You have been reading about private funds limiting redemptions and the dangers private equity and credit could pose to retirement investors in my ongoing series Private Equity Is the Next Big Thing Coming for YOU. With trouble in the market for private equity and credit, Greg Ip of The Wall Street Journal examines whether or not a collapse would be as devastating as the Financial Crisis. Ip worries that financial engineering has tied private credit to other parts of the economy. He writes:
Banks have tripled lending to private equity and credit since 2018 to over $300 billion, part of a broader expansion of lending to financial companies. As a result, funds that invest in highly leveraged companies have themselves become leveraged.
To be sure, banks’ exposure is small relative to their total assets. Many have protected themselves through “synthetic risk transfers,” under which they retain the loan but pay someone such as a hedge fund to take the hit if the loan defaults. The IMF estimates that banks worldwide have transferred the risk on $1 trillion of assets (not just private credit) this way.
Nonetheless, this ties private credit more closely to other parts of the financial system. For example, a hedge fund might borrow from one bank to take on the credit risk from another bank. These linkages raise “potential contagion risks,” the IMF said.
The IMF explained in 2024 that while private risks remained contained, there are vulnerabilities in the sector, and listed some vulnerabilities that could become systemic, writing:
- 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.
- These credit losses could create significant capital losses for some end investors. Some insurance and pension companies have significantly expanded their investments in private credit and other illiquid investments. Without better insight into the performance of underlying credits, these firms and their regulators could be caught unaware by a dramatic rerating of credit risks across the asset class.
- Although currently low, liquidity risks could rise with the growth of retail funds. The great majority of private credit funds poses little maturity transformation risk, yet the growth of semiliquid funds could increase first-mover advantages and run risks.
- 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. Funds that use only modest amounts of leverage may still face significant capital calls in a downside scenario, with potential transmission to their leverage providers. Such a scenario could also force the entire network to simultaneously reduce exposures, triggering spillovers to other markets and the broad economy.
- 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. Fund managers may be incentivized to delay the realization of losses as they raise new funds and collect performance fees based on their existing track records. In a downside scenario, the lack of transparency of the asset class could lead to a deferred realization of losses followed by a spike in defaults. Resulting changes to the modeling assumptions that drive valuations could also cause dramatic markdowns.
- Risks to financial stability may also stem from interconnections with other segments of the financial sector. Prime candidates for risk are entities with particularly high exposure to private credit markets, such as insurers influenced by private equity firms and certain groups of pension funds. The assets of private-equity-influenced insurers have grown significantly in recent years, with these entities owning significantly more exposure to less-liquid investments than other insurers. Data constraints make it challenging for supervisors to evaluate exposures across segments of the financial sector and assess potential spillovers.
- Increasing retail participation in private credit markets raises conduct concerns. Given the specialized nature of the asset class, the risks involved may be misrepresented. Retail investors may not fully understand the investment risks or the restrictions on redemptions from an illiquid asset class.
Action Line: Pay close attention to the third bullet point and the last bullet point. Those two are directly intertwined with Your Survival Guy’s recent warnings. When private equity and credit are inevitably shuffled into your 401(k), be very cautious. When you want to give yourself greater options, email me at ejsmith@yoursurvivalguy.com, and I can help you with an IRA Rollover. And click here to subscribe to my free monthly Survive & Thrive letter.
Originally posted on Your Survival Guy.