Financial analysts are divided on whether the private credit industry represents a minor concern or the seeds of the next major financial crisis, with both perspectives potentially proving accurate depending on timing.
Warning signals have been emerging from the specialized private lending market since mid-2023, as this sector had gained tremendous traction among businesses seeking customized financing and investors chasing higher yields.
Investor withdrawals from private credit funds, called business development companies (BDCs), have intensified in 2024 due to concerns about market competition, declining profits, and worries that artificial intelligence could disrupt software companies these funds support.
This week, Blue Owl Capital became the most recent BDC to announce record-breaking withdrawal requests and implemented limits on redemptions, which regulations permit them to do.
Major financial firms including Ares Management, Apollo Global, Blackstone, KKR, and private credit divisions of Morgan Stanley, J.P. Morgan, and Goldman Sachs have similarly restricted withdrawals.
Most companies have indicated these redemptions reflect an industry adjustment period rather than a full-blown crisis.
However, additional warning signs are appearing. BDCs face increased borrowing costs from banks while the historically high double-digit returns from private lending continue to decline.
“You’re going to have credit cycles, you’re going to have losses, you’re going to have some markdowns. I mean, they’re not lending at 5% for a reason, right?” said John Giordano, managing director of New York-based Seaport Global Holdings.
Giordano doesn’t view the risks as system-wide threats, highlighting how BDCs maintain low leverage, hold senior debt positions, or participate through equity stakes in company management. He also emphasized the banking sector’s strong capitalization.
The private lending sector expanded following the 2008 financial crisis, becoming an alternative to traditional bank financing for private equity firms acquiring mid-sized companies through long-term loans featuring simpler terms and higher returns.
Information about specific exposures, valuations, and losses at BDCs remains limited due to their private nature, but these companies collectively manage over half a trillion dollars in private assets. The Alternative Investment Management Association values the entire private credit industry at $3.5 trillion, making it large enough to significantly impact financial markets.
Stock prices of publicly traded BDCs have dropped significantly this year, trading at approximately 20% below their net asset values. Shares of U.S. software service companies, the sector most connected to private credit, have also declined by one-fifth in 2024.
Rory Dowie, equity portfolio manager at Marlborough in London, said his company has reduced exposure to several asset managers and eliminated holdings in Swiss private equity firm Partners Group. Partners Group’s chair Steffen Meister stated last month that default rates in private credit could double in coming years due to AI-driven economic disruption.
Dowie explains that the interconnected relationship between public and private markets in AI financing could create cascading effects. “It’s hard to say what’s going to crack first… and it becomes a self-fulfilling prophecy whereby you could get a bigger, more systemic issue occurring.”
Javier Corominas, director of global macro strategy at Oxford Economics, wrote this week that the market has already entered early phases of a gradual private credit crisis, estimating that 25%-35% of these portfolios face AI disruption risks.
“We are still at the beginning of discovering the issues and it might not happen tomorrow, it might happen in three months or six months,” said London-based Alberto Gallo, chief investment officer at Andromeda Capital Management.
“You have this box where you have 100 companies, but you know that 10 of them are dead cats. Until you open the box, they are still alive. That’s basically what they have created.”
Corominas noted that while total bank lending to BDCs remains modest and controllable, the greater concern lies with private credit holdings among U.S. life and annuity insurers, which have more than doubled over the past decade.
Private credit represents approximately 35% of total U.S. insurer investments and nearly 25% of UK insurer assets, according to his analysis.
More concerning, insurers connected to private equity firms hold an estimated $1 trillion in assets obtained through these relationships, and exposure to private credit losses will disproportionately affect U.S. pension funds and retail savers who purchased life annuities from these insurers.
“Should private credit losses erode insurer solvency, the resulting contagion would not resemble the bank-run dynamics of 2008, but would instead manifest as a slow, grinding erosion of retirement security — harder to detect in real time, and significantly more difficult to reverse,” Corominas wrote.
Andromeda’s Gallo said he wouldn’t dismiss private credit concerns as non-systemic risks simply by comparing them to the 2008 subprime crisis, which was driven by extended housing leverage through collateralized debt obligations.
“This is a different animal with different contagion channels,” he said, referring to how leverage increases in later stages of private credit through insurers.
During the subprime crisis, contagion spread through banks with proper asset valuation, but this situation involves insurance companies without mark-to-market pricing and higher default risk.
“Regulators always fight the last crisis, and here you have the opposite, the mirror image of the last crisis,” he said.
