Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch
IMF Blog, April 8, 2024
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- Authors: Charles Cohen, Caio Ferreira, Fabio Natalucci, Nobuyasu Sugimoto
- Published: April 8, 2024
Market size, structure, and recent growth
- Private credit market topped "$2.1 trillion globally last year in assets and committed capital."
- "About three-quarters of this was in the United States," where market share is "nearing that of syndicated loans and high-yield bonds."
- Originated about three decades ago to finance companies too large or risky for commercial banks and too small for public markets.
- Growth drivers: "speed, flexibility, and attentiveness" to borrowers; institutional investor demand from "pension funds and insurance companies" seeking higher returns and less volatility despite illiquidity.
- New retail-targeted funds are emerging, potentially changing the investor base and liquidity dynamics.
Key vulnerabilities and fragilities identified
- Borrower profile and interest-rate sensitivity:
- Companies using private credit "tend to be smaller and carry more debt" than those with leveraged loans or public bonds.
- "With the recent rise in benchmark interest rates, our analysis indicates that more than one-third of borrowers now have interest costs exceeding their current earnings."
- Underwriting and covenant deterioration:
- Increased competition from banks on large transactions has pressured private credit providers to "deploy capital, leading to weaker underwriting standards and looser loan covenants—some signs of which have already been noted by supervisory authorities."
- Valuation opacity and stale marks:
- Private market loans "rarely trade" and are often "marked only quarterly using risk models," creating potential for "stale and subjective valuations across funds."
- Comparative finding: despite lower credit quality, "private credit assets tend to have smaller markdowns during times of stress" versus leveraged loans.
- Leverage layering and data gaps:
- While "private credit fund leverage appears to be low," there is "the potential for multiple layers of hidden leverage" deployed by investors and borrowers, raising assessment difficulties given "the lack of data."
- Interconnectedness and concentration risks:
- Banks' aggregate exposure appears limited: the Federal Reserve has estimated that "US private credit borrowing amounted to less than about $200 billion, less than 1 percent of US bank assets," but "some banks may have concentrated exposures to the sector."
- "A select group of pension funds and insurers are diving deeper into private credit," including "private-equity-influenced life insurance companies."
- Liquidity and redemption risk:
- Funds rely on "long-term capital lockups and impose constraints on investor redemptions" to align with illiquid assets.
- New retail funds "may have higher redemption risks," and liquidity management tools (gates, fixed redemption periods) "have not been tested in a severe runoff scenario."
Potential systemic scenarios and economic implications
- Current assessment: "Today, immediate financial stability risks from private credit appear to be limited."
- But continued fast growth with limited oversight could transform vulnerabilities into systemic risk for the broader financial system.
- In a severe downturn:
- "Credit quality could deteriorate sharply, spurring defaults and significant losses."
- "Opacity could make these losses hard to assess."
- "Banks could curb lending to private credit funds."
- "Retail funds could face large redemptions, and private credit funds and their institutional investors could experience liquidity strains."
- "Insurance companies and pension funds may be forced to sell more liquid assets," with knock-on effects for public markets.
- "The cumulative effect of these links may have significant economic implications should stress in private credit markets result in a pullback from lending to companies."
- "Severe data gaps make monitoring these vulnerabilities across financial markets and institutions more difficult and may delay proper risk assessment by policymakers and investors."
Policy implications and recommendations
- Adopt "a more vigilant regulatory and supervisory posture to monitor and assess risks in this market."
- Authorities should consider "a more active supervisory and regulatory approach to private credit, focusing on monitoring and risk management, leverage, interconnectedness, and concentration of exposures."
- Enhance cross-industry and cross-border cooperation "to address data gaps and make risk assessments more consistent across financial sectors."
- Improve reporting standards and data collection "to better monitor private credit's growth and its implications for financial stability."
- Securities regulators should "pay close attention to liquidity and conduct risk in private credit funds, especially retail, that may face higher redemption risks."
- Implement "recommendations on product design and liquidity management from the Financial Stability Board and the International Organization of Securities Commissions."
Based on Chapter 2 of the April 2024 Global Financial Stability Report: “The Rise and Risks of Private Credit.”
Content in this bundle
- Financial Stability Report, May 2023