IMF joins calls for closer private debt scrutiny

April 19, 2024 (Preqin News) – The International Monetary Fund (IMF) joined the growing chorus of calls for greater scrutiny of the rapidly expanding private credit market.

As the asset class continues to attract interest from investors and borrowers, Preqin News looks at the proposals and reactions offered by international organizations, politicians, central banks, and industry groups.

The details: Last week, in its latest ‘Global Financial Stability’ report, the IMF warned that private debt markets merit closer scrutiny following two decades of rapid growth. It says that a migration of lending from regulated banks and public markets, which it describes as more transparent, to more opaque private credit creates potential risks.

‘If private credit remains opaque and continues to grow exponentially under limited prudential oversight, these vulnerabilities could become systemic,’ it warned.

The body recommended that authorities should be encouraged to consider a ‘more intrusive supervisory and regulatory approach to private credit funds, their institutional investors, and leverage providers’, identifying that closing data gaps and enhanced reporting requirements are key in fully assessing risks.

‘Authorities should closely monitor and address liquidity and conduct risks in funds – especially retail – that may be faced with higher redemption risks,’ it said.

Background: Investor demand for private credit rapidly grew in the years following the Global Financial Crisis (GFC), pushing assets under management (AUM) up from $260bn in December 2009 to $1.73tn as of September 2023, according to the latest Preqin data. Private credit is now the second largest alternative asset class behind private equity, having overtaken real estate last year, and is also now larger than traditional lending instruments such as leveraged loans and high-yield bonds, the IMF report said.

As banks have reined in elements of their lending businesses, often because of increased capital requirements brought in after the GFC, private credit managers have stepped into the gap and taken an increasing share of the market for loans to smaller and mid-sized corporates.

Private credit managers have been able to provide strong, stable returns with little volatility in a low interest rate environment, attracting more and more institutional capital into the asset class. Private debt funds have delivered a horizon IRR of 7.4% over the 10 years to September 2023, a period for which interest rates were exceptionally low until recently, and 10.4% for the three years to September 2023 as interest rates climbed, according to Preqin data.

The latest available data is from the 2023 results of listed private credit managers, who delivered double-digit gross returns in FY 2023. ‘Institutional investor focus has pivoted to asset classes that offer current income, inflation protection, and access to areas of secular growth, namely credit, infrastructure, and sustainability’, Scott Kleinman, Co-President and Director of Apollo Asset Management, said on the firm’s earnings call earlier this year.

Given the long-term capital lock-ups and high minimum investment levels, private credit funds are largely raised from institutional investors, including pension funds and insurers. However, private credit GPs are now increasingly targeting the private wealth segment, which could create further liquidity pressure on the market in the event of a ‘run’ or economic downturn.

Recent developments: The IMF is the latest addition to a growing list of regulatory and policymaking organizations to sound concerns over the fast-growing asset class:

• The International Organization of Securities Commissions (IOSCO) published a report in September, exploring the emerging risk in private finance markets that it described as ‘inherently opaque’ and ‘presents challenges for regulators and for market participants to understand the scale of risk in these activities.’

• In November, the Chair of the US Senate Committee on Banking, Housing, and Urban Affairs, Sherrod Brown, and fellow Senator Jack Reed urged regulators, including the Federal Reserve, to ‘assess the potential risks that private credit may pose to the safety and soundness of our banking system.’

• In January, the Bank of England indicated it intends to keep a close eye on private credit. In a speech from January, Lee Foulger, Director of Financial Stability, Strategy, and Risk at the central bank, said: ‘The increasing role played by non-bank finance in the provision of credit is a feature of the financial system, not a bug, and a welcome feature if undertaken on a sustainable basis. Going forward, the Financial Policy Committee will continue to closely monitor risks from private credit and interconnected markets, drawing on market intelligence and the data sources available.’

• In February, the Fed published a report titled ‘Private Credit: Characteristics and Risks’ outlining the low redemption and fire sale risks posed by private credit funds, due to its low leverage rates and derivates exposure. However, other financial stability implications include the illiquidity due to the lack of a secondaries market, a potential rise in default rates, and that ‘excessive growth in dry powder and continued competition with banks could compromise underwriting standards’, the report said.

• Also in February, the European Union announced the adoption of new rules on private credit funds – including the amended AIFMD regulations that requires GPs to ‘alleviate risks to financial stability and to ensure an appropriate level of investor protection’, by introducing leverage caps on loan origination funds, according to a statement.

The reaction: Responding to the IMF’s report, Bryan Corbett, President and Chief Executive Officer (CEO) of the Managed Funds Association, said: ‘Private credit fills an important role in the global financial system and strengthens the economy by providing capital to companies of all sizes. Private credit funds are well regulated by the SEC and do not impose a systemic risk. Banks have depositors, and bank losses are backstopped by the government. Credit funds, on the other hand, have greater stability provided by long-term investor financing.’

Jiří Król, Deputy CEO and Global Head of Government Affairs of AIMA, told Preqin News: ‘While the IMF recognizes that private credit does not pose any systemic risks, they call for the closing of data gaps when it comes to monitoring market developments. The Alternative Credit Council, with a decade-long track record of providing research about the industry, is working to improve data availability through our annual survey work which takes on board policymaker requests when it comes to better understanding key financial stability metrics.’

The final word: ‘It was always likely that the rapid growth of a new non-bank lending platform would draw the attention of global regulators – and with it some sort of new rules. Reporting rules and guidance for open-ended debt funds were low-hanging fruits for regulators, reinforced by the IMF’s comments,’ said Nicholas Mairone, AVP at Preqin research arm, Research Insights.

‘There has been significant work done by regulators on open-ended structures over the past few years, and that work may spill over into new private credit products. However, we don’t consider private debt funds as systemically risky in the same way that the deposit-taking nature of banks makes them uniquely exposed to certain types of shocks. For that reason, I’d expect regulators to be slower moving in terms of implementing broad based rules in private credit.’

_{The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.}