Financial regulation can be like a game of Whac-A-Mole. Regulators smack down risk in one area of the financial system only to see it pop up somewhere else.
This was true in the wake of the 2008-09 financial crisis. We tightened rules on banks after the crisis, but risky lending simply migrated to more lightly regulated nonbank institutions—including private credit funds, which have now become an important source of lending to the real economy.
Private credit funds primarily specialize in direct lending to highly leveraged, middle market companies. Assessing the resilience of those companies is difficult; most aren’t publicly traded, so available data are limited. Yet we do know the sector has experienced explosive growth in the U.S. since 2009, with assets under management reaching $1.7 trillion in 2024, compared with more traditional bank-syndicated leveraged loans (about $1.4 trillion) and high yield debt (about $1.3 trillion).
But these funds have never been tested by a financial crisis or prolonged recession. With markets in turmoil and recession risks rising, private-credit markets may be about to face the same pressures that led to their rise.
Advocates argue that private credit helps the economy by extending credit to companies too large and risky for banks, but too small for public bond markets. They argue that, unlike banks, the funds rely primarily on equity for their funding and don’t suffer from run risk because their investors are locked in. Most require long-term capital lockups of their investors to align with the multiyear durations of their illiquid assets. which they must hold to maturity as there is no liquid secondary market for them. Private fund advocates also boast of their superior prowess in managing credit risk, pointing to default rates that are lower than leveraged loans or high yield bonds.
The fact that private credit provides financing to companies that wouldn’t otherwise qualify for loans may, or may not, be a good thing. By doing so, these lenders raise the overall level of corporate leverage in the financial system and increase its exposure to risky borrowers. Spreads for private credit loans are higher than for leveraged loans and high yield debt, suggesting they are financing riskier borrowers. Their borrowers also have lower ratios of earnings to interest expense, making them less capable of meeting debt obligations in times of trouble. Nonbank mortgage lenders also argued before the 2008-09 financial crisis that they were expanding access to credit for subprime borrowers who wouldn’t otherwise qualify. We all remember how that turned out.
It is true that default rates have been surprisingly low for private credit, partly attributable to a prolonged period of low interest rates and use of strong maintenance covenants as the market developed. Perhaps that means these lenders can effectively manage their high-risk borrowers. But default rates are now rising. Highly leveraged companies are struggling with a higher-for-longer rate environment, and private credit funds have reportedly dropped maintenance covenants on larger deals to draw market share.
Importantly, while private credit default rates are still lower than they are for leveraged loans and high yield debt, when defaults do occur, the losses are more severe. This may be partly due to private credit’s significant exposure to industries like tech, finance, and healthcare, which have low levels of tangible assets that can serve as collateral. It may also be due to inflated valuations. There is no regulatory oversight or public price discovery over how funds value their assets. They have incentives to delay mark downs on troubled loans as their management fees are based on net asset values. Early intervention with troubled borrowers will mitigate losses. Delays will only increase them, putting off corrective measures until it may be too late.
Investor lockups may protect the funds from liquidity runs in times of crisis. But lockups could also worsen stress on their institutional investors, who will have no easy exit if the funds plummet in value. Private credit’s access to new funding could also disappear as their investors turn to highly liquid, safe haven assets. The funds began the year with significant “dry powder” that they could use to continue lending. But they may need that capital to manage losses on their portfolios if defaults spike and interest income drops from Federal Reserve rate cuts. Nonbank mortgage lenders also relied on market-funding, which evaporated as a result of the 2008-09 financial crisis. None of them survived as stand-alone companies.
Assessing the risks of private credit is guess work because of the lack of transparency. As in the children’s game, we don’t know where the moles are hiding. Institutional interest in private credit is waning—fundraising has dropped for three consecutive years. But new funds are targeting retail investors. Until these untested funds provide more information, regulators should remain wary, and retail investors should stay away.
Moles may not need sunshine, but investors do.
Sheila Bair is former chair of the Federal Deposit Insurance Corp. and founding chair of the CFA Institute Systemic Risk Council. Sheila Bair’s speaking engagements are managed exclusively by WWSG. To host her for your event, contact us!
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