Private credit is loans from non-bank financial institutions to private companies that could not qualify for the loan through the regular bank channels. Back in the 2000s this market was about a 42 billion dollars market(statista) and in the next five years this market could crest 2.3 trillion. The use of private loans to private companies is not new but the market has grown so large that there is some risk that it could potentially spill over into the greater economy. After the great financial crisis (GFC) of 2008, banks were levied with heavy handed restrictions on their ability to make loans. Operating outside of the purview state and federal regulators was private credit and with interest near zero after GFC, the risk of loans going bad was low.

As the economy tried to right itself in the wake of the GFC, the Federal Reserve did a massive amount of bond buying. At the same time, they dropped their benchmark interest rate to almost zero. They bought treasury bonds and mortgage bonds to the tune of 2 trillion dollars. This action flooded the banking sector with massive amounts of cash. When rates are held this low it makes it much more difficult to find investment that will produce a decent income. So, wealthy income starved investors were looking for a better yield. The hedge funds and private equity knew there was a demand for private loans to private businesses that traditional banks would not be able to satisfy due to strict new regulations.

More companies started to flood into the private credit business due to the attractive returns. The returns for private credit are 10 or 11% depending on the fund. If you are paid 10 or 11% what is the rate of interest that the fund managers have charged the business that is borrowing the money?  As an investor, you are relying on the private credit fund manager that they have thoroughly vetted the companies that they are lending money to. One of the provisions of a private fund is that you do not know which companies that the manager puts into your portfolio. Moreover, the money is then locked up for seven to ten years. There are companies like Apollo, Ares that offer open and closed ended private credit funds. The open-ended fund allows for quarterly withdrawals. The company also has the right to suspend withdrawals so that there are not too many at one time.  The private credit firms see the lock up of your money as a safeguard in the event of a prolonged economic downturn because you cannot pull all your money. That is why it has been hard for investment firms to turn this into an ETF. The illiquid nature makes it difficult because ETFs can be bought and sold throughout the day. However, that has not stopped firms from applying to the SEC to get a private credit ETF. Virtus as applied and so has Fidelity. If it becomes an ETF, this will democratize private credit.

As of now, the buyers of private credit funds are mostly insurance companies, pension funds, family offices, sovereign wealth funds and wealthy individuals. According to the Federal Reserve notes from February 24, 2024, with such high returns and lot of ample dry power there is the risk that this market would get over saturated and underwriters would reduce their standards to make sure they are providing the returns for their clients. What will happen if inflation stays high, and we have protracted economic slowdown. Who has the greatest exposure?

“Synthetic risk transfer” That is how the big banks are hedging their bet with private credit.  Last year Wells Fargo partnered with Centerbridge Partners in a 5 billion dollars deal to direct lending to the middle market. The big banks cannot hold all the loans on their books. So, they have engineered a way to offload the risk. Its call it “synthetic Risk Transfer”. This is where the big banks pay a private equity firm to hold an insurance policy against the private credit loans in case, they go bad. Under Basel III the US banks are going to be held to more stringent capital requirements which could increase the use of these types of arrangements. As now the, the use of synthetic loan transfer is about 200 billion mostly in Europe nowhere near the 500 billion that AIG held in 2008(Reuters). But it’s worth keeping an eye on the private credit market. If things go sour, someone is going to be left holding the bag and it’s usually the taxpayer.

Al Souza