SEC - The United States Securities and Exchange Commission
10/15/2024 | Press release | Distributed by Public on 10/15/2024 14:52
Temporarily Terrified by Thomas: Remarks on Private Credit before the SIFMA/Mayer Brown Private Credit Forum
Thank you, Joe [Seidel] for that introduction, and thanks to Mayer Brown and SIFMA for hosting today's event. It is a timely event, and I look forward to the discussion. Before I begin, I must remind you that my views are my own as a Commissioner and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.
Recently, a friend and I went for an evening walk in the neighborhood. When we turned around to head back, the path was deserted and dark. Ahead of us we saw the outline of a large animal. It sat motionless in the middle of the path and watched us approach. My friend and I debated what it might be. It must be something dangerous-a gigantic, rabid raccoon, a hungry coyote, a small bear? Why else was it just sitting there, waiting for us without any sign of fear? We discussed what to do. Though the walk had already lasted longer than I wanted, and turning away from the creature in our path would require a lengthy detour, fear of the beast ahead prevailed. We began to retrace our steps so that we could take an alternate route. Then a couple appeared with a dog in tow. They were heading down the path toward us and toward that terrifying creature, to which our backs were now turned. "May we walk with you?" we asked with quivering voices, "Because, you see, there is a dangerous animal on the path, and maybe your dog will scare him off." They acquiesced, but also informed us that the source of our terror was Thomas, their pet cat.
Apparently, Thomas was waiting for his family to return from their walk, not waiting to attack my friend and me. As we approached, Thomas the tame cat turned from us without giving us a second glance and happily followed his owners home. Our imaginations had transformed a harmless cat into a dangerous animal. Had we shone our phones' flashlights on the object of our fear, we would have discovered Thomas's true nature without terrifying ourselves unnecessarily.
Private credit is a bit like Thomas. When we look at it from a distance, it seems scary, unfamiliar, and large. Surely, it will do us harm. Shouldn't we turn back and seek a different path? In reality, Thomas was a mere housecat. Upon closer inspection, private credit is familiar too, as are the associated risks. Private credit has grown rapidly in recent years and still is growing,[1] but it is not a new phenomenon. Private credit is just bilateral lending to corporate borrowers, which has been around for ages-longer than public credit markets.[2] The current form of private credit has existed for three decades or more.[3] We know how private lending works and the risks associated with it. We should seek to understand today's private credit, the new forms it is taking, and the attendant risks. But we should not build it up into a monster of our own imagination. Doing so may cause us to run away from an efficient, effective, and economically useful form of finance. I hope today's discussion will serve, as a flashlight would have on that night's walk, to put private credit in a more realistic, and less terrifying light.
Private credit generally refers to private companies borrowing money other than from banks or bank-led syndicates, or through the public markets, for example, from institutional investors through funds.[4] The private credit market is estimated to be $1.7 to $2 trillion worldwide.[5] Given the ever-expanding iterations of private credit, those numbers are imprecise and growing. Most borrowers are smaller - and mid-sized companies, but large companies also are joining the ranks of borrowers.[6] Lenders are often private closed-end funds[7] whose investors include pension funds, sovereign wealth funds, insurance companies, family offices, and wealthy individual investors.[8] The average loan is less than $100 million.[9] Private credit is a form of relationship lending: investors and borrowers typically negotiate bilaterally, which allows for bespoke credit arrangements and other tools to meet borrowers' and creditors' distinctive needs.
Private credit has several beneficial features. It provides corporations a financing alternative to equity financing, bank financing, broadly syndicated loans, and the public bond markets.[10] It diversifies investors' portfolios, while offering them stable, attractive returns. Because private credit is not standardized, it affords flexibility to accommodate innovative arrangements, loan sizes, and terms that meet a borrower's particular needs. Creditors can negotiate for their desired level of disclosure and credit protection. Borrowers benefit from a shorter underwriting timeline and streamlined due diligence, as compared with bank loans.[11] They also enjoy more privacy and greater certainty of execution than they would have in the public markets. Due to the limited secondary market liquidity, lenders generally retain their loans until they either mature or are refinanced.[12] Private credit can foster a better partnership between businesses and creditors than other forms of financing.[13] Loan contracts can include protections for creditors, including a "structured equity component, high prepayment penalties, or a role for the lender in the oversight or management of the business."[14] Because of the direct relationship with the borrower (and perhaps also with the associated private equity firm), if the borrower runs into trouble, working out a deal with the lender may be easier than it is in other types of financing arrangements.[15]
Private credit's rapid growth is partly due to the imposition of stricter capital and lending standards on traditional banks in the wake of the financial crisis of 2007 to 2009. As banks reduced lending to smaller- and medium-sized companies, private credit stepped in to help fill the gap.[16] The regional bank failures of spring 2023 and the supervisory and regulatory response to those failures may have opened a new lending gap for private credit to fill.[17] Other factors, such as increased private equity activity in the middle market and success of private credit funds in raising capital, also are important in the growth of private credit.[18]
The growth in private credit understandably has drawn policymakers' attention. While financial regulators have not concluded that private credit is an immediate financial risk,[19] many nevertheless have expressed concern about longer-term risks arising from the growth in private credit. Common regulatory concerns stem from, among other things, the absence of prudential regulation for private credit funds;[20] questions about the reliability of private credit valuations given the lack of a secondary market;[21] the relative riskiness of private credit borrowers;[22] deteriorating credit quality and weaker creditor protections due to a surplus of investable capital;[23] rising defaults in floating rate debt due to rising interest rates or an economic downturn;[24] potential transmission of private credit losses to private fund counterparties, the financial system, and the broader economy;[25] procyclical liquidity demands made by private credit funds to their investors;[26] the increasing involvement of retail investors;[27] hidden leverage;[28] and interconnections with banks.[29] Exacerbating these concerns is a perceived lack of regulatory transparency into the private credit markets.[30]
Just as my shadowy cat turned out to be something familiar, closer scrutiny puts these concerns about private credit into proper perspective. A careful look suggests that we do not need a new regulatory solution to address concerns related to private credit. Existing regulatory tools, paired with unflinching market discipline, suffice to deal with the risks associated with private credit.
The way private credit markets are regulated is a strength. Prudentially regulated entities, such as banks[31] and insurance companies, participate in the private credit markets, but private credit funds and advisers to those funds are regulated by the SEC under a mostly non-prudential framework.[32] In being driven by non-banks, private credit is not an outlier. Much of America's capital formation occurs outside of the prudentially regulated banking system,[33] and that is a good thing. Non-banks are more dynamic, more flexible, more nimble, and more responsive than banks to the needs of providers and takers of capital. They are correspondingly less responsive than prudentially regulated banks to the desires of regulators. An orientation to the needs of other market participants, rather than to the one-size-fits-all mandates of prudential regulators, enables non-bank private credit lenders to offer tailored lending solutions to borrowers, some of which are risky. The absence of prudential regulation also fosters a healthy heterogeneity in market practices and market participants' behavior, which supports systemic resilience. Fundamentally, moving the risks associated with credit off bank balance sheets with their government backstop and into the capital markets, where fund investors' equity is the backstop, enhances systemic resilience.[34]
Lock-ups and other restrictions on private investor redemptions mitigate run risk. Private credit funds typically match the duration of their assets and liabilities by drawing capital from long-term investors.[35] Most private credit funds are closed-end funds with terms of approximately five years.[36] Investors face withdrawal restrictions, which create a stable capital base.
Although private credit has performed well, even during times of stress, defaultrisk in private credit is real.[37] The borrowers are often small- to medium-sized companies that are risky, and changes in economic conditions or interest rates can amplify the risk. Private credit has solutions here too. Because private credit lenders typically hold loans until maturity, rather than originate loans to distribute them as banks often do,[38] they have an incentive to conduct thorough due diligence, negotiate strong covenants,[39] and devise workable solutions if borrowers cannot pay.[40] Investors who add private credit because of its high returns can expect to absorb some losses,[41] but their losses are not a concern to the broader economy, and private credit is typically only a small piece of a diversified portfolio. Private credit fund advisers know how to-and have the incentive and ability-to mitigate default risk ex ante through diversification, disclosure requirements, and other creditor protections and to restructure loans that have gone bad.[42] While the popularity of the asset class has pulled in a lot of capital, which could lead to lower credit quality loans and weaker creditor protections, professional managers have fiduciary duties to the private credit funds they manage. Loan covenants do not appear to be deteriorating meaningfully, though that is something for investors to keep an eye on, and private credit increasingly serves larger and investment-grade borrowers.
Inaccurate valuations are also a real concern, but likewise not a cause for excessive worry. The lack of a secondary market and the bespoke nature of private credit make valuing outstanding loans difficult.[43] Risks associated with valuation are mitigated, however, by the long-term nature of private credit investing; private credit funds generally hold loans until they are paid off or refinanced. Moreover, as private credit finds its way into publicly traded vehicles, such as BDCs or private credit exchange-traded funds, public markets will be able to test valuations.[44]
Concerns that problems in the private credit markets will spill into the financial system and broader economy are the latest iteration of the incessant systemic risk critiques of asset managers, hedge funds, and registered investment companies. Prudential regulators almost reflexively look askance at the non-bank sector because it intentionally elevates private decision-making over regulatory decision-making. Asset managers, funds, and investors are a wonderful cacophony of market participants, each marching to its own drummer. While the idiosyncratic nature of the private credit markets makes it hard to neatly categorize and study, it also is a crucial aspect of the sector's strength.
Market participants have ways to protect themselves that also protect the broader financial system. Private fund counterparties, including banks with the oversight of their regulators, can implement risk mitigants to prevent the transmission of private credit losses. Lock-up periods and other limitations on withdrawals avert runs on private credit funds. Investors in private credit funds may face procyclical capital calls during times of stress, but investors know their exposure ahead of time and so can plan for it. Retail investor access to this asset class may occur through publicly traded funds.
Banks not only compete with, but support and benefit from the private credit market. Banks lend money to private credit funds, transfer risk from their balance sheets to private credit funds, and set up joint private credit ventures.[45] Private credit funds generally operate with less leverage than banks, which protects them and the broader financial system.[46] As the relationships between private credit funds and banks evolve, we should watch for hidden leverage, regulatory arbitrage, and hidden interconnections with banks, but the heterogeneity of those arrangements protects against a system-wide problem. In general, we should welcome the movement of risk from bank balance sheets to private credit funds.[47] To keep things in perspective, despite the growth in recent years, private credit is considerably smaller than the banking sector.[48]
Although private credit seems to show more promise than peril, as a growing sector of the market, it deserves scrutiny from market participants, academics, and regulators. Using the tools we already have, we can monitor the private credit space as it expands and evolves. The public, creditors, and regulators already have information about the private credit markets. As the sector grows, public analyses of the market have proliferated. Creditors can negotiate substantial access to information.[49] Bank regulators and supervisors can look at banks' relationships with private credit funds. Form PF, which the SEC recently expanded twice over my objection,[50] provides detailed information to FSOC, the SEC, and the CFTC about certain private funds, including information relevant to private credit, investment losses, and fund outflows. But some regulators want more.[51] To stretch my walk analogy past its breaking point, they want to turn on the flood lights to illuminate the entire neighborhood instead of pulling out the phone lights we already have to look at particular items of interest. Why should regulators have more detailed information about bilateral relationships between lenders and their borrowers? The creditors in these transactions can negotiate for the transparency they need to assess their risk and deal with problems as they arise. What precisely would the government do with such information, if it had it? Design a bailout for private credit funds during a wave of defaults? I hope not. After all, one of the strengths of the non-bank financial system is its absence of a federal safety net, which has a way of focusing minds on risk management.
Invoking systemic risk to regulate private credit in the same way we regulate bank lending would engender risks of its own. Doing so would squelch the dynamism that enables the non-bank sector to serve companies and investors so well. It would homogenize the market, which could make future financial contagion more, not less, likely. It would construct yet another obstacle to small business access to capital.[52] If anything, the growing private credit sector may highlight the need for streamlining our public market regulation. I have expressed concerns about the costs of accessing our public equity markets.[53] We should ask similar questions about our public debt markets. Publicly traded bonds are not right for every company at every stage of its life, and private credit is sometimes the right solution when bonds are not. But can we do anything to improve the way the bond markets work so that they serve more companies than they do now?
When I think back to that evening stroll marred by my fear of Thomas, I am a bit embarrassed at my there-is-a-monster-under-the-bed approach to the situation. A calmer method to discerning what I was seeing would have served me better. We ought never to be ashamed about keeping our eyes out for unusual features looming in the financial landscape or about asking whether those features carry risks that are not being taken into account by market participants. But in doing so we must assess problems and design solutions rationally rather than cowering in fear at a what turns out to be a domesticated cat's silhouette. I look forward to further discussion of these issues on the panels ahead.
[1] From 2009 through the end of 2023, private credit increased by an estimated ten-fold, which compared to 45% inflation during that period. See Faud Faridi et al., The Next Era of Private Credit, McKinsey & Company (Sept. 24, 2024), https://www.mckinsey.com/industries/private-capital/our-insights/the-next-era-of-private-credit (citing Aug. 2024 Prequin data); CPI Inflation Calculator, U.S. Bureau of Labor Statistics, https://data.bls.gov/cgi-bin/cpicalc.pl?cost1=1.00&year1=200901&year2=202312. According to one estimate, private credit will reach $2.8 trillion by 2028. Understanding Private Credit, Morgan Stanley (Jun. 20, 2024), https://www.morganstanley.com/ideas/private-credit-outlook-considerations.
[2]See, e.g., What's Next for Private Credit, Making Sense Market Matters, J.P. Morgan (at minute 4:15) (Sept. 10, 2024), https://www.jpmorgan.com/insights/podcast-hub/market-matters/whats-next-for-private-credit (comments of Jake Pollack) ("Private credit came first. Public markets developed after.").
[3]See International Monetary Fund, Global Financial Stability Report: The Last Mile - Financial Vulnerabilities and Risks at 54 (Apr. 2024), https://www.imf.org/-/media/Files/Publications/GFSR/2024/April/English/ch2.ashx ("IMF Report") ("Private credit has provided significant economic benefits during its approximately 30-year existence"); Jennifer Johnson and Michele Wong, Private Credit Primer, National Association of Insurance Commissioners Jun. 2024), (https://content.naic.org/sites/default/files/capital-markets-primer-private-credit.pdf ("Although the inception of private credit dates back to the 1980s, when insurance companies served as direct lenders to companies with strong historical borrowing standards, private credit gained broader popularity after the 2008 financial crisis.").
[4]See, e.g.,IMF Report at 54 ("Nonbank corporate credit provided through bilateral agreements or small 'club deals' outside the realm of public securities or commercial banks. This definition excludes bank loans, broadly syndicated loans, and funding provided through publicly traded assets such as corporate bonds."); Financial Stability Oversight Council, 2023 Annual Report at 34 (Dec. 2023), https://home.treasury.gov/system/files/261/FSOC2023AnnualReport.pdf ("FSOC Report") ("[D]irect lending by nonbank institutions to businesses."); Financial Stability Board, Enhancing the Resilience of Non-Bank Financial Intermediation: Progress Report at 19 (Jul. 24, 2024), https://www.fsb.org/uploads/P220724-2.pdf ("FSB Report") (Private credit is "generally understood as lending by nonbanks (typically funds) to small and mid-size unrated firms that may not be able to secure funding from banks or public markets."); Fang Cai and Sharjil Haque, Private Credit: Characteristics and Risks, FEDS Notes, Washington: Board of Governors of the Federal Reserve System, (Feb. 23, 2024), https://doi.org/10.17016/2380-7172.3462 ("Private credit or private debt investments are debt-like, non-publicly traded instruments provided by non-bank entities, such as private credit funds or business development companies (BDCs), to fund private businesses."). See alsoA Primer on Private Credit, Business Breakdowns Eps. 163-164, Colossus (May 15, 2024), https://joincolossus.com/series/business-breakdowns/page/3/#back_catalog (providing a helpful overview of private credit).
[5]See, e.g., Cai and Sharjil, Private Credit: Characteristics and Risks, FEDS Notes, (Feb. 23, 2024) (estimating $1.7 trillion in total private credit); IMF Report at 54 (estimating $2.1 trillion in total private credit and $1.7 in private credit funds). See also Wade O'Brien, Private Credit Markets Are Growing in Size and Opportunity, Cambridge Associates (Apr. 2024), https://www.cambridgeassociates.com/insight/private-credit-markets-are-growing-in-size-and-opportunity/ (placing the private credit market at $1.6 trillion, including $1.1 trillion in the US and $500 billion of dry powder, meaning committed investor capital that is not yet deployed).
[6]See, e.g., Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) ("Private credit is typically extended to middle-market firms with annual revenues between $10 million and $1 billion, but has grown rapidly in recent years to fund larger companies that were traditionally funded by leveraged loans."). Business services, manufacturing, and personal services were the top three sectors receiving support from private credit. Economic Contribution of Private Credit to the US Economy in 2022, EY, prepared for the American Investment Council at 5-6 (Oct. 2023), https://www.investmentcouncil.org/wp-content/uploads/2023/10/EY-AIC-Private-credit-attributed-employment-report-09-28-2023-2.pdf ("AIC Report"). Private credit serves companies with diverse financing needs, ranging from operational growth to complex financial restructuring. See, e.g., Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) (reporting the following uses for private credit: 47.2% general corporate purposes; 25.8% private equity buyouts and leveraged buyouts; 21.3% debt refinancing; 5.4% growth and expansion financing; and 0.3% mergers and acquisitions.).
[7]See IMF Report at 56.
[8]See, e.g., Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024). A smaller portion of private credit funds in the United States are Business Development Companies (BDCs), which are a type of closed-end investment fund that are regulated under the Investment Company Act of 1940. IMF Report at 56.
[9]See, e.g., Ahmet Degerli and Phillip Monin, Private Credit Growth and Monetary Policy Transmission, FEDS Notes (Aug. 2, 2024), https://doi.org/10.17016/2380-7172.3565 ("Private credit has traditionally served middle market companies, with a typical loan size of about $65 million."); Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) ("[T]he average size of loans has increased in recent years and exceeded $80 million since 2022, which is much larger than the standard loan size in bank-dependent borrowers observed in the Federal Reserve's Y-14Q H1 collection on commercial loans.").
[10]See, e.g., IMF Report at 58 ("[B]orrowers in the private credit market may be excluded from the syndicated loan market because of their size or their lack of high-quality collateral for bank lenders. Private credit can also offer benefits in flexibility, speed of execution, and confidentiality. Aspects of each transaction, such as the repayment schedule and collateral requirements, can be tailored to the parties involved."); AIC Report at p. 2 ("Approximately 70% of US private credit providers surveyed in 2021 reported that companies relied on private credit because they are 'too small for bank syndication.'"); Office of Financial Research, 2023 Annual Report to Congress, US Department of Treasury at 52 (Dec. 2023), https://www.financialresearch.gov/annual-reports/files/OFR-AR-2023_web.pdf ("Private debt serves an important role in allocating capital by originating loans to corporate borrowers, primarily middle-market companies, that are generally too small to access credit in traditional capital markets.").
[11] Narine Lalafaryan, Private Credit: A Renaissance in Corporate Finance, 24(1) Journal of Corporate Law Studies at 62 (Apr. 2024), https://www.tandfonline.com/doi/epdf/10.1080/14735970.2024.2351230 ("Compared to banks, private credit funds . . . offer (i) a faster way of obtaining finance due to the due diligence and underwriting process being shorter than the one conducted by banks . . . ."); IMF Report at 58 ("Compared with traditional bank loans and public debt offerings, private credit transactions are often executed more quickly . . . ."); Narine Lalafaryan, Private Credit: The Evolution of Corporate Finance and the Firm, Cambridge Faculty of Law, Paper No. 25/2023 at 56 https://www.ecgi.global/sites/default/files/Paper%3A%20The%20Evolution%20of%20Corporate%20Finance%20and%20the%20Firm.pdf (noting that for private credit direct lending, there is "[s]peedy underwriting [and] short due diligence.").
[12] Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024).
[13]See IMF Report at 54 ("Although usually more expensive than bank loans, private credit offers borrowers a value proposition through strong relationships and customized lending terms designed to provide flexibility in times of stress."); Private Credit: Investing in Main Street, American Investment Council at 11 (Mar. 2021), https://www.investmentcouncil.org/wp-content/uploads/2021/03/private-credit-investing-in-main-street.pdf ("[P]rivate credit managers invest significant time to better understand the underlying business they underwrite; with their own firms' capital and reputation at stake, they are strongly incentivized to monitor and work closely with borrowers to resolve problems."); Patrick Drury Byrne et al., Private Debt: A Lesser-Known Corner Of Finance Finds The Spotlight, S&P Global (Oct. 12, 2021), https://www.spglobal.com/en/research-insights/special-reports/private-debt ("Private debt remains very relationship-driven. With fewer lenders involved in a single transaction, borrowers tend to work more closely with their private debt lenders.").
[14] Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024).
[15]See, e.g., Jared A. Ellias and Elisabeth de Fontenay, The Credit Markets Go Dark, 134 Yale Law Journal ___ at 43 (Jul. 16, 2024), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4879742 ("[B]orrowers in the private credit markets can enter into relationship-specific transactions, arguably with greater comfort that the private credit asset manager will be willing and able to negotiate with the borrower in the event of financial trouble.") (citation omitted).
[16]The Credit Markets Go Dark at 28 ("In the aftermath [of the global financial crisis of 2008-2009], banks significantly retreated from originating corporate loans, particularly the riskiest ones. This was due, first, to regulation. Increased bank regulation in the aftermath of the global financial crisis chilled lending from regulated banks, providing non-regulated investment firms with the opportunity to fill gaps left by banks, especially for mid-market borrowers. While not solely attributable to regulatory changes, a key driver of growth in private credit has been an attempt by regulators to rein in the risks that commercial banks take on, including by requiring banks to hold additional capital against commercial loans.") (citations omitted).
[17] Christopher Alkan, The Rise of Private Credit, Accounting and Business Magazine (Dec. 2023), https://abmagazine.accaglobal.com/global/articles/2023/dec/business/the-rise-of-private-credit.html.
[18]See, e.g., What's Next for Private Credit (at minute 2:30) (comments of Jake Pollack) (discussing factors leading to growth in private credit, including the growth of private equity in the middle market, "which has effectively created the demand for debt capital").
[19]See, e.g., IMF Report at 56-57 ("At present, the financial stability risks posed by private credit appear contained."); The Federal Reserve, Financial Stability Report at 45 (May 2023), https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf ("While private credit funds have grown rapidly since the 2007-09 financial crisis and the assets they hold are mostly illiquid, the funds typically use little leverage, and investor redemption risks appear low.") (citations omitted); FSOC Report at 32 ("Despite its accelerating growth, private credit still represents a relatively small portion of the U.S. economy and also presents limited liquidity transformation risks.").
[20] IMF Report at 56 ("The migration of credit provision from regulated banks and relatively transparent public markets to more opaque private credit firms raises several potential vulnerabilities. Whereas bank loans are subject to strong prudential regulation and supervisory oversight, and bond markets and broadly syndicated loans to comprehensive disclosure requirements that foster market discipline and price discovery, private markets are comparatively lightly regulated and more opaque.").
[21]See IMF Report at 57 ("Uncertainty about valuations could lead to a loss of confidence in the asset class. The private credit sector has neither price discovery nor supervisory oversight to facilitate asset performance monitoring, and the opacity of borrowing firms makes prompt assessment of potential losses challenging for outsiders. . . ."); FSB Report at 19 ("The FSB is monitoring vulnerabilities in private credit [including] . . . opacity and the absence of observable market prices potentially leading to lagged and abrupt valuation adjustments. . . .").
[22] FSOC Report at 32 ("For example, private credit funds may lend to borrowers with risk profiles that differ from those to whom traditional corporate credit providers typically lend and, as a result, may have correspondingly different exposure to default risk.").
[23] Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024)("Dry powder has grown tremendously in private credit, particularly in direct lending. For example, relative to 2014, dry powder has nearly quadrupled. Since private credit managers have a mandate to deliver high returns to LPs within a fixed timeframe, fund managers might choose riskier deals, offer more covenant-lite loans, or more generally reduce underwriting standards as opportunities dry up when the economy slows down.").
[24] Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) ("[A]lmost all private credit loans are floating rate. . . . In the environment of inflation and rising interest rates, higher interest payments on floating-rate debt could stress borrowers' balance sheets, leading to a significant increase in defaults in an economic downturn); IMF Report at 57 ("Borrowers' vulnerabilities could generate large, unexpected losses in a downturn. Private credit is typically floating rate and caters to relatively small borrowers with high leverage. Such borrowers could face rising financing costs and perform poorly in a downturn, particularly in a stagflation scenario, which could generate a surge in defaults and a corresponding spike in financing costs.").
[25] IMF Report at 57 ("Multiple layers of leverage create interconnectedness concerns. Leverage deployed by private credit funds is typically limited, but the private credit value chain is a complex network that includes leveraged players ranging from borrowers to funds to end investors."); FSOC 2023 Report at 32 ("Similar to traditional corporate credit providers, an unexpected rate of default may have a cascading effect across broader financial markets, the impact of which may be more or less pronounced depending on the nexus private credit funds share with other market participants . . . .").
[26] Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) ("Given that fund managers have the contractual right to obtain committed capital at any point in time, investors such as insurance companies or pension funds run the risk of needing to honor capital calls when credit conditions worsen, even when their own liquidity conditions are under stress.").
[27] Charles Cohen et al., Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch, IMF Blog (Apr. 8, 2024), https://www.imf.org/en/Blogs/Articles/2024/04/08/fast-growing-USD2-trillion-private-credit-market-warrants-closer-watch ("Finally, though liquidity risks appear limited today, a growing retail presence may alter this assessment. Private credit funds use long-term capital lockups and impose constraints on investor redemptions to align the investment horizon with the underlying illiquid assets. But new funds targeted at individual investors may have higher redemption risks. Although these risks are mitigated by liquidity management tools (such as gates and fixed redemption periods), they have not been tested in a severe runoff scenario.").
[28] IMF Report at 63 ("Leverage deployed by private credit funds appears to be low compared with other lenders such as banks, but the presence of multiple layers of hidden leverage within the broader private credit system raises concerns.").
[29] Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) ("While bank lending to private credit funds appears moderate, there are growing interconnections between these two types of lenders."); IMF Blog (Apr. 8, 2024) ("While banks do not seem to have a material exposure to private credit in aggregate-the Federal Reserve has estimated that US private credit borrowing amounted to less than about $200 billion, less than 1 percent of US bank assets-some banks may have concentrated exposures to the sector.").
[30] FSOC Report at 32 ("Private credit is a relatively opaque segment of the broader financial market that warrants continued monitoring. . . . [T]he extent to which the private credit market poses financial stability risks remains uncertain."); IMF Report at 56 ("Severe data gaps prevent a comprehensive assessment of how private credit affects financial stability. The interconnections and potential contagion risks many large financial institutions face from exposures to the asset class are poorly understood and highly opaque.").
[31] Although private credit is non-bank financing, banks often work with non-bank lenders. See, e.g., David Hollerith, Wall Street Forms Super Teams to Fight for $1.7 Trillion Private Credit Market, yahoo!finance (Sept. 29, 2024), https://finance.yahoo.com/news/wall-street-forms-super-teams-to-fight-for-17-trillion-private-credit-market-140301078.html.
[32] The SEC regulates private credit fund advisers under the Investment Advisers Act, a regulatory framework rooted in fiduciary duty. Advisers to many private funds must confidentially report detailed information about the funds on Form PF, which the Commission recently expanded. They annually provide extensive information about their activities via their Form ADV submissions. The SEC also regulates business development companies, one type of credit fund, under the Investment Company Act. Sponsors have taken some of these private credit BDCs public. For more details about the regulation of private credit, see Private Credit: Investing in MainStreet, American Investment Council at 16-17 (Mar. 2021), https://www.investmentcouncil.org/wp-content/uploads/2021/03/private-credit-investing-in-main-street.pdf.
[33]See, e.g., Our Markets, SIFMA Capital Markets Fact Book 2024, Securities Industry and Financial Markets Association ("SIFMA") at 5 (July 2024), https://www.sifma.org/wp-content/uploads/2023/07/2024-SIFMA-Capital-Markets-Factbook.pdf ("In the U.S., capital markets fuel the economy, providing 74.1% of equity and debt financing for non-financial corporations. Debt capital markets are more dominant in the U.S. at 74.9% of total financing, whereas bank lending is more dominant in other regions, at 80.7% on average."); William C. Dudley and R. Glenn Hubbard, How Capital Markets Enhance Economic Performance and Facilitate Job Creation, Goldman Sachs Global Markets Institute White Paper (Nov. 2004), https://www0.gsb.columbia.edu/faculty/ghubbard/Articles%20for%20Web%20Site/How%20Capital%20Markets%20Enhance%20Economic%20Performance%20and%20Facilit.pdf (comparing the United States and United Kingdom, which have well-developed capital markets, with other countries that rely more heavily on bank financing). See alsoIMF Background Note on CMU for Eurogroup at 2, IMF (June 15, 2023), https://www.imf.org/-/media/Files/News/Speech/2023/imf-background-note-on-cmu-for-eurogroup.ashx ("Banks account for a much larger part of the financial system in Europe than in the US []. . . . European firms rely much less on market sources of financing, with less than 30 percent of their funding coming from tradable equity and debt, compared to nearly 70 percent for US firms []. And firms with fewer tangible assets to pledge as collateral are particularly constrained in a bank dominated system, which can impair their growth performance.").
[34]See, e.g., Emily Peck and Matt Phillips, Axios Markets (Aug. 14, 2023), https://www.axios.com/newsletters/axios-markets-cceef1c8-2cec-4ee0-9756-301f996e0073.html?chunk=3&utm_term=twsocialshare#story3 (According to Gary Creem, Proskauer Rose law partner and co-head of Proskauer's private credit practice, "The theory of the regulators back in 2008-09 has kind of played out. They wanted to remove risk from banks and put it with private credit managers. So the risk went where it should go."; Reassessing Systemic Risk in Nonbank Financial Institutions: A Critical Analysis of Recent NY Federal Reserve Studies from an Alternative Investment Perspective, Alternative Credit Council and Alternative Investment Management Association at 5 (Oct. 7, 2024), http://www.aima.org/asset/302795E5%2D0378%2D4E30%2DB6E9F54453D00EE3/ ("[T]his transformation from bank lending directly to the real economy to indirect lending via NBFIs results in safer and more diversified senior bank lending to NBFIs. Private credit provides safer financing to the real economy due to its more stable, less leveraged funding structure and liquidity risk management tools.").
[35]See, e.g.,Reassessing Systemic Risk in Nonbank Financial Institutions at 7, 11 ("Finally, and most importantly, the fire sale channel appears to be largely irrelevant for the private credit industry as loans originated by the private credit industry generally do not trade. These are bespoke, bilaterally originated instruments that are intended and are indeed held to maturity by private credit funds. . . . Private credit funds do not engage in significant maturity transformation, a key source of systemic risk in the banking sector. Instead, they often match the duration of their investments with their funding, reducing the risk of sudden liquidity crunches that could trigger a cascade of counterparty defaults.");Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) ("Given the absence of a liquid secondary market for many private credit instruments, lenders typically hold these loans until maturity or a refinancing event.")..
[36]See Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024).
[37] According to some estimates, private credit generally has performed well thus far. Private credit experienced a roughly 1.6% default rate compared to 3.3% for syndicated loans and 5% for high yield bonds. Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024). An important caveat is that private credit had a lower post default value of 33% compared to syndicated loans (52%) and high yield bonds (39%). Id. (explaining that "The key reason for the low recovery rate upon default is that more than half of all value-weighted private credit is provided to borrowers in sectors with relatively low collateralizable or tangible assets such as software, financial services or healthcare services . . . , and thus havelower recovery rate for every dollar of defaulted loans."). See also IMF Report at 60 ("[D]efault rates for private credit indices tend to be relatively high, but these include covenant defaults, which often lead to renegotiated terms rather than a true payment default."). Even during times of stress, private credit has performed well. See, e.g., Bill Sacher, Private Credit 2021 Outlook: A Steady Ship in Choppy Waters (Feb. 10, 2021), https://www.adamsstreetpartners.com/insights/private-credit-2021-outlook/ (one study found that, during the COVID-19 pandemic and lockdowns, for example, "[l]everaged loan default rates in the second and third quarters were as high as the levels seen during the Great Financial Crisis, and at the end of the fourth quarter, the leveraged loan default rate remained high at 4.22%. By contrast, the private credit default levels never rose above 2% throughout 2020."); Degerli and Monin, Private Credit Growth and Monetary Policy Transmission, FEDS Notes (Aug. 2, 2024) ("Overall, private credit growth is supported by both cyclical and structural factors . . . Private credit fund returns and capital raising remain relatively resilient during policy tightening cycles, and dry powder further insulates capital deployment from credit availability shocks.").
[38] Lalafaryan, Private Credit: The Evolution of Corporate Finance and the Firm at 15 ("[I]n a modern market (i.e., post-GFC) commercial banks have been mostly operating within the funding model of 'originate-to distribute' to the secondary liquid loan market. This model is also known in the finance community as the 'moving business.' By contrast, private credit funds have largely focused on the funding model of 'originate- to-suit-and-fit' the portfolio of the market that they operate in. This financing framework is also called the 'storage business.' The distinction between these two funding models can additionally be described as 'trading the risk' for commercial banks vs 'owning the risk' for private credit funds.").
[39]Credit Markets Go Dark at 49 ("Another advantage of private credit for debt investors is that, relative to public debt investments, private credit loan contracts appear more likely to contain covenants protecting investors from borrower opportunism and providing the investor with options if the borrower's business deteriorates.") (citation omitted); The Role of Private Credit in U.S. Capital Markets, Proskauer Rose LLP and Managed Funds Association at 2 (Apr. 2022), https://www.mfaalts.org/wp-content/uploads/2022/04/The-Role-of-Private-Credit-in-US-Capital-Markets.pdf ("Only 1% of all private credit loans in 2021 were without financial maintenance covenants, known as "cov-lite" loans. Rather, 99% of the loans have at least one financial maintenance covenant, typically a total leverage ratio covenant, and 21% have two or more, i.e., a total leverage ratio and fixed charge coverage ratio covenant.").
[40]The Role of Private Credit in U.S. Capital Markets at 9-10 (Private credit "lenders are motivated first and foremost to see the loan repaid, and not to trade the debt or own the company. As a result, parties are motivated to ensure the borrower business thrives. A workout of a troubled loan can take multiple paths. . . . Having all of these tools at their disposal affords private credit lenders the ability to avail themselves of the workout and restructuring toolbox to the fullest extent to maximize their recoveries at or near par.").
[41]See, e.g., Robin Wigglesworth, Is private credit a systemic risk?, Financial Times (Jan. 4, 2024), https://on.ft.com/3Y8KFjG ("But investors losing boatloads of money is not the same as a financial crisis. In fact, trillions of dollars can evaporate, prominent investment funds be forced to gate and major financial institutions can go belly-up without a wider conflagration, as long as policymakers douse the flames rather than fan them. Viz 2022-23. Not everything is a 'Lehman moment'.").
[42]See, e.g., Alfonso Ricciardelli and Philip Clements, An Introduction to Private Credit, CFA Research Institute Foundationat 26 (2024), https://rpc.cfainstitute.org/-/media/documents/article/rf-brief/introduction-to-alt-credit.pdf ("However, should a company breach one of its loan covenants or fail to meet an interest payment, the lender would be able to commence enforcement proceedings by calling a default under the loan documentation. In practice, the lender would be in a strong position to call the equity owners of a company into negotiations to provide further capital or undertake other actions with the goal of improving the creditworthiness of the company and bring it back to financial health."); Cai and Haque, Private Credit: Characteristics and Risks, FEDS Notes (Feb. 23, 2024) (noting "periodic monitoring of borrowers through loan covenants, as well as the ability to renegotiate flexibly with a relatively small group of creditors when borrowers are in distress.").
[43] Interestingly, an IMF "analysis comparing private credit to leveraged loans (which trade regularly in a more liquid and transparent market) shows that, despite having lower credit quality, private credit assets tend to have smaller markdowns during times of stress." IMF Blog (Apr. 8, 2024), https://www.imf.org/en/Blogs/Articles/2024/04/08/fast-growing-USD2-trillion-private-credit-market-warrants-closer-watch
.
[44]See, e.g., A Primer on Private Credit, Business Breakdowns, Ep. 163, Colossus (May 15, 2024), https://joincolossus.com/episode/panossian-a-primer-on-private-credit/.
(starting at approximately 45:50) (Armen Panossian explains this phenomenon: "You can get pretty comfortable that if a BDC has a mark of X . . . that there is a real basis for that mark based on performance and it is supported oftentimes by third-party valuation agents that are employed by these BDCs, and those valuation agents work across BDCs. So they know what someone else is marking the same position at and what sort of fundamental drivers, both positive and negative, another manager may be assuming in coming up with that mark or advising what that mark could be.").
[45] For a discussion of bank interactions with private credit, seeA Primer on Private Credit: Part 2, Business Breakdowns, Ep. 164, Colossus (May 15, 2024), https://joincolossus.com/episode/clarkson-a-primer-on-private-credit-part-2/.
[46] On average, banks operate with a debt to equity ratio of around 10:1, meaning they hold around $10 of debt for every $1 equity, while that ratio for private credit is only around 1.5:1. Compare Liabilities & Equity: All U.S. Banks, BankRegData https://www.bankregdata.com/allLE.asp (last accessed, Oct. 15, 2024) with Reassessing Systemic Risk in Nonbank Financial Institutions at 11. BDCs are subject to regulatory constraints on leverage.
[47] As one commentator noted, "The vast majority of the risk is being borne by equity investors in that private credit vehicle who are very often locked up or it is a permanent capital vehicle so you don't have run risk the way you do on a bank balance sheet. Very often with term and unsecured financing further subordinate to the bank line. And so that bank line will be in a pretty senior position where for that bank line to be at all impaired, you would have to see a level of losses in the private credit vehicle that is far beyond anything we have ever seen historically . . . ." The Evolution of Private Credit: Part 2, (Josh Clarkson at approximately 8:53).
[48] By one estimate, as of 2023, global private credit assets under management were approximately $2.1 trillion. IMF Report at 55. This makes private credit about 2% of the $117.6 trillion in assets at the top 100 global banks. Adrian Jimenea, John Wu, and Harry Terris, The world's largest banks by assets, 2024, S&P Global(Apr. 18, 2024), https://www.spglobal.com/marketintelligence/en/news-insights/research/the-worlds-largest-banks-by-assets-2024. Even though private credit is expected to continue growing, it is unlikely to displace other financing options. See, e.g., Kevin Wolfson and Joseph Taylor, Private Credit vs. Broadly Syndicated Loans: Not a Zero-Sum Game, PineBridge Investments (July 1, 2024), https://www.pinebridge.com/en/insights/private-credit-vs-broadly-syndicated-loans-not-a-zero-sum-game
[49]Private Credit: The Evolution of Corporate Finance and the Firm at 40 ("Private credit funds have enhanced information rights, as they actively seek board representation. These debt investors have formal and informal meetings with the board of their portfolio (i.e., borrower) firms. Driven by the relational nature of finance provided in this market, private creditors actively participate in the running of the firm. They get full access to the management team and directly influence the decisions made by the board. Such access also helps to establish relational finance. This type of involvement channels a continuous flow of information, enabling private credit funds to do firm valuations on a dynamic basis - valuations that reflect the true value of the firm at the time.").
[50]See, e.g., Commissioner Hester Peirce, Curiouser and Curiouser: Statement on Amendments to Form PF to Amend Reporting Requirements for All Filers and Large Hedge Fund Advisers, SEC (Feb. 8, 2024),
https://www.sec.gov/newsroom/speeches-statements/peirce-statement-amendments-form-pf-amend-reporting-reqs-020823; Commissioner Hester Peirce, The Changing Nature of Form PF: Statement on Amendments to Form PF, SEC (May 3, 2023), https://www.sec.gov/newsroom/speeches-statements/peirce-statement-form-pf-050323.
[51] IMF Report at 53.
[52] The recent example of Reg. AB II shows the adverse effect a wrong-headed regulatory regime can have on capital formation. Comment Letter from SIFMA at 2-3 (May 2020), https://www.sifma.org/wp-content/uploads/2020/09/Joint_Trades_SEC_RMBS_Disclosures_May2020.pdf (". . . SEC-registered RMBS have been non-existent since the Regulation AB amendments were finalized. The stalled recovery suggests that there are entrenched market impediments that must be addressed. Based on feedback from our members and other market participants, we believe that Reg AB II's revised disclosure requirements are a major contributor to the lack of SEC-registered issuances.").
[53]See, e.g., Commissioner Hester Peirce, Angels and IPOs: Remarks Before the Small Business Capital Formation Advisory Committee, SEC (Feb. 27, 2024),https://www.sec.gov/newsroom/speeches-statements/peirce-remarks-sbcfac-022724 ("The number of listed companies in the United States dropped from around 8,000 in 1996 to roughly 4,200 in mid-2022. During the 1990s, the U.S. saw around 412 IPOs annually, compared to only 248 during the last ten years. I hope that the Committee will help us identify the causes for this decline and suggest productive solutions. Some causes, of course, are outside the Commission's control, but we have a role in others-such as the rising costs of being a public company and the newly adopted special purpose acquisition company (SPAC) rules. External reporting costs for public companies have increased by 150% since the start of the century, far outstripping inflation of 71% . . ."). According to the World Bank, the number of listed companies in 2022 was 4,642. The World Bank, Listed domestic companies, total - United States, https://data.worldbank.org/indicator/CM.MKT.LDOM.NO?locations=US (last accessed, Oct. 15, 2024).