Private credit has become a market estimated between $1.5 trillion and $2 trillion that serves larger companies and retail investors. The FSB points out that because this market has not faced a major economic downturn, underlying issues related to leverage and creditworthiness could emerge.
Private credit involves non-bank lenders, with asset managers typically serving as the general partners in these investment vehicles. Institutional investors such as insurers, pension funds, and banks are providing funds. Private equity firms are also increasing their ties to private credit.
The FSB report highlights that private credit funds, traditional banks, insurance companies, and private equity firms are forming tighter links. A problem in one area could spread.
Historically, private credit was primarily directed at medium-sized enterprises and accessible solely to institutional investors. Today, it is more commonly employed by larger corporations and is opening up to retail investors as well.
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The FSB report points out two main worries: leverage and borrower quality.
The expansion of private credit into retail investor territory poses new challenges. Unlike institutional investors, retail participants may lack the expertise to evaluate the opaque and illiquid nature of these assets. Meanwhile, banks and insurers with exposure to private credit funds could face cascading losses if a downturn triggers defaults.
The FSB's report underscores that the market's rapid growth has outpaced regulators' ability to monitor it, and the absence of a prior severe test means that the true risk profile remains unknown. Additionally, the interconnectedness among private credit funds, private equity firms, and traditional financial institutions creates potential contagion channels. For instance, a private equity-backed company defaulting on a private credit loan could affect not only the fund but also the banks that provided leverage to that fund.
The FSB has highlighted that these linkages are still not fully understood due to data gaps.
The report also looks at other risks, such as links to insurers and private equity, cross-border exposures, leverage, liquidity mismatches, and concentration risks.
The FSB will continue to examine the sector given the challenges in collecting and analyzing data. The real test will come when the next downturn hits.
The inclusion of retail investors in private credit is particularly concerning because these individuals often lack the ability to conduct thorough due diligence on complex, illiquid investments. Regulators worry that losses in this sector could erode public confidence in financial markets, especially given the lack of transparency and historical data. This dynamic adds another layer of fragility to an already opaque system.
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