The burgeoning private credit industry of lending to buyout groups has grown to about $1tn, but opacity, eroding standards and the difficulty in trading these slices of debt pose “systemic risks”, according to rating agency Moody’s.
Investor money has gushed into so-called private markets in recent years, in the hope that venture capital, private equity, real estate and infrastructure will provide an alternative to the dimming outlook for returns in mainstream public stock and bond markets.
One of the hottest corners is private credit, where investment funds such as Apollo and Ares make bespoke, high-returning loans to midsized companies that are often owned by buyout groups, but too small to be able to turn to the near-$10tn US corporate bond market. Even some larger companies have been lured away from broadly syndicated markets by the growing firepower of so-called direct lenders.
This has been a boon to many companies at a time when banks have retrenched, but Moody’s warned in a report this week that the “explosive” growth of private credit was storing up risks in a hard-to-monitor corner of the financial system.
“The mounting tide of leverage swapping into a less-regulated ‘grey zone’ has systemic risks,” the rating agency said. “Risks that are rising beyond the spotlight of public investors and regulators may be difficult to quantify, even as they come to have broader economic consequences.”
The private credit industry took off in the wake of the global financial crisis, when regulatory restrictions spurred many big banks to curtail their lending to smaller companies.
Leveraged buyout groups — many of which now also have big credit investment units — have been particularly active users of the industry, weaving private equity and private credit closely together in a debt-laden ecosystem.
“Private equity’s business model relies on leverage,” said Christina Padgett, head of leveraged finance research at Moody’s. “We have become more accustomed to leverage in the institutional loan market and bond market. Now we are seeing a higher degree of leverage among smaller companies . . . At the moment that is fine because rates are low but it introduces a higher degree of risk going forward.”
Private credit suffered a blow when the pandemic hit the global economy last year, sending the shares of “business development companies” — a crucial cog of the industry — down by as much as 55 per cent in March 2020.
However, aggressive central bank stimulus to soften the economic hit of lockdowns has helped keep many companies afloat, lifting BDC shares up by 175 per cent since the March 2020 nadir and prompting many investors to go looking for opportunities in the sector.
Goldman Sachs analyst Lotfi Karoui said earlier this month that “the global private debt market continues to cement itself as a distinct and scalable asset class”, adding that its record of steady and healthy returns “provide an attractive diversification avenue to investors willing to take on more illiquid risk”.
Moody’s is not the only rating agency sounding a cautious note on the renewed boom. S&P Global has also warned of “heightened risks” in private credit, highlighting how it is increasingly marketed as a distinct asset class and increasingly found in more mainstream funds.
“This expansion of the investor base could lead to heightened risk in the market if it leads to volatile flows of money into and out of the market,” it said.