Regulators should scrutinize the fast-growing private credit market more closely, given potential concerns ranging from demands on funds' liquidity to the quality of underlying borrowers, the International Monetary Fund said in a report.
The study, released Monday as part of an IMF report on global financial stability, outlines the $1.7 trillion sector's critical role in debt markets and points to possible risks which are difficult to fully ascertain given the lack of information and transparency.
Private credit also remains largely untested in an economic slump, according to the analysis. It caters to mostly small and mid-size borrowers with higher leverage, implying more risk. If the loans falter, that could spell trouble for institutional investors who have sunk money into the assets.
"Because the private-credit sector has rapidly grown, it has never experienced a severe downturn at its current size and scope, and many features designed to mitigate risks have not yet been tested," the report says. "The current regulatory requirements for insurers and pension funds do not consider the credit performance of underlying loans."
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The IMF urged regulators to take a more active role and require more robust disclosure from participants in the market to more accurately analyze risk. It proposes enhancing reporting requirements and creating supervisory cooperation across borders and sectors.
Private credit has boomed the past few years as regulators have clamped down on banks through measures including stricter capital rules, pushing riskier borrowers to direct lending as an alternative. While the asset class has pulled in a variety of institutional investors, a separate study by a trio of academics found that after accounting for additional risks and fees, it
The IMF also warns against potential deterioration in credit markets as competition heats up among direct lenders and public or broadly syndicated markets, which risks generating loans with weaker protections.
The report also points out increased use of payment-in-kind structures, where borrowers defer interest payments and boost debt levels in the process, instead of paying interest with cash. Although that move alleviates short-term financial burdens, it could compound strains in the long run. Publicly traded direct lenders known as business development companies now have twice as much interest income from payment-in-kind debt as they did in 2019, according to the report.
That said, risks to financial stability appear contained, the study found. The fact that private credit funds are tapping long-term capital, such as from institutional investors, rather than short-term borrowings that could need to be repaid quickly, mitigated concerns. The funds also deploy a modest amount of leverage, lessening worry.
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However, the IMF also outlined liquidity risks, as retail-oriented funds gain popularity. The threat could be compounded should stress mount in the underlying investments or companies. For instance, if borrowers simultaneously drew down on credit balances, that could increase a fund's needs for cash, with potential echoes of financial market stress seen in 2020.
The report also pointed to the sector's extensive connections among private credit funds, private equity and institutional investors.
Questions around valuations, given the private and illiquid nature of the market, are another worry. The funds might be motivated to avoid marking to market or realizing losses, and in a downside scenario the opacity could lead to a deferred realization of losses followed by a potential spike in defaults, the report concludes.
"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," the report said.
