Private-debt funding has grown substantially in recent years as regulations enacted after the financial crisis largely pushed traditional financial institutions out of the business of lending to commercial and industrial companies.
Yet much of the private-debt sector, unlike the banking industry, is subject to little regulatory oversight. That’s a concern as these loans become more vulnerable to higher interest rates, a slowing economy, and a desire by many to avoid riskier investments, among other issues, according to Moody’s Investors Service.
“We’re concerned about why is this industry growing so fast with very little transparency to the regulators and the marketplace,” says Ana Arsov, managing director and co-head of global banking for Moody’s Investors Service.
Moody’s estimates the size of the private-debt market grew from about US$300 billion in 2010, post-financial crisis, to about US$1.2 trillion in 2021, based on data from Preqin—a London-based firm that tracks alternative investments—global management consulting firm McKinsey & Co., and its own research.
A report just published by Preqin found that 34 private-debt funds raised US$71.2 billion in the second quarter of this year alone.
The growth has been fueled largely by lending to firms owned by private-equity funds, a sector that swelled from US$1.7 trillion in assets in 2010 to US$6.3 trillion in 2021, according to Moody’s calculations.
But it’s also fueled by investor appetite for these largely floating-rate investments.
One way investors get exposure to private lending is by investing in business development companies, or BDCs, vehicles that typically have attributes of both publicly traded companies and closed-end funds. Moody’s estimates about 25% of private-credit assets are held by BDCs, which is “a relatively transparent vehicle,” Arsov says.
These companies have to maintain certain levels of capital against their loans, and they report details of their loan portfolios, she says. Many are also sizable. The largest, Blackstone Private Credit Fund with US$52.7 billion in assets as of the end of last year, according to Moody’s, is actually a non-exchange fund that is not publicly traded. The second largest,
Ares CapitalCorp.
(ticker: ARCC), with about US$22 billion in assets, is a publicly traded fund and is largely funded by retail investors.
The rating firm assesses the debt of roughly 80% of existing BDCs through ratings on 25 companies, largely focused on their senior secured loans, Arsov says. Moody’s rates Ares Capital’s long-term debt at Baa3—the lowest rung of investment grade—with a stable outlook.
Penta recently spoke with Arsov about BDCs and other forms of private debt, such middle-market collateralized loan obligations, and the potential risks these vehicles may face in the current economic environment.
A Mostly Unregulated Market
Aside from the BDCs, most of the private-debt market is not regulated. This can include other types of alternative asset management vehicles, including mezzanine funds and special situation funds, which are not required to hold assets against potential losses, as the BDCs are.
According to Preqin’s data, for instance, a mezzanine-debt fund was the largest fund to close in the second quarter. HPS Strategic Investment Partners V raised US$17 billion for companies in North America and Western Europe, Preqin said.
The size of the private-debt market, and its lack of transparency to regulators, raises systemic concerns should the credit quality of the companies that have taken out these private loans start to deteriorate.
“If there is a deterioration in fundamental credit, and you certainly expect that considering where the rates are going, [then] the default rates are going to go up for leveraged companies,” Arsov says. “A greater part of that market is in this opaque world,” she says. The true risks in this sector won’t be known “until they’re spilling over into the broader economy.”
U.S. banks today provide about half of all domestic commercial and industrial loans to small businesses; they used to provide about 60%, according to Moody’s. The small companies these loans finance—which had typically been family-owned businesses—provide the core, middle-market of U.S. employment, Arsov says.
Many of these companies today are owned by private-equity firms. These firms often put sophisticated managers into place—which can be a plus for a growing business—but they are also engaging in mergers and acquisitions and other activities that saddle these companies with debt.
If the credit of the companies underlying this debt financing begins to weaken, that could lead to rising unemployment, which could have ripple effects across the economy, a potential risk that is not being overseen by regulators, Arsov says.
Another issue is the lack of oversight over private-debt funds that exist outside of BDCs. The BDCs have public boards of directors that provide a check on operations—but what happens if a private-equity fund taps its own private-credit fund to finance a deal for a company it owns?
“What is the fiduciary duty here? Can it be a conflict of interest, because they are supporting their own companies?” Arsov says.
No Immunity to Bank Risks
Arsov emphasized that being financed by private debt is not in and of itself bad. The argument alternative asset managers make is that yes, private debt can be risky, but they are experienced and know how to manage the risks, she says.
One plus is that they aren’t financing private companies with overnight deposits, as a bank would, but with long-term debt financing—so there’s a better match between assets and liabilities.
Another benefit, these managers say, is that because they aren’t banks, they won’t be forced to sell a loan by regulators for whatever reason.
But private-equity firms can still have significant exposure to the banking sector. That’s because banks provide up to 50% of the funding structure for their secured lines of credit. If the banks tighten credit standards as the economy weakens, these funds could lose financing, Arsov says.
A Test for the Industry
About 70% of the investors in private debt vehicles are pension funds, but private-wealth investors, including family offices and endowments, also participate.
Goldman Sachs found that the very wealthy families it surveyed at the beginning of the year allocated only 3% of their investment holdings to private debt, but 30% said they expect to boost their allocation in the next 12 months. According to Goldman, families like the fact the rates on the loans are floating—meaning they have been on the rise, which produces more income for investors.
But those rising rates can make paying off loans more difficult for borrowers. If a company was paying 7% last year for a private loan, that same company would pay about 11% or 12% today. “That’s a huge increase in interest-rate coverage,” Arsov says.
Rising rates haven’t presented problems for the sector just yet, but they could. “Everything is good until there is a big hiccup,” she says. At that point, a retail investor could say they didn’t realize the risks inherent to the asset class. That has the potential to balloon into a big issue involving the Securities and Exchange Commission or the U.S. Congress.
“We haven’t had issues because this asset class has performed very well,” she says. But, “it’s a relatively new asset class.” Higher rates, “and higher rates for longer, will be a test for the industry.”
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