Private Credit under scrutiny. But the proof is in the backing.

At a Glance:

• The private credit market is growing fast but faces regulatory scrutiny due to high leverage and reliance on cash guarantees
• Asset-Backed Lending offers a more structured and predictable risk profile making it an attractive option for institutional investors, especially during market downturns
• Collateral is king, but due diligence is queen. Thorough due diligence ensures loans are structured to withstand market volatility and borrower defaults, reducing risk for investors.

Are we witnessing a non-stop race to the top for the private credit industry? According to Morgan Stanley, at the beginning of 2024, the market reached $1.5 trillion — a substantial leap from approximately $1 trillion in 2020 — and is projected to grow to $2.8 trillion by 2028.

But not so fast. With higher levels of funding come increased scrutiny. Moody’s recently issued a warning of ‘systemic risk’ in the leveraged lending market, while the Australian Securities and Investments Commission (ASIC) has initiated a taskforce to explore the need for regulatory measures within the sector. ASIC Chairman Joe Longo expressed concern that investors in private credit funds may not be adequately protected.

A recent global survey from Moody’s shows that between 2021 and 2023, bank lending to private credit funds grew by 18% year-on-year. The trend was more pronounced in North America (23%) than Asia-Pacific (17%) or Europe (12%).

In 2023, loans linked to private credit accounted for only a small fraction of banks' total lending, approximately $525 billion or less than 4% of overall commitments. Despite this relatively modest share, regulators like the European Central Bank have expressed growing concern about the potential risks associated with this exposure.

Where the real risks lie

Credit rating agencies and regulators are raising their eyebrows due to the limited regulatory oversight and reporting standards of the industry. Private credit deals often have fewer disclosure requirements compared to traditional public markets. This can make it difficult to assess risk profiles and gain insight into borrowers' financial health and loan terms, leaving lenders potentially exposed to unforeseen risks.

Many private credit funds operate with significant leverage, yet the current reporting standards do not always provide detailed disclosures regarding this risk. In times of economic stress, leverage can magnify losses, but without clear reporting, stakeholders may not become aware of these risks until it's too late. Limited oversight increases the risk that deteriorating borrower creditworthiness or weakening cash flows may not be identified early enough.

This leads to what is possibly the most significant risk: the heavy reliance on cash guarantees. This is a common feature in many US private credit deals, especially in the direct lending segment. This form of lending typically appeals to private, non-investment-grade companies because of its flexibility and the speed at which deals can be executed.

While cash guarantees provide short-term liquidity assurance, they are inherently more volatile than physical assets, especially during liquidity crunches or volatile market conditions.

Cash guarantees are prevalent in deals where borrowers are looking for junior capital solutions, such as mezzanine or second-lien debt, which do not involve direct claims on physical assets. This structure gives borrowers flexibility but exposes lenders to greater risk if cash flow weakens due to market downturns​.

The US Federal Reserve reports that over two-thirds of private credit consists of term loans, while around 15% are hybrid pari passu loans, which sit lower in the capital structure and carry higher risk due to their junior status in default scenarios.