Banks are joining private equity funds in issuing private credit to corporate borrowers – despite regulators’ concerns about unseen risks.
As private equity becomes an increasingly dominant force in backing corporate transactions, banks are adopting an “if you can’t beat ’em, join ’em” approach to debt equity financing.
Corporate borrowers who cannot obtain traditional bank financing will benefit from this. But the intertwining of largely unregulated private credit and regulated bank lending – with the attendant risk of government bailouts for providers of both if their loans go sour – raises questions about the threats to the financial system.
What might once have been considered an unlikely partnership may nevertheless become vulnerable to deepening, because the forces behind it have been building for some time.
The global private credit industry, which is mainly provided by closed-end credit funds sponsored by the same private equity firms that back equity instruments, has seen significant growth since the financial crisis in 2008. It has $2.8 trillion in assets under management at last count, up from $200 billion in the early 2000s, according to the Bank for International Settlements (BIS). In contrast, bank lending fell from 44% of total U.S. corporate borrowing in 2020 to 35% in 2023, an analysis by global consulting firm Deloitte of Federal Reserve data found.
“Some private credit funds may have a degree of liquidity mismatch between their investments and the redemption terms of their investors.”
Lee FolgerBank of England
The use of private credit is expanding dramatically elsewhere as well. The Bank for International Settlements estimates that the total volume of private credit loans outstanding worldwide has increased from about $100 billion in 2010 to more than $1.2 trillion today, and that more than 87% of these total loans come from the United States. Europe, excluding the United Kingdom, has accounted for about 6% of the total in recent years, the United Kingdom about 3% to 4%, and Canada making up most of the rest. Total credit fund assets under management in the Asia-Pacific region are about $92.9 billion, up from $15.4 billion in 2014, according to research firm Preqin.
The appeal of private credit to corporate borrowers is clear: many middle market companies, often backed by private equity sponsors, prefer private credit because of its speed, flexibility, confidentiality, and lower disclosure obligations compared to the public bond markets available through broadly syndicated loans. These advantages are beginning to attract larger, more creditworthy companies as well.
At the same time, banks are increasingly lending to private credit funds for the purposes of financing corporate borrowers, often those in sponsors’ equity portfolios. This lending often takes the form of so-called direct lending: business loans that companies use for working capital or growth financing, and which the industry claims traditional banks will not guarantee.
The Federal Reserve estimated bank lending to the private credit industry in May 2023 at $200 billion, and the Fed acknowledged that its estimate may be an underestimate of the actual amount. Fitch Ratings found that nine of the 10 banks with the largest loan balances to non-bank financial intermediaries of all types had $158 billion in loans to private credit funds or related vehicles at the end of last year. The volume of outstanding loans made by banks to private credit funds rose by 23% in the quarter ending June 30, compared to the previous quarter, compared to just 1.4% for bank lending overall, Fitch said.
The growing importance of bank lending to private credit is well illustrated by Blackstone Private Credit Fund, one of the largest private credit funds in the world with assets of more than $50 billion. Fully 98% of the $23.5 billion senior secured credit commitment facility arranged by its affiliates as of December 2022 was provided by 13 banks, with the remaining amount by an insurance company. The total amounts drawn on these facilities amounted to about $14 billion, representing about 50% of the Fund’s total debt obligations.
Deepening cooperation
Of course, banks have long been involved in financing private equity buyouts, such as Sycamore Partners’ acquisition of Walgreens Boots Alliance. Two other private equity firms, HPS Investment Partners and Ares Management, have together provided $4.5 billion in direct loans for the deal, while banks including Citigroup, Goldman Sachs and JPMorgan Chase have drawn up financing proposals to work jointly with private credit, providing some access to the private credit market. BSL. Overall, the deal Sycamore completed in August is worth $23.7 billion, with more than $10 billion in committed financing from private credit funds and banks.
Increasingly, collaboration between banks and private equity firms takes the form of direct lending to borrowers. For example, PNC Financial and TCW Group teamed up to create a lending platform for middle market companies. Citizens Financial Group has built a unit focused on lending to private equity funds.
Competition from banks is also increasing. Standard Chartered and Goldman are setting up their own units dedicated to providing private credit, while Morgan Stanley is launching funds to exploit private credit opportunities. Loans may not remain on banks’ balance sheets for long, as risk is transferred once investors’ capital is deployed. But just as the securitization market has frozen in the post-Covid inflationary environment, it may also risk conversion when liquidity suddenly disappears.
Indeed, regulators fear that banks’ involvement in private credit, whether through cooperation or competition with private investment firms, may impose hidden risks on the financial system. Researchers from the Bank of England, the Bank for International Settlements, the European Central Bank, and the Federal Reserve, among others, have recently issued reports warning of the systemic financial risks these relationships may pose. Without greater visibility, the Bank of England has instructed banks to strengthen risk management in this area.
“Some private credit funds may have a degree of liquidity mismatch between their investments and the repayment terms of their investors,” Lee Folger, director of financial stability, strategy and risk at the Bank of England, warned in a January 2024 speech to a middle market finance conference sponsored by Deal Catalyst and the Financial Markets Association of Europe.
Who is the most creditworthy?
The industry counters such concerns by pointing out that credit funds are less vulnerable to loan defaults than the BSL market, where sponsors typically monitor borrowers’ performance more closely, use less leverage, adopt more conservative loan-to-value structures, and offer more flexible terms than banks, while locking investors in for longer periods. In a recent report titled “Understanding Private Credit,” Ares Management asserts that its borrowers are more creditworthy than public market borrowers and back more equity, and that although the private credit market is still small by comparison, it is on its way to becoming less leveraged while any mismatches in financing will diminish as it grows.
However, concerns remain, especially given the potential for a difficult economic environment in the future.
For example, Fitch notes that the industry has not yet been able to withstand higher interest rates. As the ratings firm put it in a June report, “Sponsors and lenders have largely assumed a low base rate environment, as the Fed has indicated amid interim inflation expectations, when determining optimal sizes of capital structures vis-à-vis revenues, EBITDA, and free cash flow expectations.”
As for liquidity risks, Julie Solar, an analyst at Fitch, points out that an increasing number of credit funds are open and subject to withdrawal under difficult conditions. Although she acknowledges that the number of such funds is still small, at least in the United States, and many of them impose restrictions on redemptions, she adds that this is an issue worth monitoring. If more open-end funds are created and interest rates rise too high, “then you can start to have liquidity issues,” she warns.
In the eurozone, 42% of funds are open-ended, according to the European Central Bank, although most of their investors are institutions and tend to have longer time horizons than individual investors.
Solar also raises concerns about what it calls “leverage on leverage,” noting that business development companies — publicly traded vehicles that account for about half of private credit — as well as private equity firms themselves are often heavily indebted to banks. In fact, bank lending for acquisition may pose a greater risk, simply because it is much greater than direct lending.
Banks’ participation in credit funds is an additional concern for regulators. The European Central Bank’s May 2024 Financial Stability Report noted that “private markets still need to demonstrate their resilience in a rising interest rate environment, having only grown to a significant size in the past decade.”
The industry counters that the interest rates on many, if not most, of its loans are floating, eliminating the need to refinance in a rising interest rate environment. But this will likely do nothing for the borrowers themselves.
“The floating-rate debt structure of private credit agreements makes them vulnerable to challenges related to debt servicing and refinancing in a higher interest rate environment,” the Bank of England’s Folger noted at a January 2024 conference.
A report issued by the Federal Reserve Bank of Boston in May acknowledged that bank losses could be mitigated in response to adverse conditions, as most private credit debt is collateralized and is among the funds’ most important liabilities. However, the authors caution, “Substantial losses could also occur in a less adverse scenario if the default correlation between loans in (private credit) portfolios turns out to be higher than expected – that is, if a larger than expected number of (private credit) borrowers default at the same time. Such additional risks may be underestimated.”
