The IMF has called for more vigilant regulation and supervision of private credit as part of its Global Financial Stability Report, April 2024.
While the asset class poses limited immediate financial stability risk, its fast growth coupled with limited oversight could exacerbate existing vulnerabilities into more systemic risk, the IMF said.
Last year, the global private credit market topped US$2.1 trillion in assets and committed capital, of which three-quarters was in the US market.
It has grown in appeal over the last few years, with features like speed and flexibility appealing to borrowers. For institutional investors, such as pension funds, private equity funds have, though illiquid, offered higher returns and less volatility.
Among the fragilities it identified in its report, the IMF noted companies that tend to tap the private credit market are generally smaller and carry more debt than their larger counterparts with leveraged loans or public bonds.
“This makes them more vulnerable to rising rates and economic downturns. With the recent rise in benchmark interest rates, our analysis indicates that more than one-third of borrowers now have interest costs exceeding their current earnings,” it observed.
Additionally, it warned that pressure on private credit providers to deploy capital, as they face increased competition from banks on large transactions, could be leading to looser loan covenants and weaker underwriting standards.
Moreover, the IMF explained, as private markets rarely trade and can’t be valued using market prices, they are often only marked quarterly using risk models, and could suffer from “stale and objective” valuations across funds.
“Our analysis comparing private credit to leveraged loans (which trade regularly in a more liquid and transparent market) shows that, despite having lower credit quality, private credit assets tend to have smaller markdowns during times of stress,” the fund said.
The IMF also called for caution with regards to the interconnectedness of the private credit ecosystem.
It explained that while banks do not seem to have a material exposure to private credit in aggregate, some banks may have concentrated exposures to the sector. In addition, a select group of pension funds and insurers are said to be “diving deeper into private credit waters”, significantly upping their share of these less liquid assets.
Its words of warning extend also to the growing retail presence in the asset class, with the fund noting that while liquidity risks appear limited today, this expanding retail presence may alter the assessment.
Ultimately, the IMF conceded that the vulnerabilities it cited do not pose a systemic risk currently, but stressed they may continue to build with implications for the economy.
“In a severe downturn, credit quality could deteriorate sharply, spurring defaults and significant losses. Opacity could make these losses hard to assess. Banks could curb lending to private credit funds, retail funds could face large redemptions, and private credit funds and their institutional investors could experience liquidity strains,” the fund said.
“Significant interconnectedness could affect public markets, as insurance companies and pension funds may be forced to sell more liquid assets.”
As such, the IMF made several recommendations to governments, highlighting the need for “more vigilant regulatory and supervisory posture” to monitor and assess risks.
Among the recommendations is the need for authorities to enhance cooperation across industries and national borders to address data gaps, and to improve reporting standards and data collection to better monitor private credit’s growth.
Securities regulators are also encouraged to pay close attention to liquidity and conduct risk in private credit funds, especially retail, that may face higher redemption risks.
In Australia, private credit is considered a fast-growing alternative asset class that mostly targets capital-seeking companies and income-seeking investors.
In a statement published on the ASX, Metrics Credit Partners’ Andrew Lockhart said last month he expects private credit worldwide to continue its growth.
He predicted that as regulators seek to reduce systemic risks in financial markets by ensuring banks are appropriately regulated, more organisations will have to turn to non-bank lenders for funding.
“In Australia, we don’t have a bond market of any size or scale, so private credit has an important role in supporting the growth of quality companies and projects. But for all the potential, private credit is only as good as the managers behind it, in terms of how they assess and monitor loans, manage risk and allocate capital.”
