Private credit is now so big that the IMF dedicated an entire chapter in its latest Global Financial Stability Report to its “ rise and risks ”. But JPMorgan argues that even the IMF is underestimating the true size of the industry.
As Alex wrote yesterday, the broadly syndicated loan market has clawed back some market share lately, but private credit remains one of the hottest asset classes out there.
The IMF estimates the size of the global private credit industry at just over $2tn, most of which is in the US, rivalling the high yield and leveraged loan markets. Our friends at the Unhedged podcast discussed the GFSR’s private credit chapter last week.
However, thanks to Marathon founder turned LinkedIn poaster Bruce Richards, FT Alphaville took a belated look at a JPMorgan report from earlier this month that puts the true size at well over $3tn. Or $3.14tn to be precise.
That’s because Preqin — the main data source for private credit funds — apparently undercounts business development companies and doesn’t account for leverage. JPMorgan’s emphasis below:
How big really is the private credit asset class? Naturally the answer to this question depends upon your definition of what constitutes ‘private credit’. If you want to include all non-bank lending to the private sector, then you get a figure that is very large indeed!
Using a more mainstream definition of loans to large and middle-market leveraged businesses, the market size figures often cited come from Preqin, which maintains a time series back to 2000. Preqin’s latest estimate based on data to Jun-23, stands at $1.71tn globally, with $1.08tn of that situated in North America.
These numbers aren’t the whole story, however. Firstly, approximately 30% of the Global and North American totals are made up of ‘dry powder’ , i.e. undrawn capital commitments. While these commitments can be used to fund future loans, there’s a case for excluding this amount from the total and focusing solely on invested assets, which amount to $1.21tn and $760bn, respectively.
On this front, the value of invested assets that Preqin reports is done on a net basis , i.e. after subtracting the amount of any external funding. For example, if a private credit fund owns a $150mm loan, funded by $100mm of investor capital and $50mm of external leverage, this would be counted as $100mm of assets, assuming the loan is valued at par. While this approach is useful for calculating fund returns, it means that the quantity of private credit loans outstanding will be undercounted, assuming that some funds employ leverage. We believe leverage is more widely used by US private credit funds than European funds, and that 1-2x is typical.
Finally, the Preqin figures only capture commingled, closed-end funds. This means that separately managed accounts, along with open-ended, evergreen and listed funds are not included. In particular, we think that the Preqin data set underrepresents the size of BDCs , one of the fastest growth areas within the private credit landscape. BDCs or Business Development Companies are set up to provide financing to small and middle market enterprises. They are typically managed by an external manager and, like REITs, distribute most of the their earnings to shareholders. Importantly, leverage is capped at 2x, but most BDCs operate at 0.8-1.2x leverage.
Assuming one turn of leverage on average and including dry powder but excluding ca $133bn of middle-market CLOs, here’s what JPMorgan came up with:
Does this latest figure matter to anyone but financial journalists who always prefer to quote the bigger, scarier number on a market’s size?Well . . . kind of?
Yes, we already knew that private credit is big, is getting bigger and growing globally — albeit from a lower base outside the US — and warrants scrutiny given its opacity and expansion. Like FT Alphaville , the IMF seems sceptical of the argument that private credit is truly a systemic risk, noting that loans are funded by locked-up capital, relatively modest leverage, and limited interconnectedness with the rest of financial markets.
But the IMF has been paying attention to the market’s size as well, and notes that systemic risk may increase if the growth continues at its current pace.
From the GFRP’s private credit chapter, with the IMF’s emphasis below:
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 re-rating 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.
If a $2tn industry is worth scrutiny but probably not dangerous yet, what about a $3tn industry? $4tn?