit shocks than high-yield bond and leveraged-loan markets. - Procyclical elements exist: capital deployment in private equity and private credit is positively correlated with stock market returns. ### Leverage, rollover risk, and contagion channels - Multiple layers of leverage: - Investors (insurance firms, pension funds) may use leverage. - Investment vehicles can employ fund-level leverage through special-purpose vehicles or collateralized fund obligations. - Borrowers extensively deploy leverage; many are private-equity-backed. - Observed fund metrics and rollover risk: - Federal Reserve (2023) confidential study: funds at the 95th percentile have borrowing-to-assets ≈ 1.27 and derivatives-to-assets ≈ 0.66. - BDC regulatory leverage: debt-to-equity ratio cap at 2 (increased from 1 in 2018); observed BDC debt-to-equity ratios ≈ 0.8 to 1.2×. - Middle-market CLOs: all debt-to-equity ≈ 6×; AAA to other classes ≈ 1×. - Tabled characteristics (reported): - Closed-End Funds: Debt-to-equity ratios ~0 to 1.3×; main leverage sources: portfolio financing, NAV loans, subscription lines, derivatives; total AUM (United States): ~$1.2 trillion. - BDCs: Debt-to-equity ratios ~0.8 to 1.2×; leverage sources: secured bank lines of credit and secured/unsecured bonds; total AUM (United States): ~$300 billion. - Middle-Market CLOs: All debt-to-equity: ~6×; main lenders: insurers, pension funds, hedge funds, banks; total AUM (United States): ~$100 billion. - Rollover and collateral-call risk: - Bank-provided leverage often includes loan-to-value triggers, exposing funds to large collateral calls during stress. - Private credit funds often provide borrowers with revolvers or credit lines; correlated drawdowns could create considerable funding needs. - Data limitations: maturity profiles, composition, and amount of debt often not publicly available. ### Valuation dynamics and risks - Stale marks and mark-to-model: - Absence of secondary markets, limited comparable transactions, and irregular appraisals lead to mark-to-model valuation practices. - Managers often use third-party pricing services, which may have conflicts of interest. - BDC visibility: - BDCs disclose quarterly position-by-position fair-value marks under ASC 946 / ASC 820–10; most BDCs concentrate 70 to 90 percent of portfolios in first- and second-lien senior secured loans, often across 100 to 200 borrowers. - Empirical findings (BDCs vs public markets): - Reaction of BDC loans to credit shocks is much smaller than that of B-rated leveraged loans despite lower credit quality. - Smaller valuation adjustments for loans are offset by additional discount applied to market prices of BDC shares; the discount widens during stress periods. - Price and NAV take at least four quarters to converge after an unexpected shock (impulse response sized to one standard deviation based on an AR(1) model using quarterly data). - Trade-offs: - Stale valuations create first-mover advantage and runoff risk in downside scenarios; limited redemptions in many private credit funds mitigate immediate run risk. - Frequent mark-to-market could increase procyclicality and short-termism. - Stale valuations can distort capital allocation and exacerbate conflicts of interest. ### Interconnectedness with private equity and traditional institutions - Private credit–private equity links: - Many managers of private credit funds also manage private equity funds; interconnectedness is stronger among managers of the largest private credit funds. - About 70 percent of private credit deals are sponsored by private equity firms. - Intersegment spillovers: vulnerabilities in one segment of private financing could spill over to another given these ties. - Exposure of traditional financial institutions: - US bank exposures to private credit: about $200 billion at end-2021, representing less than 1 percent of banks’ assets (Federal Reserve 2023). - Pension funds and insurers: for most institutions, private credit exposures remain a low single-digit percentage of total assets under management; certain large pension funds and selected private-equity-influenced insurers have substantially higher exposures. - US private-equity-influenced life insurers manage well more than $1 trillion, over 15 percent of all US life insurance assets. - Median exposure to level 3 assets: private-equity-influenced insurers 20 percent of assets; sample of largest 50 insurers globally 6 percent of assets. - Private-equity-influenced insurers illiquid composition: 36 percent structured credit; 23 percent direct credit lending. ### Liquidity, semiliquid structures, and retailization - Fund structures and redemption features: - Closed-end funds and CLOs typically do not allow redemptions during their life span, reducing liquidity risk. - Semiliquid structures (certain BDCs and perpetual nontraded BDCs) provide limited redemption windows and are more common as funds seek broader investor bases, including retail. - Redemptions in semiliquid structures are often constrained by gates, fixed redemption periods, and suspension clauses; these tools have not been tested in a severe runoff. - Semiliquid structures: the analysis aggregates 143 BDCs, 50 of them being traded. - Retailization and conduct risks: - Retail participation (“retailization”) increases herd-risk behavior and conduct concerns; retail investors may not understand liquidity features and redemption limits. - Suggested design measures: create and redeem shares at lower frequency than daily or require long notice/settlement periods; consider requiring closed-end structures where appropriate; require stringent liquidity-management tools and stress testing when product design permits significant liquidity mismatch. - Where funds permit retail participation, require comprehensive and clear disclosures on potential risks and redemption limitations. ### Data gaps and monitoring challenges - Severe data gaps limit comprehensive assessment of risks: interconnections, leverage, and investor concentration are poorly understood and highly opaque. - Fragmented reporting across borders and sectors prevents macro-level supervisory monitoring. - The rapid growth means many risk-mitigating features have not been tested in a large downturn. ### Policy recommendations and regulatory actions - General stance: - Encourage more intrusive supervisory and regulatory approaches to private credit funds, their institutional investors, and leverage providers. - Strengthen cross-sectoral and cross-border regulatory cooperation; make asset risk assessments more consistent across financial sectors. - Data and reporting: - Close data gaps: enhance reporting requirements for private credit funds, their investors, and leverage providers to allow improved monitoring and risk management. - Fill data gaps by enhancing comprehensive reporting of leverage across the value chain, with domestic and international cooperation. - Liquidity and conduct: - Closely monitor and address liquidity and conduct risks in funds—especially retail-facing and semiliquid funds. - Implement relevant product design and liquidity management recommendations from the Financial Stability Board and IOSCO. - Where funds permit retail participation, require clear disclosures and suitability tests to prevent mis-selling. - Limit liquidity mismatch by reviewing permissibility of open-end structures for highly illiquid assets and ensure liquidity-management tools are robust and tested. - Leverage and prudential supervision: - Enhance risk management practices when banks or other supervised institutions provide leverage to private credit firms, including thematic reviews and stress-testing scenarios (tightening of funding availability, markdowns of levered portfolios, sudden drawdowns of credit facilities). - Insurance and pension supervisors should address excessive risk taking by adjusting prudential requirements under the principle of "same activity, same risk, same regulation." - If monitoring finds excessive leverage with potential systemic implications, securities regulators should consider regulatory tools such as leverage caps. - Valuation oversight: - Closely monitor valuation approaches and procedures of private credit funds, insurers, and pension funds. - Consider mandating independent external valuations and audits and strengthening managers’ internal governance on valuation procedures. - Increase frequency of external valuations and audits if necessary; continue intrusive supervision including on-site inspection; take timely enforcement actions for improper or fraudulent valuation. - Supervisory coordination: - Lead authority for systemic risk monitoring should analyze overall trends and assess contagion risks. - All sector regulators should actively coordinate to address data gaps and better understand interconnectedness risks. - International bodies (Financial Stability Board, IOSCO) can aid in improving data gaps globally. - Jurisdictional and recent regulatory measures: - US SEC: enhancing regulatory requirements and reporting for private funds. - EU AIFMD II amendments: enhanced reporting, risk management, liquidity risk management; specific leverage caps for loan-origination funds — 175 percent for open-end and 300 percent for closed-end funds — and a design preference for closed-end structures with additional requirements for open-end funds. - Other jurisdictions (China, India, United Kingdom) have taken steps to enhance regulation and supervision of private funds. ### Regional note — Private Credit in Asia (Box 2.1) - Market size and share: - Asia total private credit: about $93 billion. - Asia accounts for about 5 percent of the global total. - Market characteristics: - Most investors are local and focus on smaller deals. - Global allocation to private credit in Asia remains limited: "0 to 5 percent of assets under management." - China, India, and Indonesia are emerging examples; Australia and New Zealand have more mature markets with superannuation fund participation. - Many credit funds have investment teams based in Hong Kong SAR and Singapore; private credit in Korea has grown steadily. - Segment focus and structure: - Asia primarily fills gaps left by banks; funds focus on acquisition financing, asset-light businesses, and distressed debt. - Most funds are closed-end structures of 6 to 8 years for performing credit and up to 10 years for distressed assets. - Covenants tend to be tighter in emerging market Asia. - About half of capital raised is for special situations; direct lending is gaining share. *Source: IMF, GLOBAL FINANCIAL STABILITY REPORT: THE LAST MILE: FINANCIAL VULNERABILITIES AND RISKS, CHAPTER 2 THE RISE AND RISKS OF PRIVATE CREDIT.* ### Chapter 2 at a Glance ### Chapter 2 at a Glance ### Overview and purpose - Assesses vulnerabilities and potential risks to financial stability in corporate private credit, a rapidly growing asset class traditionally focused on providing loans to midsize firms outside commercial banks or public debt markets. - Focuses on performing corporate credit rather than distressed assets, infrastructure, and real estate. - Notes that private credit has provided significant economic benefits by offering long-term financing to firms too large or risky for banks and too small for public markets. ### Size, growth, and structure - Private credit assets grew to approximately $2.1 trillion globally in combined assets and undeployed capital commitments in 2023. - Private credit has grown exponentially over approximately 30 years and expanded markedly over the last 5 years. - Typical structure: - Dominated by alternative asset managers using closed-end GP/LP funds with capital call structures and limited life cycles. - Closed-end funds account for approximately 81 percent of the total market. - Business development companies (BDCs) account for 14 percent of the market (rapidly growing segment in the United States). - Specialized collateralized loan obligations (CLOs) constitute an additional 5 percent of the market. - Geographic and scale statistics: - As of June 2023, assets under management (deployed and committed) of private credit managers located in the United States reached $1.6 trillion, growing at an average annual rate of 20 percent over the last five years. - In Europe, private credit increased at an average rate of 17 percent per year over the same period and accounts for 1.6 percent of corporate credit. - Private credit now accounts for 7 percent of the credit to nonfinancial corporations in North America, comparable with the shares of broadly syndicated loans and high-yield corporate bonds. - Asian private credit accounts for about 0.2 percent of credit to nonfinancial corporations and has grown at 20 percent annually over the last five years. - North America–focused managers ($1.1 trillion); Europe focus ($460 billion); Asia focus ($114 billion); Other focus ($59 billion) (percent breakdown shown as of June 2023 in source figures). ### Economic role and investor base - Private credit offers flexibility, speed of execution, confidentiality, and tailored repayment and collateral arrangements; typically more expensive than bank loans. - Managers claim greater resources to manage problem loans, enabling fewer sudden defaults and smoother restructurings relative to banks or public markets. - Funding predominantly from institutional investors: pension funds, insurance corporations, sovereign wealth funds, family offices, and high-wealth individuals. - Managers active in private equity hold more than three-quarters of private credit assets; about 70 percent of private credit deals have private equity sponsors. ### Main vulnerabilities and channels to financial instability - Migration of credit from regulated banks and transparent public markets to more opaque private credit raises vulnerabilities: - Private credit loans are unrated, rarely traded, typically “marked to model” by third-party pricing services, and lack standardized contract terms. - Rising risks may be difficult to detect in advance due to opacity and data gaps. - Key vulnerability categories identified: - Borrower fragility: Firms borrowing private credit tend to be smaller and riskier than public market counterparts; loans are typically floating rate and cater to relatively small borrowers with high leverage. - End-investor exposures: Increased exposure of pensions and insurers to private credit and other illiquid investments could produce significant capital losses if credits are dramatically rerated. - Liquidity mismatches: Growth of semiliquid and retail-facing funds increases redemption and first-mover risks despite most private credit funds posing little maturity transformation risk today. - Leverage and interconnectedness: Multiple layers of leverage across the value chain (borrowers, funds, leverage providers, end investors) could transmit stresses; modest fund-level leverage today could still lead to significant capital calls in a downside scenario. - Valuation opacity and stale marks: Lack of price discovery and supervisory oversight, incentives to delay realization of losses, and reliance on models could produce deferred loss recognition followed by large markdowns. - Conduct risks from retail participation: Retail investors may not fully understand risks or redemption constraints in an illiquid asset class. - Cross-sector spillovers: Entities with high exposures (for example, private-equity-influenced insurers) pose potential channels for contagion; data constraints hamper supervisors’ ability to assess exposures and spillovers. ### Current risk assessment and scenarios - Despite vulnerabilities and opacity, financial stability risks from private credit appear contained at present: - Funding is largely long-term capital, mitigating maturity transformation risks. - Use of leverage appears modest; liquidity and interconnectedness risks appear modest at present. - Stress scenario concerns: - The sector has never experienced a severe downturn at its current size and scope; in an adverse scenario there could be a delayed realization of losses followed by a spike in defaults and large valuation markdowns. - Rapid growth and increasing competition (including from banks on larger deals) may degrade underwriting standards and covenants, increasing future credit loss risk. - If private credit continues to grow exponentially with limited prudential oversight and opacity, vulnerabilities could become systemic and amplify negative shocks to the economy. ### Characteristics of private credit borrowers - Typically highly leveraged middle-market companies that are smaller and riskier than leveraged-loan and high-yield bond issuers. - Median firm sizes cited in source figures (comparative): - Private credit: Median firm size: $0.5 billion - Leveraged loans: Median firm size: $4.6 billion - High-yield bonds: Median firm size: $4.5 billion - Investment-grade bonds: Median firm size: $16 billion - Sector composition (from source figure): Information technology, 41%; Healthcare, 14.5%; Consumer discretionary, 11.5%; Industrials, 8.5%; Raw materials and natural resources, 8.2%; Telecoms and media, 6.1%; Financial and insurance services, 5.8%; Other, 4.5%. - Reasons firms choose private credit: - Difficulty accessing traditional bank loans or syndicated markets (weaker firms with low or negative earnings and high leverage more likely to borrow from nonbank sources). - Benefits of flexibility, speed, confidentiality, and customized terms, despite higher cost. ### Data gaps and monitoring challenges - Severe data gaps limit comprehensive assessment of risks: interconnections, leverage, and investor concentration are poorly understood and highly opaque. - The private credit sector’s rapid growth means many risk-mitigating features have not been tested in a large downturn. - The opacity complicates supervisors’ ability to evaluate exposures across financial sectors and to assess potential spillovers. ### Policy recommendations - Encourage authorities to consider a more intrusive supervisory and regulatory approach to private credit funds, their institutional investors, and leverage providers. - Close data gaps so supervisors and regulators can more comprehensively assess risks, including leverage, interconnectedness, and the buildup of investor concentration: - Enhance reporting requirements for private credit funds and their investors, and leverage providers to allow for improved monitoring and risk management. - Closely monitor and address liquidity and conduct risks in funds—especially retail—that may be faced with higher redemption risks: - Implement relevant product design and liquidity management recommendations from the Financial Stability Board and the International Organization of Securities Commissions. - Strengthen cross-sectoral and cross-border regulatory cooperation and make asset risk assessments more consistent across financial sectors. *Source: ch2 - Chapter 2 at a Glance (ch2 - Chapter 2 at a Glance).* ### 1. US Corporate Debt Yields and ### 1. US Corporate Debt Yields and Median Private Credit Loan Rates (Percent) ### Cost of Debt and Variable-Rate Exposure - Private credit loan interest rates are typically higher than yields on market-based debt instruments (corporate bonds, leveraged loans). - Private credit borrowers almost exclusively use floating rate loans. - Only about 29 percent of high-yield corporate bond issuers’ total debt is variable rate. - For a sample of 518 North American and 157 European high-yield corporate bond issuers, the average share of variable rate debt is 29.4 percent, at the end of 2022. - The transmission of higher rates into firms’ cost of debt is swifter for firms with a higher share of variable-rate debt. ### Size, Leverage, and Sector Allocation of Private Credit Borrowers - Private credit borrowers are significantly smaller than broadly syndicated loan or high-yield bond-issuing firms. - Private credit borrowers have higher debt-to-earnings ratios but better asset coverage than syndicated loan counterparts. - A breakdown of private credit borrowers by sector shows a greater weight of the information technology and health care sectors. - For comparison, the weights of the technology and health care sectors in the S&P 500 Index are 30 percent and 12 percent, respectively, whereas these shares are 24 percent and 11 percent for the Bloomberg World Large and Mid Cap Index. ### Payment-in-Kind (PIK) Interest and Interest Coverage - The rise in benchmark rates has increased the interest burden for private credit borrowers, prompting some firms to resort to payment-in-kind interest. - The share of payment-in-kind interest in BDC interest income has doubled since 2019. - The proportion of firms with unsustainable interest coverage ratios has increased to over one-third among firms with size and leverage characteristics similar to private credit borrowers. - When interest is paid in kind, no cash flow occurs; instead, the interest coupon is added—usually at an extra cost—to the loan’s principal. ### Credit Losses, Collateralization, and Private Equity Sponsorship - Despite the risky profile of private credit borrowers, their credit losses have not historically exceeded losses in high-yield bonds and are comparable to leveraged loans. - Headline default rates for private credit indices tend to be relatively high because they include covenant defaults, which often lead to renegotiated terms rather than true payment defaults. - Private equity sponsorship mitigates private credit risks: private equity sponsors may inject additional capital into portfolio firms if stress is expected to be transient. - Evidence from the leveraged-loan market shows that firms sponsored by private equity have lower default rates during periods of stress than nonsponsored firms. - Most private credit loans are secured, which mitigates credit losses; collateralization can be lower in some sectors (for example, software), where unitranche and mezzanine loans are more common. ### Cyclicality of Private Credit Lending - Private credit lending did not “dry up” in March 2020, while high-yield bond and leveraged-loan issuance contracted strongly. - Private credit lending subsequently proved more stable than similarly floating-rate leveraged loans during the COVID-19 period. - Structural analysis shows private credit market activity is less responsive to a sudden credit shock than high-yield bond and leveraged-loan markets. - There is also evidence of procyclical behavior: capital deployment in private equity and private credit is positively correlated with stock market returns. - New private credit loans contract when banks tighten lending standards; new lending by private credit funds appears less procyclical than BDC lending, and fundraising shows a weaker relationship to bank lending conditions. ### Liquidity Risks in Private Credit Funds and Semiliquid Structures - Private credit funds hold highly illiquid underlying assets but are typically structured to minimize liquidity and maturity transformation risk through long-term lockups and constraints on investor redemptions. - Private credit CLOs and closed-end funds do not typically allow redemptions during their life span, significantly reducing liquidity risks arising from such funds. - Semiliquid structures (including certain BDCs and perpetual nontraded BDCs) provide limited redemption windows and are more common as funds seek a broader investor base, including retail investors. - Redemptions in semiliquid structures are often constrained by gates, fixed redemption periods, and suspension clauses, but these tools have not been tested in a severe runoff scenario; redemption pressures have sometimes forced fund managers to allow redemptions above established limits. - Potential liquidity pressures could also arise from credit and liquidity facilities offered to portfolio companies (for example, revolving facilities) if firms simultaneously withdraw balances. - The trend toward semiliquid structures may increase maturity transformation and liquidity risk over time, especially as insurance companies and pension funds shift toward products and liability profiles that may increase demand for liquidity in underlying investments. ### Private Credit and BDC Market Indicators - The analysis aggregates 143 business development companies, 50 of them being traded (BDCs). - Semiliquid products, such as perpetual business development companies, can increase liquidity risk. *International Monetary Fund | April 2024* ### CHAPTER 2 ThE RISE ANd RISkS OF PRIVATE CREdIT ### CHAPTER 2 ThE RISE ANd RISkS OF PRIVATE CREdIT ### Leverage in Private Credit — multiple layers and systemic concerns - Multiple layers of leverage exist across investors, funds, and borrowers, forming a complex multilayered structure. - Investors such as insurance firms and pension funds may use leverage (Figure 2.8, channel 1), making them vulnerable to deterioration in credit outlook, credit downgrades, defaults, and margin/collateral calls. - Private credit investment vehicles may employ leverage within a fund, through special-purpose vehicles or holding companies (Figure 2.8, channel 2), and via structures such as collateralized fund obligations (IOSCO 2023). - Borrowers extensively deploy leverage (Figure 2.8, channel 3); many firms borrowing from private credit funds are backed by private equity sponsors, leading to higher debt or leverage ratios deemed excessive by banks. - Data gaps obscure the full extent of leverage across the network, complicating assessment of amplification effects in a forced deleveraging scenario; even funds with modest fund-level leverage could face material capital calls that propagate through leverage providers. ### Leverage of private credit funds — observed metrics and rollover risk - Closed-end funds: information is scarce; Federal Reserve (2023) confidential regulatory-data study finds: - Funds at the 95th percentile have borrowing-to-assets ratios of about 1.27 and derivatives-to-assets ratios of about 0.66. - Business Development Companies (BDCs): - BDCs issue unsecured bonds and notes and are subject to a regulatory limit on leverage. - Regulation caps BDC debt-to-equity ratio at 2, which was increased from 1 in 2018. - BDC leverage has steadily increased over the past 20 years (Figure 2.9, panel 2). - Private credit CLOs: - Use securitization structures allowing tranche allocation by risk appetite. - Ratio of CLO non-equity tranches over equity tranches often about 6 to 1. - Tabled characteristics (as reported): - Closed-End Funds: Debt-to-equity ratios ~0 to 1.3×; Leverage sources: Portfolio financing, NAV loans, subscription lines, derivatives; Rollover risk: Yes; Collateral call frequency: Varies (typically quarterly); Main lenders: Banks, insurers, pension funds; Total AUM (United States): ~$1.2 trillion. - BDCs: Debt-to-equity ratios ~0.8 to 1.2×; Leverage sources: Secured bank lines of credit and secured/unsecured bonds; Rollover risk: Yes; Collateral call frequency: Varies (typically quarterly); Main lenders: Banks, insurers, pension funds; Total AUM (United States): ~$300 billion. - Middle-Market CLOs: All debt-to-equity: ~6×; AAA to other classes: ~1×; Leverage sources: Term leverage through structured notes; Rollover risk: No; Collateral call frequency: None (cash-flow structure); Main lenders: Insurers, pension funds, hedge funds, banks; Total AUM (United States): ~$100 billion. - Rollover and collateral-call risk: - Leverage provided by commercial banks often has loan-to-value triggers, exposing funds to large collateral calls during stress. - Private credit funds often provide borrowers with revolvers or credit lines; sudden correlated drawdowns of these lines could create considerable funding needs for funds. - Anecdotal evidence: funds maintain cushions but experienced pressures during COVID-19 stress in 2020. - Data limitations: maturity profiles, composition, and amount of debt often not publicly available, hindering risk evaluation. ### Valuations — stale marks, discounts, and convergence dynamics - Private credit loans suffer from stale valuations due to absence of secondary markets, limited comparable transactions, and irregular appraisals; mark-to-model approaches are common and subjective. - Managers often use third-party pricing services, but those may have conflicts of interest (Efing and Hau 2015; Short and Toffel 2016). - BDCs give a visible window into private credit valuation via quarterly position-by-position accounting fair-value marks and disclosures under ASC 946 / ASC 820–10. - Portfolio composition and valuation facts: - Most BDCs concentrate 70 to 90 percent of their investment portfolios in first- and second-lien senior secured loans, distributed across multiple industries and borrowers (often ranging from 100 to 200 borrowers). - Empirical findings (BDCs vs public markets): - Reaction of BDC loans to credit shocks is much smaller than that of B-rated leveraged loans, despite lower credit quality of BDC loan portfolios (Figure 2.10, panel 1). - Smaller valuation adjustments for loans are offset by additional discount applied to market prices of BDC shares (Figure 2.10, panel 2); the discount widens during stress periods, proxied by the LSTA US Leveraged Loan 100 Index. - Adjustments to private credit loan values are smaller and slower than in public markets; deviations persist for several quarters before share prices and NAV per share converge. - Panel 3 (impulse response): price and NAV take at least four quarters to converge after an unexpected shock; the shock is sized to one standard deviation and the impulse response is based on an AR(1) model using quarterly data. - Risks and trade-offs from infrequent valuations: - Stale valuations create first-mover advantage and runoff risk in downside scenarios, but limited redemption features in many private credit funds significantly mitigate immediate run risk. - Frequent mark-to-market could increase procyclicality and short-termism, undermining buy-and-hold rationale. - Stale valuations can distort capital allocation, exacerbate conflicts of interest (managers may maintain high valuations during fundraising), and make timely assessment of potential losses difficult. ### Interconnectedness — private credit links to private equity and other institutions - Private credit–private equity links: - Many managers of private credit funds also manage private equity funds (Figure 2.11, panel 1); interconnectedness is stronger among managers of the largest private credit funds. - Private credit is a key funding source for private-equity-sponsored firms (Figure 2.11, panel 2). - About 70 percent of private credit deals are sponsored by private equity firms; Figure 2.11, panel 3 shows a large share of borrowing firms in private credit deals have private equity sponsors. - Example figure snippets (Figure 2.11 text): High-yield bonds / Institutional leveraged loans / Direct lending (estimate) — Sponsored vs Nonsponsored shares include numbers such as 81.2%, 42.3%, 13.8%, 43.9%, 42.3%, 77%, 72%, 51%, 23%, 28%, 49% (as presented in the figure). - Intersegment spillovers: - Vulnerabilities in one segment of private financing could spill over to another given these ties. - Potential conflicts of interest arise from managers’ multiple connections through portfolio firms and investors (limited partners). ### Exposure of traditional financial institutions to private credit - Bank exposures: - Aggregate exposure of US banks to private credit was about $200 billion at end-2021, representing less than 1 percent of banks’ assets (Federal Reserve 2023). - Credit risks to banks are mitigated by secured nature of many loans, though concentrated exposures at some banks cannot be ruled out due to data limits. - Pension funds and insurers: - Pension funds and insurance companies have emerged as important end investors in private credit, with significant investment growth in recent years (Figure 2.12). - For most institutions, private credit exposures remain relatively small, accounting for only a low single-digit percentage of total assets under management (Figure 2.12, panel 2). - Certain segments (some large pension funds and selected private-equity-influenced insurers in advanced economies) have substantially higher exposures, increasing investments in CLOs, bonds and notes issued by BDCs and other private credit investment vehicles. - Systemic implications: - Rapid expansion of private credit exposures among large institutional investors raises questions about concentration risk, rollover and collateral-call transmission channels, and potential amplification of market stress. *IMF — CHAPTER 2 ThE RISE ANd RISkS OF PRIVATE CREdIT (April 2024)* ### 1. Share of Private Credit Fund Investment ### 1. Share of Private Credit Fund Investment ### Key findings - Private credit allocations are rapidly increasing among institutional investors, contributing to a rise in illiquid assets held by pension funds and insurers. - A sample of 26 large pension funds that disclose gross notional derivative exposure have combined assets under management of more than $7 trillion, which is about 17.5 percent of global pension fund assets. - The financial leverage of those pension funds rose to 80 percent of assets in 2022 from 67 percent in 2016. - The average share of level 3 assets for the sample rose from Average 2016: 31% to Average 2022: 42% (panels report regional and distributional detail). - For selected pension funds with embedded derivatives leverage, private credit accounts for a significant share of the increase in level 3 assets since 2016. - US pension funds had $69 billion in uncalled capital commitments as of the end of 2021; insurers had $23 billion (Federal Reserve (2023) estimate). ### Vulnerabilities to liquidity stress and spillovers to public markets - Growing illiquid allocations heighten vulnerability to margin and collateral calls from derivative exposures, which could exacerbate stress in government bond, equity, and corporate bond markets. - Pension funds’ use of repurchase agreements can further increase financial leverage and amplify liquidity pressures. - The interaction between defined-contribution product features (clients’ ability to switch funds quickly) and illiquid private credit allocations could generate redemption pressures in the private credit industry. - Liquidity mismatch risks in most private credit funds appear minimal today, yet the growth of semiliquid structures and open-end funds investing in highly illiquid assets raises concern because mitigating liquidity-management tools have not been tested by a systemic shock. ### Pension funds — detailed metrics and trends (selected) - Sample: 26 large pension funds, combined assets > $7 trillion (≈ 17.5 percent of global pension fund assets). - Financial leverage (proxy: gross notional derivatives/total assets): 2016: 67 percent; 2022: 80 percent. - Assets under management of the 26-fund sample rose to more than $7 trillion across 2011–2022. - Level 3 assets / investable assets: Average 2016: 31%; Average 2022: 42%. - Private credit share of level 3 assets for selected pension funds increased between 2016 and 2022 (panel-level percentages reported in source figures). ### Private-equity-influenced life insurers — exposures and capital - US private-equity-influenced life insurers manage well more than $1 trillion, over 15 percent of all US life insurance assets (panel 1). - Median exposure to level 3 assets for private-equity-influenced insurers: 20 percent of assets; for a sample of the largest 50 insurers globally: 6 percent of assets (panel 2). - Composition of illiquid exposure for private-equity-influenced insurers: 36 percent structured credit; 23 percent direct credit lending. - These insurers’ solvency metrics are weaker than the median US insurance firm (panel 3). - Private-equity-influenced reinsurers (primarily in Bermuda) have expanded assets to over a $1 trillion, constituting about 4 percent of total life insurance assets globally. ### Credit risks and underwriting concerns - Current prudential requirements for insurers and pension funds often depend on legal form and instrument rating rather than on the credit performance of underlying loans. - Multiple layers of leverage and reliance on manager valuations and rating agencies impede end-investors’ and supervisors’ ability to monitor underlying loan performance and collateral quality. - Private credit expansion intensifies competition with banks in syndicated and broadly syndicated loan markets; underwriting standards and covenants have reportedly deteriorated in some larger-deal segments. - A sharp rise in defaults in an economic downturn could cause significant losses for banks and nonbank lenders if credit risk is not properly priced. ### Regulatory landscape and specific measures - US Securities and Exchange Commission: enhancing regulatory requirements and reporting for private funds. - European Union AIFMD II amendments: enhanced reporting, risk management, and liquidity risk management; specific leverage caps for loan-origination funds — 175 percent for open-end and 300 percent for closed-end funds — and a design preference for closed-end structures with additional requirements for open-end funds. - Other jurisdictions (China, India, United Kingdom) have taken steps to enhance regulation and supervision of private funds. ### Policy recommendations - Undertake a comprehensive review of regulatory requirements and supervisory practices where private credit markets or exposures to private credit are becoming material. - Enhance reporting requirements and supervisory cooperation on cross-sectoral and cross-border bases to address data gaps and enable accurate, comprehensive, and timely monitoring of emerging risks. - Supervisors of insurers and pension funds with high exposure to private credit should strengthen monitoring of aggregate portfolio risks in private credit and adopt some banking supervisory practices regarding credit risk. - Supervisors should strengthen prudential assessments of credit exposures through both structured products and direct lending. - Supervisors of private credit funds should closely monitor underwriting practices and credit risks, with attention to systemic amplification channels: liquidity, leverage, and interconnectedness. - Address liquidity risk in fund structures: limit liquidity mismatch by reviewing permissibility of open-end structures for highly illiquid assets and ensure liquidity-management tools are robust and tested. *Source: IMF staff synthesis from chapter "The Rise and Risks of Private Credit," GLOBAL FINANCIAL STABILITY REPORT: THE LAST MILE: FINANCIAL VULNERABILITIES AND RISKS (April 2024).* ### CHAPTER 2 ThE RISE ANd RISkS OF PRIVATE CREdIT ### CHAPTER 2 ThE RISE ANd RISkS OF PRIVATE CREdIT ### Liquidity and Retailization Risks - "Retailization" increases participation by individual investors who may not fully understand liquidity features, potentially creating herd behavior toward redemption during stress episodes. - Securities regulators should adopt Financial Stability Board and IOSCO recommendations on product design and liquidity management tools. - Suggested measures: - Private credit funds should create and redeem shares at lower frequency than daily or require long notice or settlement periods. - Authorities should consider requiring such funds be closed-end. - Require stringent use of liquidity management tools and stress testing when product design permits significant liquidity mismatch. - Where funds permit retail participation, require comprehensive and clear disclosures on potential risks and redemption limitations. ### Leverage Risks - Current reporting requirements are insufficient to comprehensively assess leverage used in private credit; potential transmission of funding shortfalls from leverage providers cannot be fully evaluated. - Fund-level reporting to securities, insurance, or pension supervisors may not capture complex, multi-layered sources of leverage, including subscription lines and levered special-purpose vehicles or feeder funds. - Reporting is fragmented across borders and sectors, creating data gaps that prevent macro-level supervisory monitoring. - Recommended supervisory actions: - Enhance risk management practices when banks or other supervised institutions provide leverage to private credit firms, including thematic reviews of liquidity management practices. - Thematic reviews should incorporate stress scenarios featuring: - tightening of funding availability, - markdowns of levered portfolios, - sudden and significant drawdowns of credit facilities by private credit funds’ corporate borrowers. - Fill data gaps by enhancing comprehensive reporting of leverage across the value chain, with close domestic and international cooperation. - Insurance and pension supervisors should address excessive risk taking by adjusting prudential requirements under the principle of "same activity, same risk, same regulation." - If monitoring finds excessive leverage with potential systemic implications, securities regulators should consider regulatory tools such as leverage caps. ### Asset Valuation Risks - Regulatory requirements for private credit funds focus on policy documentation, governance, and investor disclosures but do not specify how assets should be valued; the overall framework tends to be light-touch on valuation. - Institutional investors (insurance companies and pension funds) may lack incentive to challenge fund managers' valuations because they desire investment stability; managers' discretion leads to wide variation in valuation for the same asset across funds and entities. - IOSCO found valuation approaches vary significantly by country; IOSCO's agreement with the International Valuation Standards Council to identify potential approaches is noted. - Supervisory recommendations: - Closely monitor valuation approaches and procedures of private credit funds, insurers, and pension funds. - In case of heightened valuation risks, strengthen regulation on valuation independency, governance, and frequency. - Consider mandating independent external valuations and audits and strengthening managers’ internal governance on valuation procedures. - Consider increasing frequency of external valuations and audits if necessary. - Continue intrusive supervision, including on-site inspection, of valuation practices; improper or fraudulent valuation should be followed by timely and strict actions, including enforcement. - Example regulatory actions already taken: - US SEC strengthened regulation concerning independent audits and intensified supervision. - UK Financial Conduct Authority and European Securities and Markets Authority intensified supervision relating to valuation of private funds. ### Interconnectedness Risks - Risk taking is concentrated in some jurisdictions and subsectors; differences in regulatory requirements across sectors may have encouraged insurance companies and pension funds to hold excessive exposure to private credit. - Banks continue to provide leverage to private funds and affiliates; excessive concentration and interconnectedness among private equity firms, insurance companies, and pension funds could exacerbate systemic risks. - Data gaps hinder monitoring of concentration and interconnectedness risks. - Recommended actions: - Fill data gaps and cooperate across sectors and borders to ensure effective monitoring of interconnectedness risks. - The authority in charge of systemic risk monitoring should lead analysis of overall trends in private credit markets and assess potential contagion risks. - All sector regulators should actively coordinate to address data gaps and better understand interconnectedness risks. - Cross-border cooperation is important where cross-border interconnections are significant and concentrated. - International bodies, such as the Financial Stability Board and IOSCO, can aid in improving data gaps globally. - If regulatory arbitrage across sectors and borders leads to excessive concentration, relevant regulators should coordinate to ensure more consistent risk assessments and corresponding prudential treatments. ### Conduct Risks - Increasing retail participation raises conduct risks; existing frameworks assumed investors are sophisticated and applied a light touch to investor protection safeguards. - Although existing regulatory requirements cover conflicts of interest in detail, conduct risks rise with more retail participation because more frequent redemptions may exacerbate concerns regarding valuations and follow-on investments. - Conduct supervisory recommendations: - Closely monitor conduct risks and enhance disclosure requirements, particularly relating to conflicts of interest. - Apply stringent regulatory requirements for conduct with retail investors. - Monitor private credit funds’ distribution channels and marketing practices; tailor suitability tests to prevent mis-selling. - Ensure retail investors (including holders of unit-linked products and defined-benefit plans) fully understand higher credit and liquidity risk of private credit investments and limitations on redemptions. - Continue monitoring potential conflicts of interest in sponsored deals involving affiliated private debt and private equity managers, given that privately negotiated transactions lack market pricing. ### Private Credit in Asia (Box 2.1) - Asia's private credit market is growing rapidly but remains relatively small: - Totaling about $93 billion. - Accounting for about 5 percent of the global total. - Market characteristics: - Most investors are local and focus on smaller deals. - Global allocation to private credit in Asia remains limited ("0 to 5 percent of assets under management") and is relatively less appealing because of tighter spreads and high foreign exchange hedging costs. - Regions with highly liquid banking systems or modest growth tend to have small or nonexistent private credit markets. - China, India, and Indonesia are emerging key examples; Australia and New Zealand have more mature markets with active participation from superannuation funds. - Many credit funds have investment teams based in Hong Kong SAR and Singapore; private credit in Korea has grown steadily. - Segment focus: - Unlike the United States, Asia primarily fills gaps left by banks; funds focus on acquisition financing, asset-light businesses, and distressed debt, providing financing to the high-yield segment, which remains underdeveloped in many emerging market and developing economies in the region. - Most funds are closed-end structures of 6 to 8 years for performing credit and up to 10 years for distressed assets. - Covenants tend to be tighter in emerging market Asia because of weaknesses in investor protection. - About half of the capital raised is for special situations, although direct lending is gaining share. - Sources cited within the box include industry surveys indicating many institutional investors in the region intend to increase allocations to private credit. *Italicized source attribution:* IMF, GLOBAL FINANCIAL STABILITY REPORT: ThE LAST MILE: FINANCIAL VuLNERABILITIES ANd RISkS, CHAPTER 2 ThE RISE ANd RISkS OF PRIVATE CREdIT. --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2024/april/english/ch2.pdf_