Few asset classes have experienced as fast a rise in popularity as private credit over the past decade. A recent Morgan Stanley analysis found the private credit market – which refers to lending to companies by institutions other than banks – has grown a considerable 60% from $875bn in 2020 to more than $1.4tn in 2023. And it shows no signs of slowing. By 2027, it is estimated the industry could be worth $2.3tn.
Although private credit began by providing finance to private equity houses, it has expanded rapidly since the global financial crisis, after banks came under greater regulatory scrutiny and subsequently reined in lending activities. The asset class has since become a favourite on Wall Street, attracting capital from a much wider range of institutional investors, including hedge funds, sovereign wealth funds, insurers and pension providers.
Private credit: under-regulated?
While the space offered a compelling opportunity for institutional investors to realise strong returns and shield themselves from the volatility of mark-to-market losses in public markets, there are growing concerns among leading market commentators that the private credit market is under-regulated. According to two senior executives at global investment giant Pimco, the substantial inflow of money flooding into the sector is troubling due it being channelled into debt funds that offer little to no transparency. It begs the question, who is responsible for this rapidly growing sum of cash, and is it in safe hands?
Adding to growing calls for a thorough regulatory investigation into the private credit market is its relative illiquidity. Private credit does not work the same way as alternative forms of debt, like sovereign debt markets, for instance. This must be carefully considered when producing valuations and risk assessments, as there is a greater danger that investors cannot quickly or easily exit their positions.
This may not have been too great a problem prior to 2020, when markets were much calmer. But the elevated levels of market volatility and economic uncertainty witnessed over the last few years could dramatically impact the true valuations of these assets.
2024 regulatory outlook
With allocations to private credit from systemically important institutions including insurance firms and pension funds set to continue rising, we anticipate regulators will heed the calls of private credit’s critics. Indeed, it wouldn’t be unreasonable to expect a significant regulatory examination of the private credit space over the coming months. For investment houses with considerable exposure to private credit, this will pose a serious challenge.
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Such institutional investors must ensure they are in a position to make full and accurate risk assessments, as well as highly precise valuations of their private debt holdings. There are two reasons for this. From a self-governance perspective, it helps ensure the company’s risk, accounting, operations, and portfolio management teams are harmonised. The other rationale relates to regulatory pragmatism. It is far preferable to be equipped with the data likely to be requested by watchdogs before they come knocking.
However, to conduct these private debt risk assessments and valuations in a timely manner, firms must ensure they possess sophisticated data infrastructure. A key aspect of private credit’s lack of transparency comes down to the fact the data underpinning these assets is vastly different to that of traditional asset classes. For many family offices, pension funds and insurers – which may possess more antiquated internal systems or be used to more vanilla investing strategies – this presents a significant headache. Many will not be operationally configured to handle this new type of data, or to extract the requisite information from the data they already have access to.
With this in mind, it is prudent that institutional investors look to take concrete steps towards enhancing the data infrastructure underpinning their asset allocation activities. Those that do not could find they are woefully unprepared when watchdogs come sniffing.
Yann Bloch is head of product & pre-sales, Americas, NeoXam