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Rising supervisory concerns about the growth of the under-regulated private credit market, including the exposures of banks to this fast-growing segment, appear to be inversely correlated to the actions taken by banks and asset managers to accelerate their engagements in a testy market environment.
“Complex exposures to private equity and credit funds require sophisticated risk management,” read the title of the ECB Banking Supervision’s November newsletter. Translation: banks lack sophisticated risk-management for their private equity and private credit exposures. We are concerned.
Sufficiently concerned, in fact, that they are getting ready to lay out supervisory expectations for banks’ management of risk exposures in this area that will require more onerous disclosure and gap analyses relative to those expectations. The Financial Stability Oversight Council, a unit of the US Treasury, had noted in its 2023 annual report that private credit is relatively opaque and warrants continued monitoring.
Yet market players don’t seem to be paying much heed. When BlackRock announced its US$12 billion acquisition of HPS Investment Partners, the credit investment manager, in early December, it said it reckons the private debt market will more than double to US$4.5 trillion by 2030. That kind of growth trajectory is seemingly too good to pass up.
BlackRock’s acquisition will move it closer to what it sees as the future of fixed income: “building public and private portfolios to optimize liquidity, yield, and diversification”. HPS has around US$148 billion in client assets while BlackRock manages nearly US$90 billion in private-debt client assets.
Defaults, re-valuations, leverage
In the eurozone, the fact that ECB supervisors felt motivated to launch an exploratory review of the risk exposures of the banks under their supervision in this area speaks volumes about their concerns. They had made those concerns patently clear when they raised red flags in the May Financial Stability Review about the financial stability risks posed by the significant growth of private equity and credit.
They pointed to risks stemming from adverse economic shocks leading to rising defaults, valuation corrections and losses for private funds and their investors, exacerbated by multiple layers of leverage at company, fund and investor level, by liquidity mismatches for some open-ended private funds, and by a general lack of transparency for market participants and themselves.
The stratospheric growth of private credit is a story well told. It’s still predominantly a US phenomenon but one that has given rise to a crescendo of warnings in Europe and Asia as the regional markets ramp up. Warnings not just about the lack of transparency but lack of transparency just when funds and portfolio companies may be struggling in a lower-growth, higher-for-longer interest-rate period.
And just as the private credit strategy has expanded into large-scale financing, into the investment-grade arena, and into a competitive face-off with banks, putting pressure on underwriting standards. The fact that banks and credit funds have, over a relatively short period, built what some see as a worrisome doom loop as banks offer financing and hedging solutions to leveraged private credit funds in increasing volumes and through multiple channels adds a layer of concern.
As does the fact that banks ( and asset managers too ) have fuelled growth in private credit by initiating their own private credit platforms and strategies. Just a few of multiple examples:
One of the key concerns emanating from the survey that formed part of the ECB’s exploratory review is that banks can’t systematically identify deals where they lend to companies alongside private credit funds. They are apparently better at identifying transactions where borrowers are owned by private equity, although even here investigations by supervisors have revealed weaknesses.
“Failure to properly identify on an aggregate level exposures to companies that also borrow from private credit funds means that this exposure is almost certainly understated and the concentration risk cannot be properly identified and managed,” the ECB supervisors warned.
They say risk management associated with bank exposures to private equity/credit is fragmented and fails to capture the risks generated by these exposures holistically. For example, a bank may finance a company that is owned by a fund. The fund may also have obtained financing from the same bank while also being an interest-rate and FX derivatives counterparty. Investors in the fund, meanwhile, may also have borrowed from the bank to finance their fund investments. Banks aren’t currently aggregating this data into usable format to manage risk exposures.
This past year saw some interesting market skirmishes between banks and private credit lenders as the two sides sought supremacy. It will be fascinating to see how the interaction evolves as the regulatory shadow starts to loom.
