After the recent collapses of auto parts maker First Brands and subprime car finance company Tricolor, three executives from private finance firms appeared before a House of Lords committee last month to address what they called “misinformation.”
Daniel Reiter of Blackstone emphasized that private credit is generally safer than what banks would typically manage, pointing out that the reliance on leverage leaves larger lenders vulnerable to “single points of failure” within their businesses.
However, banks hold a different view. Jamie Dimon, president of JPMorgan Chase, noted that there is a significant shift as loans transition from the banking sector to less regulated entities, expressing concerns that more issues, or “cockroaches,” could emerge as the private credit market continues to grow.
The relationships between banks and private credit funds are quite complex. Banks often extend loans worth hundreds of billions, effectively enhancing the profitability of private credit funds.
Amid these developments, regulators, economists, and public officials are becoming increasingly wary.
Last month, the IMF cautioned that “beneath the placid surface, the ground is shifting.” The European Central Bank commented on how the ties between banks and private credit could amplify and spread financial shocks throughout the system.
A senior executive in private credit acknowledged the situation bluntly, stating, “The model will be pushed to its limits.” He recalled that this was also a concern during the 2008 financial crisis when the banking system nearly reached its breaking point.
The interconnectedness of banks and private credit has been a major factor in the rise of non-bank lending. Banks provide essential support for the burgeoning private credit market, contributing to liquidity and leverage.
Investor Financing
Investor participation in private credit funds involves both limited partners (often large institutions like pension funds) and general partners (the private credit firms managing the funds). Limited partners usually supply capital for loans, while general partners manage the fund’s activities.
Both types of partners can borrow from banks—limited partners for their commitments, while general partners can secure loans based on their fee incomes from managing the fund.
Once a fund has gathered enough commitments, it can start borrowing through subscription lines, using these commitments as collateral.
Subscription Line
These revolving credit facilities enable faster capital deployment without waiting for actual cash transfers, which is why they are quite popular in the industry. Subscription lines also enhance performance metrics, as returns are calculated from the date cash is invested, not simply when commitments are made.
Private credit funds extend loans to borrowers and then leverage those loans to acquire additional financing from banks.
Back Leverage
Funds rely on banks for loans channeled through special purpose vehicles (SPVs), giving banks indirect exposure to private credit borrowers, a relationship commonly referred to as “back leverage.” This setup helps banks shield their assets and allows them to monitor which loans serve as collateral.
When loans are made through the fund, they are transferred to the SPV, which then serves as collateral for further loan financing. If a fund leverages loans from various banks, it could manage numerous SPVs, with each assigned a different bank.
Banks usually provide around 60% to 70% of the loan amount attributed to the SPV. They seek not only security but also diversification to mitigate potential losses.
They monitor loan performance and have the right to withdraw poor-performing loans from the SPV, asking the fund to substitute them with better ones. To mitigate risks, banks may also limit the leverage available to private credit funds.
Typically, these loans are “over-collateralized,” meaning less is borrowed than the value of the collateral offered. Still, there is potential for rapid loan deterioration, which poses a risk of losses for banks.
Repo Financing
Other financial arrangements, such as repurchase agreements, can hide the extent of banks’ exposure to this sector. In repurchase financing, an SPV sells loans to a bank and plans to repurchase them at a later date at a premium—a process often characterized by opacity.
Repo markets are notoriously hard to navigate since terms can be negotiated privately. Regulators have raised concerns over a data “black hole” in repo funding, making it difficult to gauge how much private credit funds employ these strategies.
There’s worry that links between the repo market and private credit could heighten systemic risk, particularly if illiquid private debt needs to be sold quickly during crises. Analysts at Barclays pointed out that the use of short-term funding could serve as a channel for financial shocks, especially as private credit firms reach out to retail investors.
NAV Loan
Net asset value loans, known as NAV lines, are secured by the value of a fund’s assets. These can help investors access cash more quickly, which narrows the timeframe for measuring returns. While NAV lines are controversial—considered “leverage-on-leverage” because they involve borrowing against previously leveraged investments—there’s a consensus that their value is growing.
Loans to Investees
Banks can lend directly to companies within a private capital fund or SPV. While both parties claim lending to the same company is rare, the European Central Bank indicated this could be due to tracking challenges.
The ECB noted that failing to identify co-lending arrangements leads to underestimation of exposure and concentration risks. Additionally, private credit funds often draw from the $1.5 trillion collateralized loan obligation (CLO) market to fund loans.
In the CLO structure, loans are bundled and divided into tranches, which are marketed to investors based on risk appetite. While banks are common investors in CLOs, so too are insurance companies and sovereign wealth funds, which also have stakes in private credit funds.
CLOs necessitate a diverse loan pool, leading private credit SPVs to rely on temporary funds from banks called warehouse lines until they can obtain enough loans.
How Healthy are Private Credit Borrowers?
Though executives tout low default rates within private credit, the IMF recently estimated that nearly half of these borrowers experience negative free operating cash flow. This has led funds to seek alternative strategies to mask defaults, like the use of payable-in-kind notes that effectively increase the loan balance, potentially lowering recovery rates during defaults.
Much of this debt carries variable interest rates, putting borrowers at risk amidst rising rates. “CLOs are riskier because they tend to be highly leveraged,” noted one banker involved in structuring deals.
Moreover, banks are increasingly shifting risks from their loan portfolios to private credit funds through material risk transfers, often involving repackaged loans for which they purchase default protection.
This trend has emerged largely around standard assets like corporate loans and mortgages while banks target private equity and credit funds for lucrative deals aimed at minimizing risks linked to subscription lines and NAV loans, thereby strengthening their presence in the sector.
