I’ve been quite critical of private investments. They’ve grown tremendously over the past decade. Drawn to their seemingly high returns and low volatilities, investors have poured billions into them, reallocating funds from traditional public stocks and bonds.
While the Federal Reserve’s (Fed) aggressive policy hikes slowed inflows for some alternative investments, private credit’s continued to climb. Investors clamor for more. Despite my belief that many alternative investment benefits are misunderstood, private credit, in my view, has its virtues; just not what’s commonly discussed.
Investments in alternatives have grown significantly over the past decade. Source: Bain Private Equity Outlook in 2023
Private credit is a subset of the alternative investment universe. Yield-starved investors surged into this market in search of higher returns. Some estimate its market size to have reached $1.5 to $2.1 trillion, globally, placing it on par with the public leveraged loan market. Such growth has understandably raised fears of systemic risk. However, I find them misplaced. Private credit stabilizes the financial system.
New Look, Same Great Taste
To assess the potential risks private credit pose, it’s important to first understand it. Private credit encompasses a broad range of debt investments, including direct lending, mezzanine loans, venture debt, bridge loans, distressed debt, and even structured products. Private credit typically lends money to borrowers unable to access more traditional pools of capital like banks and the public bond market, though the defining lines have increasingly blurred.
While fashionable of late, private credit is not new. (All) private investing predates public markets by millennia. Markets and exchanges where assets could be openly bought and sold among strangers weren’t invented until the 12th or 13th century. Before then, investing was reserved for the wealthy who invested directly with those seeking capital. To be sure, the pool was small for both capital providers and seekers. Most people were preoccupied with basic survival. Few had the luxury of excess savings to invest.
While non-traditional, private credit carries the same investment risk as public credit. In both cases, investors only accept the possibility of borrowers missing contractual principal and interest payments. Public and private lenders just differ in the magnitude of credit risk they underwrite and the liquidity profiles of their loans—i.e. the ability to sell them easily and near “fair value.” These characteristics account for the yield differentials between public and private credit. There’s no free lunch. Private credit investors often assume greater risks for higher yields.
Private Credit’s Replacing Banks
Shifting dynamics in the capital markets fueled private credit’s growth, pulling it into the limelight. Commercial bank consolidation, stringent bank regulations, and changing investor preferences left a financing void for small companies. Traditional financiers shifted their focus to larger companies and larger deal sizes. Private capital stepped in to pick up the slack. Drawn to their higher returns, yield-starved investor interest rose in the near-decade of near-zero interest rates.
Today, private credit funds finance a variety of risks. Banks and the public markets would have traditionally underwritten some, such as loans to private equity firms buying companies; however private lenders’ ability to act quickly has gained them share. Other types of transactions are new, like synthetic risk transfers from banks which only arose from recent regulatory changes. In all respects, private credit’s market participation has grown.
Such large shifts in financing markets carry systemic ramifications. While it worries some, private credit’s growth comforts me.
The Financial System Runs On Leverage
It’s easy to take the financial system for granted. Quietly operating in the background of our daily lives, most give it no thought at all. Only when it breaks do we notice. Buying physical items with swipes of valueless plastic cards, living luxurious lives in retirement without working for decades, and eating out-of-season fruits have become commonplace. They were unimaginable to our forefathers. Our modern financial system enables such wonders.
Despite its pervasiveness, the financial system remains nebulous. While frequently used in market discussions, few consider the concretes comprising the abstraction. At its core, the financial system describes the interconnections and interactions of banks and other financial services companies in their normal courses of business. It is not a singular institution that one can point to. The financial system quite literally is the entire ecosystem surrounding financial transactions.
Thus, sizing and delineating the financial system becomes a difficult task. The Financial Stability Board estimates it to comprise $461 trillion of global assets. Banks account for 40% of them. Non-bank financial intermediaries control an even larger share at 47%. The financial system’s ambiguity speaks to the intimate relationships connecting the various participants.
There are $461 trillion of assets in the financial system globally. Source: Financial Stability Board
Less ambiguous is what fuels the system: leverage. Moving so much value across such vast distances at lightning-fast speeds requires an unimpeded flow of credit. As a matter of routine, institutions lend to and borrow from each other in a dizzying array of arrangements. Financial companies could not perform their basic operations or earn acceptable returns without them. Fundamentally, banks and financial companies are types of carry trades. They make their money by lending and investing borrowed money.
Leverage Fuels and Breaks Financial Companies
Leverage fuels the financial system’s profits. However, it also creates perils. Leverage can cause financial firms to collapse. Borrowing to lend can lead to liquidity strains, and ultimately failure, if cash inflows and outflows are not expertly managed.
Take, for example, the five banking panics preceding the Fed’s founding in 1913. Liquidity mismatches caused them all. Combinations of farmers’ seasonal cash demands, the prohibition of bank branching, and the use of correspondent banking left numerous local banks simultaneously short on cash. Credit typically tightened during the harvest as farmers needed cash to “move the crops” to market to sell. Unable to diversify their customer bases via branching (due to regulatory restrictions), agrarian banks drew on their credit lines with urban banks, such as those in New York, to meet their seasonal cash needs. These interconnections of common risk concentrations created fragile conditions such that an exogenous event, like the run on a New York bank associated with a failed speculator, could spook enough depositors to withdraw their funds to create system-wide bank failures like in the Panic of 1907.
Another systemic bank run predicated the Great Financial Crisis in 2007 and 2008 (GFC). Rating agency downgrades of housing-related securities triggered margin calls at shadow banks that had pledged those securities as collateral in lending schemes. Institutions that could not meet their additional liquidity requirements failed. So too did the institutions that were reliant upon those.
Deposit flight in March of 2023 caused the latest, and second-largest, spike in bank failures when customers fled Silicon Valley Bank, Signature Bank, Silvergate Bank, First Republic Bank, and even Credit Suisse. The banks collapsed when they could not meet cash withdrawal requests.
Absent leverage, no bank could fail. The unplanned demands for capital—which cause their collapse—vanish. Banks’ borrowings—i.e. leverage—create those combustible conditions. Of course, without their leverage, banks wouldn’t be banks; they’d be investment funds.
Less Leverage Is Safer
The use of leverage has always been a tension point. It both fuels economic growth and raises the risk of ruin. Every business relies on it in some shape or form. Most corporations (primarily) employ operating leverage. They mobilize property, plants, equipment, and labor to create goods and services for sale. These upfront costs amount to borrowings to be covered by their revenues. Financial companies—like banks and financing companies—primarily employ financial leverage. They borrow money explicitly to lend and invest. Thus, financial companies’ use of financial leverage is more visible and larger.
Financials play a central role in the economy. They touch nearly every company and individual. Thus, their failures can have widespread public impacts, (in part) leading to their strict political oversight throughout modern history. Minimizing their contagion amounts to constraining financial leverage. Thus, regulatory and statutory responses to crises, from the creation of the Fed in 1913 to the latest Basel framework, share the same goals of boosting liquidity and bolstering capital cushions of the financial institutions they oversee. They all attempt to reduce system-wide leverage to minimize failures and fragility.
Broker-dealer leverage peaked in the GFC. Source: The Fed’s Financial Stability Report
To be sure, the relentless regulatory responses have successfully wrung leverage out of the U.S. financial system. Leverage peaked (in the modern era) during the GFC. It’s halved at broker-dealers (defined as the ratio of assets to equity, shown above) and significantly improved at banks (the inverse measure of tangible common equity to tangible assets, shown below).
Banking sector leverage peaked in the GFC. Source: The Fed’s Financial Stability Report
However, stricter regulations do not account for the entire change. Markets continue to evolve to safeguard investors’ precious capital while still productively deploying it.
Private Capital Fills In
The increased regulatory burdens invariably curbed banks’ lending activities. By reducing their leverage levels, regulations eroded banks’ profit margins. Many were forced to exit lines of business that became unprofitable leaving a market gap in their wake.
Yet, lending did not stop. Instead, new participants entered the market to meet the demand. Other institutions and capital markets evolved and developed. As a result, banks’ market share of loans has cratered.
Lending has increasingly moved away from banks. Source: Deutsche Bank via Topdown Charts
The development of capital markets facilitated companies to access larger and more diverse pools of capital. Deals for credit and equity could be syndicated across many different investors rather than just a handful of banks. Markets opened investing to diverse types of investors possessing varied risk and return profiles.
The risk-averse, risk-seeking, short-term, and long-term capital provider could each participate in different segments. Diversified portfolios could be created. Banks no longer determined the terms for investment capital. The investing ecosystem expanded, diversified, and, as a result, became more resilient.
Changing Capital Providers Changes Market Structures
One expanding class of capital providers is private credit. Here, investors pool their capital in fund structures to provide loans to the aforementioned growing market segments. Aside from increasing capital accessibility, private credit changed the lending landscape in a systemically important way. Since they don’t employ leverage (or much less), private credit’s growth has significantly reduced the leverage of the financial system.
A large bank today might have 16 to 17 times more assets than capital on its balance sheet (using the inverse of the 6% ratio of tangible common equity to tangible assets figure cited by the Fed in the above chart). While low compared to recent history, banks still carry substantially more leverage than private credit funds. Most private credit funds are unleveraged vehicles. Fund investors directly absorb portfolio losses, on a dollar-for-dollar basis via lower future returns. Losses remain contained to the investors’ invested capital. This differs from banks whereby their use of leverage can (and has) magnified losses beyond banks’ existing capital base; hence all their bailouts.
Furthermore, private credit funds typically restrict investors’ abilities to withdraw their funds. This greatly limits the potential for liquidity problems. Private credit funds invest in illiquid assets, by design. Positions cannot be quickly sold (if at all) and might require deep discounting. Limiting investor redemptions provides funds time to raise needed cash and preserve value. Recall that some bank lenders, like depositors, can withdraw their funds at any time, on-demand, which can (and has) lead to catastrophic runs. Private credit funds are not carry trades like banks. They don’t possess hidden liability risks that could bring such a fate, let alone on a systemic scale. Thus, the market share shift to private credit from banks makes the financial system safer.
Private Credit (Inadvertently) to the Rescue
Investors continue to find private credit attractive, drawn to their higher returns and alleged diversification benefits. As a result, some lending has shifted from traditional commercial banks into various investment vehicles focused on that market segment. Private credit’s growth has also expanded to other investment markets such as mezzanine loans, venture debt, bridge loans, distressed debt, and structured products.
Such rapid expansion has understandably raised concerns. Increased competition for deals will likely erode the attractive underwriting standards and expected returns that first attracted investors. However, I believe that any negative result of such behavior will likely be contained without the same systemic risk that banks pose. This does not come from my faith in private credit funds; but rather due to their safer structures than the banks’ they’re replacing.
Banks’ use of leverage weakens them. It creates the potential for asset-liability mismatches and, as a result, liquidity shortfalls that can lead to runs and collapse. Given banks’ interconnectivity and relatively homogenous activities (due to regulations), failures can quickly escalate into systemic risks. The greater the leverage in the financial system, the greater the potential for widespread collapse. Thus, regulators have tried to curb banks’ use of leverage.
Private credit funds, however, employ virtually no leverage (in comparison). As a result, losses will be contained to their existing capital. They pose no threat to anyone beyond their investors. Unlike banks, private credit funds also restrict investors’ redemption rights limiting the potential for the liquidity shortfalls that cause banks to fail.
The shift from banks to private credit illustrates the continued evolution of capital markets. Sure, investors enjoy their new allocations’ higher unleveraged returns. However, we all benefit. By taking market share from banks, private credit funds lower leverage throughout the financial system thereby reducing its systemic fragility.
Thus, while private credit likely will encounter problems, they’ll be for their investors—and theirs alone—to fret. The rest of us should rest easy.