Latest / Look Forward / Pressure Points: Liquidity, Complexity, and the Rise of Private Credit | Look Forward Ep. 37

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Pressure Points: Liquidity, Complexity, and the Rise of Private Credit | Look Forward Ep. 37 · Look Forward

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Hello, and welcome to the Look Forward podcast, powered by the S&P Global
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Institute, the platform for enterprise thought leadership across S&P Global.
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I'm Molly Mintz, Lead Strategist at S&P Global Ratings, and
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I'll be your host today.
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Markets are moving faster, risks are shifting, and
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decision-makers need foresight.
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In this podcast, we bring you expert perspectives from across S&P Global on
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the macroeconomic, market, energy, and technology forces shaping what comes
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next, helping you navigate uncertainty and look forward with confidence.
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Recent investor redemptions and the potential for AI disruption have put
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private credit under fresh scrutiny.
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As private markets expand and new capital enters the financing ecosystem, greater
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scale and growing interconnections with public markets have raised questions
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about whether systemic risks could emerge.
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On this episode of the Look Forward podcast, powered by the S&P Global
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Institute, I'm joined by two colleagues from S&P Global Ratings, Matthew Mitchell,
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Managing Director for Structured Finance, and Evan Gunter, Managing Director
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and Head of Private Markets Research.
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Today, we're delving into their recent insights on the pressure points to
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watch in the market for potential systemic risk from private credit.
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Matt, Evan, thanks so much for joining the podcast today.
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Thanks, Molly.
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Great to be here.
1:41
Molly, thanks for hosting us.
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So good to see you again.
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My first question is about the rise of private credit.
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So the rise of private credit has added to the dynamic nature and the
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depth of capital markets and provided additional sources of financing to
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borrowers, evolving over the past two decades of banking disintermediation
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into an advanced ecosystem of alternative asset managers and the
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investment vehicles that they manage.
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Now, we've seen private credit recently experience a shift in perception
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from being an enviable asset class to enduring heightened scrutiny.
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Matt, I'm looking to you to start and set the stage.
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How did we get here, and what is driving this current state of play?
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Sure.
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So the initial growth phase of private credit really followed
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the global financial crisis, where banks significantly curtailed
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their lending, leaving a gap for many mid-market borrowers.
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Uh, and that's where private le- pr- private credit lenders really
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stepped in to, to fill that void.
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So they stepped in via direct lending.
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The market has since really experienced dramatic growth.
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Uh, right now in the direct lending space, some participants estimate
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that it's at about $2 trillion, so really mirroring that now of
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the broadly syndicated loan space.
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Uh, and naturally, as markets grow in scale and sophistication, there
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is going to be increased concern about their potential influence on
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the broader financial system Uh, we are also seeing a changing landscape
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though with respect to the originations now of many private credit lenders.
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So some of the initial draw was to direct lending and the yield pickup
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that you could get, but now with more competition, we've seen spread compression
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in that space and a look for managers to really diversify, uh, and grow and
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diversify their AUM into other sectors.
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And I think one of the fastest-growing segments has been in the asset-based
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finance space, uh, where the collateral as well as deal structure can provide
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significant protection to lenders.
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Uh, and when I talk about asset-based finance, it's really
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a very, very diverse sector.
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It can include things such as equipment finance, so think
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airlines, think shipping.
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Uh, you can think of royalty streams such as music rights, residential
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and commercial real estate, and really recently gathering all the
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headlines is digital infrastructure.
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And it's not just the data centers themselves, but also their power
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supplies, the, you know, equipment in the racks, cooling, uh, and GPU leases
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as well, uh, really taking off within probably the past 12 to 24 months
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in the private credit space and the types of queries that we're getting.
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Uh, now I've touched on half the growth story, looking at the assets.
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Uh, the other half of the equation though needs to be where
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is this capital coming from?
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Uh, and we do see a mix of institutional investors, uh, you know, sovereign wealth
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funds, pension funds, some high net worth individuals and other retail money.
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Uh, but one of the key growth, growth drivers here has been insurance companies
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and just the amount of capital that's been flowing into retirement annuities.
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This has resulted in innovative fundraising structures by these funds
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and by the private credit managers.
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Uh, examples like rated note feeders, collateralized fund obligations, uh,
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and the fund structures as well now evolving to match the amortization
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profile of these longer-dated liabilities.
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Matt, thank you.
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That's a perfect transition to take a closer look at what's
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happening with business development companies, a different investment
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vehicle that are really capturing market attention right now.
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Evan, this is a question for you.
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S&P Global rates over 15 BDCs with total assets of approximately $325 billion
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at the end of last year, providing us with visibility into BDCs that
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cover around 55% of total BDC AUM.
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Given this breadth of perspective, what is S&P Global Rating's view of
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these investment vehicles' credit and redemption risks at this time?
5:47
Molly, thanks for having us here.
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Um, this is a good question, and it's one that is being asked
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frequently throughout the market.
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With AI advancement, what kind of potential disruption does that
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have for the software sector?
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And, uh, if related to that, what kind of impact does it have on the-- what
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kind of impact does it have on BDCs?
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We don't believe that the credit impact or the redemption risk impact
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is a near-term risk, uh, for the software companies or for the BDCs.
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Uh, among software companies for which we have a, a credit opinion
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through our credit estimates, so these are, uh, companies whose
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loans are held by mid-market CLOs.
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We see recent credit quality has shown resilience.
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There's been more upgrades than downgrades of credit estimates, and the default rate
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has been coming down over the last year.
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Within this strong performance, software is one of the strongest performing
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sectors within credit estimates.
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When we think about the potential impact of AI and AI disruption, we
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don't expect this to be uniform.
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Uh, we expect the impact to be more differentiated.
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Uh, you can kinda think about that as there's gonna be
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some winners and some losers.
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Those with a wider moat, uh, those companies we would expect to be more
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resilient, are likely those that have proprietary data, embedded customer
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relationships, or ones that offer more mission-critical products And on the
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other side, those that are more vulnerable to the potential for AI disruption are
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those that likely have more narrow moats.
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And, but also the credit risk for these is not immediate.
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It's more of an eventual impact to the enterprise valuations, and
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this could add to the refinancing challenges down the line, uh, such as
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in twenty-twenty eight when maturities rise, uh, those twenty-twenty eight
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maturities are kind of-- There was a lot of debt that was issued right
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after COVID, uh, much of which is coming due in twenty-twenty eight.
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Even though we expect the impact of AI disruption will be differentiated,
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investors took-- Well, investors took a more sell first, ask questions
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later approach earlier this year.
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In broadly syndicated loans, we saw software prices drop from about
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ninety-four in January down to below eighty-eight by March, and those
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prices really haven't recovered yet.
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Meanwhile, the publicly traded BDCs are trading at near twenty-- were trading
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at near twenty percent discounts.
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But the private, the non-traded BDCs did not have such a discount.
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They weren't marked down, and we saw a surge of redemption
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requests coming from investors.
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Now, typically, a non-traded BDC limits redemptions to five
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percent of its net asset value.
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This is a way for them to protect the existing investors
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and prevent forced selling.
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Where the non-traded BDCs limited their outflows to five percent, they were
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functioning as they were intended, but the headlines of funds limiting
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redemptions added to investor concerns So our rating analysts who cover the
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BDC sector recently did a stress test.
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It was a very, uh-- It was a pretty harsh assumption in their stress test
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where they were assuming no inflows for the perpetual non-traded BDCs
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and no, uh, level two asset sales.
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And the stress test was to see, uh, how is their liquidity if they're
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facing continued elevated redemptions.
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So in the stress test, even with no inflows, uh, the rated perpetual
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non-traded BDCs showed sufficient liquidity to withstand four quarters
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or more of these elevated outflows.
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The software sector is facing potential disruption from AI, and this
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is adding to the pressure on BDCs.
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But we don't view either of these cases, the potential disruption for AI or,
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uh, the potential, uh, for elevated redemptions, uh, to be a near-term risk.
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Credit quality in software is holding up, as is the liquidity among the rated BDCs.
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So from a macro credit perspective, given the rapid change in this market and its
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recent challenges, S&P Global Ratings' latest credit conditions research noted
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that rising stress in private credit is a top risk to watch due to its potential
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to impair liquidity, erode investor confidence, and add to market volatility,
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primarily in North America, but with a possible spillover to other regions.
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Bringing both of you into the conversation now, what are the pressure
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points in private credit that could potentially have systemic implications?
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So Matt and I worked together on a research report earlier this
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year that looked at pressure points in private credit.
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And one of the things that we were looking at is that the private credit
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market is changing as it's growing, and some of these changes could
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put more pressure on the system.
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First of all, a pressure point is liquidity.
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Private credit assets are by and large gonna be illiquid buy-and-hold assets.
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A fund manager must match the timing of their liabilities against this largely
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illiquid asset For a fund structure with locked-in capital, it's easier
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to plan for the timing of liabilities, but a semi-liquid fund structure,
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uh, such as those non-traded BDCs or interval, or interval funds, it's
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harder to predict when the investor will demand a return of capital.
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But as the market's been changing, semi-liquid funds have seen the
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most growth in recent years.
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Five years ago, publicly traded vehicles accounted for the majority
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of BDCs, but now they've been far surpassed by the non-traded BDCs.
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So this rise of semi-liquid vehicles adds one potential pressure point
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Another potential pressure point is the complexity.
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Uh, private credit is not just mid-market corporate direct lending anymore.
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As Matt was mentioning, there's lending that's going to large corporates, digital
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infrastructure, as well as vehicles such as asset-based finance and SRTs.
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It's a market that's growing in diversity and complexity.
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One sign of this, uh, is among recent fund launches, specialty finance
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is gaining as a strategy with more new fund launches, uh, growing as
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a share relative to direct lending.
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Another potential pressure point is the interconnections.
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As the market is growing, we're also seeing it's increasingly connected
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to banks and insurers, which are some of the more systemically
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important players in the market.
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Among banks, non-bank financial institution lending has been their fastest
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growth area, and among insurers, private credit has been a growth area for their
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asset holdings, especially for life insurers, where, uh, in life insurers, we
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estimate that about 10% of North American life insurers have bond holdings that
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are privately rated and privately placed
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Another, uh, another area
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is concentration is a potential pressure point.
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What we've seen with the investor concerns for software is a good reminder
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about the importance of diversification.
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BDCs show a concentration in software that accounts for about twenty percent of their
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loan assets, and mid-market CLOs have about a sixteen percent concentration.
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Diversification is a key pillar of risk management, and so we'd
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expect that rising concentration in non-diversified risks would further
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add to the pressure within the system
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And maybe I'll dive in with some specific examples, uh, speaking to what
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Evans talked about with respect to the complexity and interconnectedness aspect.
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So on the complexity side of things, as I mentioned at the start and as Evans
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alluded to, we have seen kind of material growth within the digital infrastructure
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and asset-based finance or ABF space.
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Uh, this can add complexity relative to direct lending because it requires
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an assessment of risk related to construction, technology, some esoteric
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assets, uh, alongside additional legal and structural mechanics, uh,
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and increased operational risks.
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Uh, furthermore, with some of the new debt structures that we're seeing
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now, so I mentioned, uh, you know, rated note feeders, collateralized
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fund obligations at the fund level.
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Looking down to the underlying asset level, you've got different
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combinations of backed leverage, structured equity, uh, and these can
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really increase the structural and contractual complexities that are at play.
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On the interconnectedness side of things, the common one that comes up right now
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is significant risk transfers or SRTs.
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This is getting a lot of attention by regulators, uh, in particular given
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the relatively small number of private credit funds that comprise some of
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the largest investors in this market.
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Uh, some of the risks that have been identified here include potential
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hidden leverage in the financial system.
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And what that's speaking to is if banks are providing funding, so fund
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finance facilities, repo facilities to these lenders, have you actually truly
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transferred the risk of those portfolios outside of the financial system?
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Uh, and also just from a capital perspective, banks' reliance on
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these private capital providers, uh, given that it's not a permanent
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source of capital for these banks.
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Uh, so you know, banks need to be conscious of the ability to
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go out and issue new SRTs to continue their originations and
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just from a capital perspective.
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But we have seen mitigants to these risks.
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For instance, for banks, they typically are staggering their maturity
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profiles such that there's not kind of a refinancing wave, uh, that's
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needed to really mitigate that, that potential capital impact if, for
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whatever reason, they can't access the SRT markets and these private
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capital lenders aren't available.
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But notably, these pressure points haven't imploded.
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Your view is that current stresses in private credit are unlikely to pose a
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risk that would materially disrupt the financial system or the broader economy.
16:50
So my bigger question is: what would it take for systemic risk
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to materialize in private credit?
16:56
Thanks, Molly.
16:57
So as you're kind of mentioning there in your question, a systemic risk is
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one where the risk of disruption of financial services has serious negative
17:08
consequences for the real economy.
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We get the question, does private credit pose a systemic risk?
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And when we started thinking about it, uh, we came to the approach that
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systemic risk is not a singular risk.
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It consists of three separate components.
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The first component is system-wide risk.
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So what are some of the risks that are s- across the entire system?
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In this case, we're looking at some of those things that are inherent to
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private credit, including the limited liquidity, uh, the limits to transparency,
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and also, as Matt was describing, kind of like a new system-wide risk that's
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sort of on the rise is this rising complexity, uh, especially as the market
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is extending, uh, to asset-based finance, digital infrastructure, uh, and SRTs.
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The second component is the contagion risk.
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How could the failure of one entity pose risks to another in the system?
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Some of the factors that can heighten contagion risk
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include the interconnection.
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So like Matt was describing, uh, banks' funding and the transfer of risks
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within the private credit system.
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Uh, these dependencies across institutions for funding or the
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shared exposures is one potential factor that can affect contagion.
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Uh, another factor for contagion to look at is leverage.
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Leverage amplifies risk, and as you have new vehicles in the market, uh, it can add
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new leverage or new layers of leverage.
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Uh, separately, uh, always with contagion risk, uh, there's concentrations.
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Are there concentrations of non-diversified risks that
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are pooling within the system?
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That's one of the factors to consider, uh, for whether there's contagion,
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uh, contagion risk within a system.
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The third component is systemic importance.
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How critical is the entity to the system itself?
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For an institution, uh, there's the risk that a failure or loss of a specific
19:19
party, like for instance a bank, an insurer, or an investor, could trigger
19:23
a loss of economic value or confidence in the broader financial system.
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So when we look at these exposures, we think, okay, is this exposure held by
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an entity that's systemically important?
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And then the other key systemic importance is what is the exposure level?
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So it's not just is this party holding a risky asset, but how
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exposed are they to a risky asset?
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And is the size of the investment, uh, particularly as held by a
19:55
systemically important institution, is that exposure large enough
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that a loss would be material?
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So taken together, this system-wide risk, contagion risk, and systemic
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importance are the factors to evaluate and to determine if private
20:12
credit poses a systemic risk.
20:16
And maybe jumping further into Evan's comments on concentration.
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So with increased concentration has the potential for increased
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correlation of performance as well.
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Uh, that's not only necessarily default risk, but also market value risk.
20:29
A lot of the financing structures that we've seen in place aren't
20:32
necessarily just credit-dependent, but they could have triggers related
20:35
to the actual mark-to-market values.
20:38
Uh, and if pricing models were to change, we question whether that potentially
20:43
means an impact across any asset, uh, in particular those level three assets
20:47
that may be hard to value that are illiquid in the private credit space.
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Uh, and also the, the other thing that we think about is not just
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default risk, but in going back to the earlier comments of, well, where
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is the capital coming from that's fueled this growth in private credit?
21:02
It's from prudentially regulated institutions, so
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primarily insurance companies.
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And so it's not just about default, but what is the capital impact upon downgrade?
21:11
And so thinking about credit stability is also a big part of what we've been
21:15
doing, and some of the sensitivity and stability tests and, and commentaries
21:19
that Evan's, uh, already discussed look at what would the capital impact be if you
21:24
were to have wide-widespread credit stress within these private credit portfolios.
21:29
And right now, we do believe that there is a sufficient capital buffer that
21:32
we wouldn't be expecting a material ratings impact even under a, you know,
21:36
fairly conservative stress scenario.
21:39
Now we're going to bring out our crystal ball.
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It wouldn't be the Look Forward podcast if we didn't look ahead.
21:46
The interplay between public and private markets, the potential risks
21:50
that could arise from the rapid growth and interconnectedness of these
21:54
markets, and the complexity of exposure between traditional financial market
21:59
institutions and private market players, all of these are clearly intensifying.
22:05
So looking forward, how do you both anticipate that this nexus will
22:09
evolve, and likewise, the potential for systemic risk over time?
22:15
Thanks, Molly.
22:16
So when I look into my crystal ball for the future of markets, one thing that it's
22:21
clearly pointing to is that this private market, private credit in particular, is
22:27
a market that's growing and it's evolving, and the investor base for it is expanding.
22:33
While liquidity and transparency are key features of the private credit
22:38
market, with this expanding investor base, there are new investors coming
22:43
into the market that are putting new demands, uh, for liquidity, new demands
22:49
for more sources of transparency.
22:52
Like Matt was just mentioning, uh, looking into where the capital is coming from, uh,
22:57
and more insurers coming into this market.
23:00
That's creating new demands out there, uh, for liquidity as well
23:04
as for transparency and reporting.
23:08
For liquidity, there's new fund structures.
23:10
Uh, I mentioned the growth of semi-liquid structures.
23:13
Uh, also, uh, there's initiatives to start secondary market for
23:18
trading of private credit assets.
23:21
Uh, so that'll be another source of liquidity at the asset level There's
23:25
also the growth of credit secondaries as LPs that have been holding onto funds in
23:32
a slowing exit environment, uh, or GPs looking for ways to unlock liquidity.
23:39
For transparency, the stress that private credit has come under so
23:42
far this year is adding to more demand from investors and regulators
23:48
for more standardized information on asset quality and performance.
23:54
In an opaque market, a question on confidence from
23:57
investors can spread quickly.
23:59
Already we're starting to see signs of enhanced and more standardized
24:04
reporting coming to market.
24:06
Like for instance, we've seen U.S. banks have started providing
24:09
more disclosures on private credit and private equity exposures.
24:13
Insurers are updating how they classify private assets
24:17
with guidance from the NAIC.
24:19
And LPs are increasingly looking for more standardized reporting
24:23
of performance and assets that are included, uh, from the GPs.
24:29
As the market matures, I expect investors will likely coalesce
24:33
around new standardizations for tracking, uh, and for the reporting
24:38
and analyzing of private credit.
24:41
And from my perspective, where we've seen a lot of the headlines related
24:45
to private credit today are in the direct lending space, and naturally
24:48
we do view those as riskier credits.
24:50
Those are typically in the single B to triple C rating category, uh, where we
24:55
believe that the likelihood of default is, you know, is a material risk.
24:59
Where we've seen the shift in capital flows within private markets is more
25:03
now into the asset-based finance space or multi-credit strategy funds.
25:08
And a lot of the times these are being structured, and I'm probably
25:11
biased because I have the structured finance background, but these
25:13
investments are being structured to an investment-grade rating level.
25:16
So you're seeing r- a, a fundamental shift in the risk profile that's being
25:20
taken, uh, to really more stable, predictable cash flows that are matching
25:26
that of who ultimately the end LPs are now in the, in these vehicles.
25:31
Matt, Evan, I certainly learned so much from this conversation.
25:35
Thank you both so much for joining the podcast and sharing your insights.
25:40
Thanks, Molly.
25:40
Thanks for having us, Molly.
25:42
To our listeners, thank you for listening to the Look Forward podcast,
25:45
powered by the S&P Global Institute.
25:49
To access the research and insights discussed, please visit
25:52
spglobal.com/ratings/private markets.
25:57
And to learn more about the S&P Global Institute, please visit spglobal.com.
26:03
I'm your host, Molly Mintz, and I'm looking forward to accelerating essential
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intelligence together next time.