Banks are joining private equity funds to extend private credit to corporate borrowers, despite regulators’ concerns about invisible risks.
As private equity becomes an increasingly dominant force in supporting corporate deals, banks are taking an “if you can’t beat ’em, join ’em” approach to debt financing.
Business borrowers who would otherwise be unable to obtain traditional bank financing will benefit. But the intertwining of largely unregulated private credit and regulated bank lending – with the associated risk of state bailouts of providers of both if their loans go bad – raises questions about the threats to the financial system.
What would once have been considered an unlikely partnership is nevertheless likely to deepen, as the forces behind it have been building for some time.
The global private credit industry, fueled primarily by closed-end credit funds sponsored by the same private equity firms that back private equity vehicles, has grown dramatically since the 2008 financial crisis. At last count, its assets under management (AUM) stand at $2.8 trillion, up from $200 billion in the early 2000s, according to the Bank for International Settlements. (BIS). As a result, bank lending fell from 44% of all U.S. corporate borrowing in 2020 to 35% in 2023, according to an analysis by global consulting firm Deloitte using Federal Reserve data.
“Some private credit funds may have some degree of liquidity mismatch between their investments and the redemption terms of their investors.”
Lee FougeBank of England
The use of private credit is also experiencing spectacular expansion elsewhere. The BIS estimates that total outstanding private loans have increased globally from around $100 billion in 2010 to more than $1.2 trillion today, with more than 87% originating in the United States. Europe, excluding the UK, has accounted for around 6% of the total in recent years, and the UK around 3-4%, with Canada accounting for most of the remainder. Credit fund assets under management in the Asia-Pacific region total 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 mid-sized companies, often backed by private equity sponsors, prefer private credit for its speed, flexibility, confidentiality and reduced disclosure requirements compared to the public bond markets available through broadly syndicated loans (BSL). These benefits are also starting to attract larger, more creditworthy companies.
At the same time, banks are increasingly lending to private credit funds to finance corporate borrowers, often those that are part of sponsors’ equity portfolios. These loans often take the form of so-called direct loans: commercial loans used by companies to finance working capital or growth, which the industry claims traditional banks would not underwrite.
Bank lending to the private credit sector was estimated by the Federal Reserve in May 2023 at $200 billion, and the Fed acknowledged that its estimate may have underestimated the actual amount. Fitch Ratings found that nine of the ten banks with the largest loan balances to nonbank financial intermediaries of all kinds had $158 billion in loans to private credit funds or related vehicles at the end of last year. And outstanding loans from banks to private credit funds increased 23% in the quarter ended June 30 from the previous quarter, compared with just 1.4% for all bank loans, Fitch reports.
The growing importance of bank lending in private credit is well illustrated by the Blackstone Private Credit Fund, one of the largest private credit funds in the world, with more than $50 billion in assets. In total, 98% of the $23.5 billion in secured credit commitment facilities put in place by its subsidiaries as of December 2022 came from 13 banks, with the remaining amount coming from an insurance company. The outstanding amount drawn from these facilities was approximately $14 billion, representing approximately 50% of the fund’s total debts.
A deepening collaboration
Of course, banks have long been involved in financing private equity buyouts, such as Sycamore Partners’ takeover of Walgreens Boots Alliance. Two other private equity firms, HPS Investment Partners and Ares Management, together provided $4.5 billion in direct loans for the deal while banks including Citigroup, Goldman Sachs and JPMorgan Chase developed financing proposals to work in conjunction with private credit, providing some access to the BSL market. In total, the deal Sycamore closed in August is valued at $23.7 billion, including more than $10 billion in committed financing from private credit funds and banks.
Increasingly, cooperation between banks and private equity firms takes the form of direct lending to borrowers. PNC Financial and TCW Group, for example, have partnered to create a lending platform for middle-market businesses. And Citizens Financial Group created a unit focused on lending to private equity funds.
Competition from banks is also increasing. Standard Chartered and Goldman are preparing their own units dedicated to private credit provision while Morgan Stanley is launching funds to exploit private credit opportunities. The loans may not stay on banks’ balance sheets for long, as risk is transferred once investors’ capital is deployed. But just as the securitization market froze in the post-Covid inflationary environment, risk transfer can also occur in the event of a sudden disappearance of liquidity.
Indeed, regulators fear that the involvement of banks in private credit, whether through cooperation or competition with PEs, presents hidden risks for the financial system. Researchers from the Bank of England (BoE), BIS, European Central Bank (ECB) and Federal Reserve, among others, have recently published reports warning of the systemic financial risk these relationships could pose. Without more visibility, the BoE, for example, asked banks to strengthen their risk management in this area.
“Some private credit funds may have a degree of liquidity mismatch between their investments and their investors’ redemption terms,” warned Lee Foulger, director of financial stability, strategy and risk at the BoE, in a January 2024 speech at a conference on middle market finance sponsored by Deal Catalyst and the Association of Financial Markets in Europe.
Who is the most creditworthy?
The industry responds to these concerns by pointing out that credit funds are less likely to default than in the BSL market because sponsors generally monitor borrower performance more closely, use less leverage, adopt more conservative loan-to-value structures, and offer more flexible terms than banks, while locking out investors for extended periods of time. In a recent report, “Understanding Private Credit,” Ares Management says its borrowers are more creditworthy than those in the public markets and are backed by more equity and that while the private credit market is still small in comparison, it is on track to become even less leveraged and any funding asymmetry will diminish as it grows.
Yet concerns remain, especially given the prospect of a difficult economic environment ahead.
Fitch, for example, notes that the sector has yet to withstand higher interest rates. As the ratings company noted in a June report, “sponsors and lenders had largely assumed a low base rate environment, as reported by the Fed amid transitory inflation expectations, when determining the optimal size of capital structures relative to revenue, EBITDA and free cash flow projections.” »
As for liquidity risk, Julie Solar, an analyst at Fitch, notes that a growing number of credit funds are open-ended and subject to mass withdrawals in difficult circumstances. Although she admits that the number of such funds is still small, at least in the United States, and that many of them have limits on redemptions, she adds that the issue bears monitoring. If more open-end funds are created and rates rise significantly, she warns, “that’s when you can start to have liquidity problems.”
In the eurozone, 42% of funds are open-ended, according to the ECB, although most of their investors are institutional and tend to have longer time horizons than retail investors.
Solar also worries about what she calls “leverage on leverage,” pointing out that business development companies — publicly traded vehicles that account for about half of private credit — as well as private equity firms themselves are often highly indebted to banks. Indeed, bank loans for company buyouts can present an even greater risk, simply because they are much larger than direct loans.
The involvement of banks in credit funds constitutes an additional concern for regulators. An ECB financial stability report from May 2024 highlighted: “Private markets have yet to prove their resilience in a higher interest rate environment, as they have only reached significant size in the last decade. »
The industry counters that interest rates on many, if not most, of its loans float, eliminating the need for refinancing in a rising rate environment. But it probably won’t do anything for the borrowers themselves.
“The floating rate debt structure of private credit arrangements makes them vulnerable to debt servicing and refinancing challenges in a higher rate environment,” noted BoE’s Foulger at the January 2024 conference.
A report released in May by the Federal Reserve Bank of Boston acknowledged that banks’ losses could be mitigated in response to adverse conditions, as most private credit debt is collateralized and among the funds’ highest priority commitments. Yet the authors warn that “substantial losses could also arise in a less adverse scenario if defaults among outstanding loans correlate.” [private credit] portfolios turned out to be higher than expected, that is, if a larger than expected number of [private credit] borrowers defaulted at the same time. Such extreme risk could be underestimated.