The foundations of the private credit—and private equity—markets are showing signs of crumbling. This matters because an extraordinary amount has been built on them. In the UK, government strategy is explicitly encouraging pension funds to allocate more capital to private assets in order to finance “productive” investment—particularly infrastructure—as a driver of economic growth. At the same time, large life insurers are betting their growth strategies on committing vast sums to acquire defined benefit pension schemes, in part on the assumption that they can generate attractive returns by deploying assets into private credit.
If the underlying markets are becoming unstable, the implications are significant. The question for policymakers, investors and firms alike is simple: what exactly is going on?
A paradox at the heart of private credit
Private credit is often described as a “shadow banking” system—credit intermediation that takes place outside the traditional banking sector. Its very existence poses a paradox. If the returns available in private credit are genuinely attractive relative to risk, why are banks not competing more aggressively to originate and hold these assets?
Investors should be asking precisely that question.
There are, of course, good reasons why banks do not dominate this space. First, the assets themselves often do not match banks’ funding and liquidity profiles. Banks fund themselves largely through deposits that can be withdrawn at (relatively) short notice. While they perform some degree of maturity transformation, long-duration lending—such as financing infrastructure or regulated utilities over decades—sits uncomfortably with this model. The liquidity risk alone can be prohibitive.
By contrast, long-term investors such as life insurers are structurally better suited to hold such assets. Their liabilities are predictable and long dated, enabling them to invest in similarly long-term credit exposures. For a regulated utility with stable cash flows and a quasi-monopolistic position, they can appear to be an almost ideal match.
Second, regulatory and structural factors have historically pushed certain types of credit activity out of the banking sector. Capital requirements, cost bases and business models all play a role. The development of the US commercial paper market in the 1970s provides a useful precedent: a limit on bank deposit rates under Regulation Q drove savings into money market funds, which in turn funded high-quality corporate and financial borrowers directly. Once established, these markets proved both resilient and competitive with over $1 trillion of lending now taking place at any one time.
When the risks are harder to see
The more difficult question arises when private credit extends beyond long-term, stable assets into riskier segments—such as leveraged finance. Here, the risk-return trade-off becomes far more opaque.
The leveraged finance market is vast, and much of it is tied to private equity transactions. Many such deals were structured in a period of exceptionally low interest rates, with high levels of leverage and optimistic assumptions about growth. Over time, the equity assets have often been traded between private equity sponsors at progressively higher valuations, reinforcing reported performance.
Today, that model is under pressure.
Exit routes—particularly via public markets—have become challenging particularly at the high valuations at which PE firms are carrying these investments. Valuations remain elevated on paper, but realisation has slowed. Investors are becoming more vociferous in their demands for liquidity. At the same time, rising interest rates have significantly increased debt servicing costs for portfolio companies. In many cases, this is beginning to erode equity value, weaken credit quality and, in some instances, threaten business viability.
A sign that things are really not well in the market and could get worse was the headline in the FT recently: “Distressed-debt funds excited at private credit opportunity”.
But for long-term investors, particularly pension funds, the prospects are much less exciting.
Concerns about underwriting standards are also becoming more explicit. Jamie Dimon has warned that credit standards in leveraged lending have been weakening and that losses in a future downturn could exceed expectations.
There is increasing scrutiny of the opacity of private credit markets—and the role of smaller, less established credit rating providers. The lessons from the Global Financial Crisis about understanding credit and having transparency of what risks lay where, have either not been learned, been forgotten or simply been ignored.
Liquidity risk: the next fault line
As credit risks begin to crystalise, a further and potentially more destabilising risk has emerged to further tip the balance of risk versus reward: liquidity risk. Shadow banking is starting to show signs of “shadow bank runs” with several funds bringing down the shutters and limiting the amount of funds that investors can withdraw. This can only amplify market stress and undermine confidence.
Implications for the UK policy agenda
These developments are not good news for UK policy in several areas.
First, it’s not good news for life insurers and their growth plans in the rapidly expanding bulk purchase annuity market. Recognising the risks in the UK, the Bank of England has already conducted a Life Insurance Stress Test last year. It has now launched a broader System-Wide Exploratory Scenario to probe private credit risk.
Second, these developments are not good news for the government’s push to channel pension savings into private assets.
What needs to change
For private credit to play a sustainable role in financing the real economy, particularly infrastructure, several shifts are likely to be required.
- More specialisation of funds going forward so that investment and lending to infrastructure is separated from the more potentially problematic investments such as leveraged lending and invoice financing (of companies whose credit quality is lower than that of their customers).
- More transparency and confidence in the credit ratings of investment.
- A focus on proven and standardised types and structures of investment for local authority investment. While some private investments are large enough to justify careful credit analysis and bespoke structuring of the risks, a lot are much smaller. For example, the economic growth projects of the newly formed Mayoral Combined Authorities are going to need strong and compelling business cases and simple and easily understood structuring and terms.
A market at an inflection point?
The private credit market doesn’t have to go into decline. But the current signs are that action is needed to ensure it provides the market for investment that finances the growth in the real economy.
Written by Jonathan Davidson, Founding Partner, Prysm Global
