In our previous Insights, we highlighted how private credit could become a systemic problem for financial markets, but we were also very careful not to indulge in narratives that painted catastrophic scenarios. In fact, we have repeatedly emphasized that the current situation is nothing more than a phase of stress (which, incidentally, is being well managed through the use of “gates”) that many new market segments—sooner or later—end up experiencing before they mature. However, we have never denied that this new asset class could, under certain conditions, trigger systemic risk.
On April 24, an article appeared by Amit Seru—a senior fellow at the Hoover Institution and professor of finance at Stanford’s Graduate School of Business—who, along with two colleagues, analyzed approximately 1,300 private credit funds and nearly 9,000 underlying loans over the past 25 years — about two-thirds of the market — concluding that private credit funds are structured completely differently from the institutions that triggered past financial crises, thereby reinforcing their belief that private debt does not inherently possess the characteristics to trigger a systemic crisis, though they do not deny—obviously—the period of crisis this market is currently experiencing.
Since we consider this an interesting perspective, we have decided to expand on the points raised in the article in order to provide a more solid foundation for the author’s and his research collaborators’ position.
Private credit, we reiterate, is a segment of the non-bank credit market in which closed-end funds provide direct financing to companies, typically mid-market or sponsor-backed (LBO). Its structural characteristics include the use of closed-end funds with capital locked up through multi-year lock-ups; a time mismatch (average duration of liabilities versus average duration of assets) that is not excessively pronounced; limited use of leverage; and, finally, a waterfall structure in which equity tranches bear losses first. These characteristics distinguish private credit from the banking system—especially the one that existed prior to the devastating financial crisis of 2008. Let’s look at a few more details.
U.S. investment banks entered the 2008 crisis with a leverage ratio of approximately 30x and an equity ratio (i.e., the percentage of equity relative to assets) of 3%, thus revealing enormous fragility because they risked insolvency even in the face of small asset value losses. The Dodd-Frank Act—along with the broader framework of other reforms—reduced the banking system’s leverage to 8x, bringing the equity ratio to about 12%: still too low to prevent a systemic crisis. These figures highlight private credit as a model of soundness, as it exhibits an average leverage ratio of 1.25x and an equity ratio between 65% and 80%, where perhaps the only real concern is the wide dispersion within this broad range—a potential sign of inadequate regulation. However, when faced with a stress test based on a scenario of a 10% loss in asset value, we can reasonably conclude that:
• a pre-2008 bank would have seen its capital wiped out;
• a post-2008 bank would have suffered significant capital erosion;
• the private credit sector would suffer only a marginal impact.
Another key point of differentiation is the cascading structure of losses. In private credit, losses first affect equity investors (LPs) and then other creditors (such as banks), who hold senior, protected claims. In the banking system, depositors are indirectly exposed, whereas in private credit, the risk is concentrated among sophisticated investors.
In such a situation, is it plausible to envision a contagion scenario through the banking system? The operational reality is that leverage in private credit is almost never used structurally—that is, to amplify the profitability of the underlying assets—but only to meet temporary cash needs, usually to pay early redemptions. This explains why the Fed’s stress test does not identify any particular vulnerabilities for the banking system caused by leverage. Furthermore, the use of redemption gates in stress situations limits the well-known “run on the bank” that fully characterizes the banking system, but not the private credit sector, because funds are authorized to make early redemptions within the limit of 5% of the quarterly NAV. And the maturity mismatch also turns out to be a strength of the sector. While banks have long-term mortgages and loans on the asset side and short-term deposits on the liability side—creating a genuine structural mismatch—private credit, on the other hand, benefits from a healthy alignment on this front because it includes illiquid, long-term loans on the asset side and locked-in capital on the liability side. This mismatch is at the root of virtually all banking and financial crises: private debt is virtually immune to it.
But let us now turn to the critical issues facing private credit, and first and foremost the fragility of asset valuations based on pricing models and the absence of frequent mark-to-market adjustments. As we have already highlighted, this creates an underestimation of true market volatility, with a delayed recognition of losses and sudden changes in value during stress situations, which inevitably leads to: credit deterioration, model revisions; a decline in NAV; a slowdown in capital raising; a contraction in credit supply, and thus an indirect credit crunch. The consequences are: an increase in default rates; a widening of spreads; and a deterioration of covenants. But these are idiosyncratic, not systemic, phenomena—primarily because risk is not reallocated from the banking system to private funds, institutional investors, insurers, and pension funds.
For these reasons, the author concludes that private credit represents a structurally less fragile system because it is less exposed to liquidity crises and therefore more resilient to shocks. However, it remains an opaque system in terms of valuation and thus risk measurement, and is highly exposed to the risk of a macroeconomic slowdown (credit supply). These characteristics, however, do not make it a systemic trigger, but rather a slow and indirect amplifier in adverse scenarios.
Disclaimer
This post expresses the personal opinions of the Custodia Wealth Management staff who authored it. It does not constitute investment advice or recommendations, nor personalized consulting, and should not be considered an invitation to engage in transactions involving financial instruments.
