How worried should asset owners be about a private credit bubble?
Allocations to private credit have increased, along with the number of managers entering the market, but the Bank of England has warned about the risks this asset class poses.
In recent years, allocations to private credit have been on the up among large institutional investors. By some estimates, the private credit market will reach $2.6tn in assets under management by 2029.
Data from a recent Goldman Sachs survey shows insurers are looking to private credit above other asset classes, with 58 per cent of respondents saying they plan to increase their allocations in the next year.
On average, debt-based investments make up for 32 per cent of a private market portfolio, according to Aviva Investors’ research of 500 institutional investors.
Yet as the asset class has been expanding, it has led some to question whether a bubble is forming.
Cecile Retaureau, head of private markets at Phoenix Group, told AOX the definition of private credit varies from infrastructure to corporate lending, depending on the book it is servicing.
In the last two years, Phoenix has doubled its private lending to corporates from £1.4bn to £3.2bn. And last year it formed a joint venture with Schroders called Future Growth Capital, which involves committing £2.5bn over three years to strategies that incorporate private debt.
“Most of the market is assuming private credit is corporate and financial loans, so mainly direct lending,” she said, adding that a further misconception is that players are in the sub-investment grade universe, where a sponsor or alternative manager is lending to midmarket companies.
She highlights that “very small Ebitda companies” would feel the pressure if financial woes hit the market.
What is more, in private credit there has been a growing trend towards payment-in-kind.
PIK allows borrowers to defer interest payments by adding them to the loan principal. This allows for greater flexibility but adds risks to the health of the company.
Retaureau says that from a lender’s perspective, PIK-type loan structures place all the risk at the end of the loan term: “are you not creating a J-curve when you don't get paid up until the end?”
“We don't want to add a lot of PIK and if you're looking at direct lenders or private credit managers, the well-behaved or conservative underwriting strategies tend to not have a lot of those PIK-type features,” she says.
Nonetheless last year the Bank of England’s director of financial stability Lee Foulger warned that while PIK deals might be “individually rational” they could collectively increase the risks of default.
He says: “As interest rates have risen, so has the riskiness of borrowers, which all else equal should impact valuations.
“Lagged or opaque valuations could increase the chance of an abrupt re-assessment of risks or [the chance of] sharp and correlated falls in value, particularly if further shocks materialise.”
Phoenix is also cautious in the rise of private credit managers joining the market.
Retaureau says she is “not scared of a bubble yet” as “the leverage is still well-behaved, and we still see a good correlation between bank retrenchment and rise of private credit”.
According to PitchBook, the leverage for European private equity-backed transactions in the direct lending market has slightly increased by some measures.
JPMorgan says fears about the rise of private credit leading to a systemic crisis are “overstated”, highlighting that the sector’s AUM is 9 per cent of all corporate borrowing.
The BoE has pointed out the risk of market concentration.
Foulger says: “High market concentration can amplify price moves and increase the risk of disruption, especially where firms’ liquidity demands are large compared to the system’s ability to supply.
“For example, liability-driven investment funds are significant holders of long-dated and index-linked gilts.
“In September 2022, when these funds faced a correlated stress, there were few buyers of the gilts they needed to sell, which created the potential for ‘doom loop’ dynamics.”
Phoenix’s head of private markets says if we were to see defaults in the broadly syndicated loan market and the “robust” collateralised loan obligation market, “we should expect a series of defaults in the mid market as well”. Alternatively there could be an increase in arrears or restructurings.
The BoE warns that ‘amend and extend’ practices, when a lender restructures or pushes back a loan’s maturity in return for a higher yield, have become “increasingly common” and may “mask” the financial vulnerability of the underlying companies.
So while we may not see a catastrophic bubble burst, the possibility of a slow death for the private credit market remains very much on the table.