Private credit has swiftly emerged as one of the hottest corners of global finance, and its rapid rise is prompting alarm bells. Once a niche player catering to middle-market borrowersย โ or companies that fall between small businesses and large corporations, which are typicallyย underserved by traditional banks โย private creditย has grown into a $1.7 trillion industry . It is now a key financing engine behind private equity deals, asset-based finance, and even retail investor portfolios. Some caution that the boom, if left unchecked, could morph into the next source of systemic risk. Managers may find themselves lowering lending standards in a bid to lend more money, which leads to a higher default risk. Morningstar Shihan Abeyguna “The growing interconnectedness between private credit funds and other financial institutions can amplify financial instability, as evidenced by higher correlation and network connectivity during stress,” Moody’s Analytics said in a recent report. While a more interconnected network of financial institutions may enhance efficiency and capital allocation, the increased number of connections is also a “shock amplifier” during periods of market stress, Moody’s analysts noted. This opacity means stress can build unnoticed โ and if investors suddenly demand redemptions, fire sales of illiquid loans can exacerbate market dislocations. “The same linkages that facilitate risk-sharing in calm conditions can become conduits for contagion under strain.” Lower underwriting standards It comes as no surprise that industry observers are saying private credit could become a locus of contagion in the next financial crisis, said Shihan Abeyguna, Morningstar’s Southeast Asia managing director. According to PitchBook data, the private debt industry is sitting on $566.8 billion worth of funds ready for deploymentโ a historic level of dry powder. Fund managers are incentivized to lend quickly and put them to work, as one cannot collect fees on cash that is lying around, added Abeyguna. “If this becomes reality, then managers may find themselves lowering lending standards in a bid to lend more money, which leads to a higher default risk,” he told CNBC. “So yes, there is the possibility that it could lead to a financial crisis,” said the Morningstar director. The sentiment is shared by JPMorgan. As more capital flows into private credit, including that from traditional banks, a potential concern could be more relaxed underwriting standards and less stringent covenants, echoed Serene Chen, the bank’s APAC head of credit, currency and emerging markets sales. “I think that happens with any asset, if there’s too much money chasing it,” she said. However, Chen noted that this is not happening yet. House of cards? Additionally, the rising use of paid-in-kind (PIK) loans in the sector, in which borrowers defer cash interest payments, also bears watching, said industry experts. “What’s taking shape is there’s a lot of PIK loans that go into private direct lending,” said PIMCO’s managing director and portfolio manager, David Forgash. How PIKs work is that instead of paying cash interest on these loans, the borrower adds more debt, essentially “paying” by promising even more IOUs. So lenders aren’t getting any real cash payments, just more paper promises. By skipping cash payments and piling on more debt, companies that borrow on PIK loans end up owing a lot more in the future . The risk is that all this unpaid interest quietly adds up, creating a mountain of hidden debt. In the event of a recession, private credit will be “one of the shoes to drop,” Forgash noted, given how recessions are bad news for any companies that rely on borrowed money, especially those with a lot of debt. But not everyone agrees that private credit is the next subprime crisis. Despite some warning bells, many investors and analysts remain confident in the sector’s long-term resilience. The direct exposure of banks to private credit is relatively limited through their loans to Business Development Companies (BDC), said Michael Ostro, Union Bancaire Privee’s head of private markets in Asia, who explained that most of the lending sits atop solid capital structures, often with 50โ60% equity cushions. This means that even if something goes awry with the businesses that BDCs lend to, the businesses will have to lose over 50 to 60% of their value before BDCs start taking losses. Suvir Varma, advisory partner at Bain & Company, also believes fears of a contagion are overblown. “Given the lessons learned from the GFC, underwriting is now far more disciplined. Private credit managers typically hold the risk themselves rather than slicing and distributing it across the market like CLOs used to do.” “This implies that losses to the bank loans would require seismic losses at the underlying portfolio levels [to really hit them]” said Ostro. In the lead up to the 2008 global financial crisis, leaders were issuing risky loans, usually bundled with complex financial products like collateralized loan obligations or mortgage-backed securities. These products were then sold to investors, which led to the risk being “distributed” and reckless borrowing from poor underwriting standards. Historically, systems with many interlinked relationships have proven vulnerable in crises. However, while there’s potential for fragility, the current financial ecosystem is not comparatively more fragile than before 2008, said Ludovic Phalippou, professor of Financial Economics at Saรฏd Business School, University of Oxford. That said, he cautioned that the view that private credit is safe because it’s not subject to classic bank runs is “a bit naรฏve.” “The pressure points are different: investor defaults, margin calls, asset revaluations could create a new type of issues,” he said. “This isn’t a house of cards, but it smells like one, and definitely a house with a lot of mezzanine floors and a very expensive elevator.”
