Private debt is Wall Street's new favorite asset class, as the market size rises from less than $500 billion a decade ago to more than $2.7 trillion by 2023, and estimates suggest it could reach $3.5 trillion by 2028. While this lucrative asset class has attracted institutional investors, including private equity, pension funds and insurance companies, some top financial voices—such as the IMF and UBS Chairman Colm Kelleher—have warned that it could be the next big financial bubble.
Private credit generally refers to loans issued by non-banking organizations, such as private equity funds, that lend directly to businesses. This method of financing fills the gap left by traditional banks, which, after the 2008 financial crisis, were restricted by strict rules on high-risk lending. With few restrictions and a willingness to help risky borrowers, private equity funds quickly moved into areas where banks feared to tread, lending billions to companies in industries from manufacturing to retail. The sector, however, is not as closely regulated as traditional banks, raising concerns about whether investors are fully prepared for the risks involved.
Industry leaders have warned that the call is coming from inside the house. “There has been a change in the private markets; before the global financial crisis, the risk was inside the banks, now it's outside,” Jamie Weinstein, managing director at PIMCO that helped lead $170 billion in alternative investments, told Bloomberg TV in November 2023. “There's been this massive transfer of risk. investors. The question is when will the regulators start looking,” he added. Kelleher expressed a similar view: “There is clearly an asset bubble going on in private debt,” he told investors at the FT Global Banking conference in November last year.
The data supports their concerns. A study by Bloomberg and Solve, a fixed-income analyst firm, found that private equity managers tend to rate their holdings as safer than publicly traded investments held by big banks. In addition, the ratings of the same asset can vary widely across private equity funds, highlighting significant inconsistencies in how these companies measure risk. For example, a loan given to Magenta Buyer, the financing arm of a cybersecurity company, was valued at 79 cents on the dollar by a highly optimistic private lender, suggesting strong recovery expectations. However, another lender is marking the same loan at 46 cents on the dollar, putting it firmly in distressed territory.
Evidence is beginning to mount that sovereign credit ratings may not be sustainable. On average, private equity firms recovered only 48 cents on the dollar after a default, compared to 55 cents for loans issued by banks. Poor recovery rates among private loans indicate higher-than-expected risk among their funds. Notably, private loan managers tend to value their loans very optimistically in the lead up to defaults. Six months before paying off the loan, private loans averaged 76 cents on the dollar, compared to 67 cents for bank-backed loans. In the three months before the crash, the gap narrowed slightly, with private loans marked at 70 cents compared to 61 cents for bank loans. Private equity funds, it seems, are trying to keep investment rates up, which gives investors a false sense of security.
For institutional investors, private debt is an attractive investment. It promises higher risk-adjusted returns than equities and government bonds and is relatively protected from the volatility of the publicly traded markets. However, it is possible that the industry is standing on weak legs.
