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Banks may find it irritating to see loosely regulated private credit making inroads into their businesses. But in general, the growth of the sector is good news for the financial system. Instead of converting short-term deposits into long-term loans (a mismatch that has been known to trip up banks), the funds draw on genuinely long-term capital, broadly matching the duration of their loans.
However, that is only true to the extent that private credit sticks to its primary mission. As the industry expands and extends its tendrils toward new investors and new investment opportunities, there are some areas that should begin to attract regulatory scrutiny.
On the one hand, private loans are becoming increasingly tangled with the traditional banking system. Banks sign partnership agreements with private credit funds and lend them money. This is not necessarily worrying, since the debt is divided and banks end up keeping the less risky tranches on their balance sheets. It is also still minuscule in the context of banks’ loan portfolios. But it’s worth keeping an eye on overall exposure (and whether it’s concentrated on a few lenders in particular or a few private credit managers in particular).
Another issue is the quality of private credit loans. When you engage in direct lending, you often serve riskier businesses, especially now that banks and the syndicated loan market are once again available for those seeking simple debt. Pay-in-kind loans, which allow issuers to defer interest payments, have been increasing, partly as a result of struggling companies looking to refinance.
Whether this additional flexibility will only delay the inevitable blowouts – a drag on the private credit groups themselves and the economy as a whole – or help fundamentally good companies find a path to profitability, is an open question. But as the private credit industry grows, regulators may be interested in delving deeper into loan portfolios.
Most obviously, any effort to attract high-net-worth money, or even retail, is bound to make huge leaps. Just think of the complexities involved in the much-discussed State Street and Apollo project. public-private listed credit fund, for which the companies requested approval in September. There are obvious questions around transparency, pricing and valuation, quite difficult to resolve on a quarterly basis, let alone a daily basis.
The issue of liquidity is even more problematic. If more investors than buyers in the market want to sell their ETF, Apollo is available to purchase a portion of the private loans to provide supporting liquidity. It may not be necessary, especially if the nascent secondary market for private loans develops. But as private credit expands, the old problem of how to convert short-term money into long-term loans may end up resurfacing in unexpected places.