Despite Wall Street’s image as populated by supremely practical, calculating, and somewhat ruthless men and woman — who can solve differential equations in their head while simultaneously using the phone to gain the upper hand in two separate and exotic trades — they really are a fashion-following group of guys and gals. Unlike bell bottoms or purple hair, Wall Street fashions always have a practical origin. Once they get rolling, however, the fashion sustains itself, not the least because Wall Street folk like to see themselves as always on the cutting edge. Because the sweep of investment fashion usually ends in tears, it is only reasonable to cast a wary eye on the latest craze – for private debt.
To describe private debt as fashionable in investment circles is to understate the figures. From next to nothing 10-15 years ago, private lenders control some $1.5 trillion at last count. The amount has almost doubled in just the last three years. Deals are getting bigger. Not too long ago, a single company raised $5.0 billion in private loans. According to Blue Owl Capital, a major player in this space, a $10 billion deal is not far away. Morgan Stanley has forecast that the area will grow to at least $2.3 trillion by 2027. Aside from the drama of the big deals, private credit has all but taken from public markets and the lower end of business lending. Some ten years ago, 60 percent of loans under $250 million were done in public markets. The growing dominance of private lending has reduced that proportion to 10 percent.
At base, private lending is pretty straightforward stuff. Asset holders – individuals, pension funds, insurers – work with specialized institutions to offer credit to companies that otherwise would go to banks for a loan or use investment banks to float bond issues on public markets. Borrowers prefer the private borrowing route because their credit quality might preclude the use of bank or public credit and/or because they can get favorable covenants on private loans that they could not get from the banks or in public debt issues. They accordingly pay a higher interest rate on the loans. That high rate is what attracts the asset holders who fund the private lenders. Of course, as the area has grown, the deals have become increasingly complex and opaque.
As with so many Wall Street fashions, private credit’s initial impetus was practical enough. In the aftermath of the 2008-09 financial crisis, regulators understandably saw a need to constrain risk taking by the banks. The Dodd-Frank financial reform legislation discouraged risk by imposing extra capital requirements on banks that lent to less than highly-credit-worthy borrowers. Facing the great expense of compliance, banks became weary of lending to many businesses. Private lenders filled those financing needs. The rates on these loans were higher than those charged by banks, but borrowers needed the funds and willingly paid the premium rates. Initially, it was easy to pay the premium since market interest rates at this time were close to zero. After the failure of Silicon Valley Bank, the regulators and the banks became even more weary of risk, giving the private lenders still more opportunity.
The ensuing growth attracted more and more enthusiasm on Wall Street – the fashion element – and asset holders flocked to the new attractive asset class. Takeover firms, such as Blackstone and KKR captured the flow of money by establishing their own private lending operations, effectively gathering funds into themselves to finance their other activities. The area has become so popular that inflows have outpaced even the hefty borrowing demand so that at last measure some $400 billion on the $1.5 trillion in the area remains un-employed.
Risks have grown with the increasing size and dominance of the area. If something were to go wrong with many of these undeniably risky credits – say because a recession squeezed borrowers’ profits — the losses would run through financial markets and deepen any economic downturn. Morgan Stanley has tried to dismiss this kind of risk, pointing out that even in the Covid pandemic, private lending losses only amounted to 1.2 percent. But of course three years ago the area was much less hyped, and besides much federal support mitigated the economic strains of the Covid lockdowns in ways that would not exist in any other recession.
More specific risks have arrived with the rise in interest rates since spring 2022. Private loans have always carried higher rates than exist in public markets, but the spread has increased as interest rates generally have risen. Five years ago, private borrowers could procure loans of five-year maturity at about 7 percent, sometimes less. As that loan comes due today, that lender would have to refinance at rates in double digits. Even without the profits squeeze that a recession would impose, this situation could place the borrower in an untenable position. And if that borrower could not meet his or her obligations, the untenable pressure would pass to the private lenders and their backers. Individuals, pension funds, insurers, and the like would suffer losses accordingly. Those close to the situation describe this matter as a debt “cliff.”
As with all investment fashions, dangers have risen with Wall Street’s mounting enthusiasm. Accordingly, some – now well after the fact of the risk taking – are calling for safeguards. PIMCO is asking for regulation (no doubt because it is already well positioned). None of this can address existing risks, of course. For that risk controls, through custom or regulation, should have been in place years ago. Still, even though the horse has gone, it might pay to close the barn door.
If Washington decides to go the regulatory route (no doubt with PIMCO’s sage guidance) it needs to act with an understanding of what it can and should protect. It is a fool’s game to try to stop losses on investments. They occur periodically, with, among other things, recessions and with fashion crazes that have gone too far. Regulation to stop such losses would have to stop all speculation and risk taking, in other words, hold back the basis of economic growth. Heavy regulation on banks is justified not to stop losses generally but because banks accept deposits. Since they are the basis of the nation’s payments system, the authorities need to protect them. That need is not present with private lenders. Even if they and their borrowers disappeared tomorrow and caused heavy losses to asset holders, the nation’s payments system would remain sound. PIMCO and others pushing for regulation now are asking for rules to protect them from losses that are an unavoidable part of their business and something they should have considered when they got involved.
It is a good bet that the private lending boom will end with heavy losses to many. Those losses may extend and deepen a downturn in financial markets and the economy. Because those losses will not threaten the nation’s payment system, they, however severe, will do much less damage that did the crisis of 2008-09, which did threaten that system. As for regulations now, it is neither the business of regulators to protect investors from loss nor in their competence to do so.
