Private equity principals could scarcely contain their enthusiasm for the virtues of private credit or debt (and the juicy fee income to be generated from originating these deals) at the recent African Private Capital Association (Avca) private equity conference in Sandton.
The allure of private credit is undeniable. It offers borrowers flexibility away from the prying eyes of public markets and provides investors with juicy returns in a yield-starved world. But, like an iceberg, what lies beneath its surface could sink the unwary.
Just last week, private equity titan Apollo, headquartered in New York, announced an upward revision of its projections for the long-term trajectory of its lending division. Shareholders were informed of the company’s expectation that new loan origination would top the $200bn mark annually, a significant increase on the previous estimate of $150bn. This surge contrasts sharply with last year’s issuance of $97bn, which notably included loans extended to European giants Vonovia and Air France-KLM.
Private credit, once a back seat player, now finds itself at the heart of financial strategies globally, including in Africa, as demand for debt swells despite rising interest rates, ballooning to sizes that rival traditional credit markets. But as this sector grows it drags along a raft of risks that remain largely underexamined.
Let's consider the facts laid bare in a conversation I had with industry leader Edmund Higenbottam, who helped design Pan African investment manager Verdant Capital’s hybrid fund strategy. “Fifteen years ago, private credit was just mezzanine. But now we see a variety of different strategies sectorally but also in terms of layers in the capital stack. The big asset class in private credit today is senior and stretch seniors, not mezzanine any more. And that in itself is interesting. To some extent, that's the funds competing with the banks,” said Higenbottam.
His observation touches on one of the main drivers of this tectonic shift in private equity and credit markets: changes in bank regulation since the global financial crisis. The air inflating the ballooning private credit market has been largely by design of the regulators. After the 2008 global financial crisis regulators wanted to squeeze out a lot of the riskier stuff from the banks’ capital structures and into the so-called shadow banking market, which includes things like business development companies and private credit funds.
Higenbottam says there are “societal issues of deposit-taking institutions with implicit sovereign guarantees playing in risky asset classes” and we saw the backlash against socialising losses during the global financial crisis. “We’re living in a world today where regulation of deposit money banks is relatively tight but actually so it should be.”
I’m not sure I buy it. Societal risks are just being shifted from depositors to pensioners while the fund managers rake in the fees. Institutional investors such as pension funds and insurance firms have enthusiastically invested in these long-dated illiquid products that provide better returns and lower volatility. But that means a portion of our retirement savings are tethered to this market segment too.
Higenbottam believes the resilience of private credit can be attributed to its structural advantages over syndicated markets. The personalised, relationship-based nature of private credit deals provides more direct communication and flexibility between lenders and borrowers.
The private credit market is clearly revelling in its newfound freedom, yet this freedom comes with an expensive price tag opacity and illiquidity. Private market loans are rarely traded and hence cannot be evaluated using market pricing. Instead, they are frequently marked just quarterly using risk models, which may result in stale and subjective values among funds.
In his annual letter to shareholders JPMorgan CEO Jamie Dimon dedicated an unusual lot of space to the subject. Maybe he’s just talking his own book as private credit funds encroach on banking’s traditional terrain, but he raises some important concerns.
Anticipating increased regulatory scrutiny, Dimon made the call for greater transparency in asset valuation, an area where private credit falls short compared to public markets. Private credit is yet to be tested by a market downturn, and the potential for liquidity challenges could lead to a “credit crunch” for borrowers. “Under stress conditions, private creditors would have to charge exorbitant prices that companies simply cannot afford to book the new loan at par. Banks are in a slightly different position,” writes Dimon.
The regulatory watchdogs that once kept the banks on a short leash have now turned their gaze towards this burgeoning sector as the IMF flagged the growing risks in a blog post two weeks ago based on chapter 2 of the April 2024 Global Financial Stability Report: “The Rise and Risks of Private Credit.”
With more than $1-trillion of debt poised to mature and refinance at climbing interest rates, the real test of this market’s resilience is upon us. In Africa, where private credit has seen a meteoric rise, the stakes are particularly high. As interest rates remain higher for longer, the siren song of private credit may well lead many into precarious waters.
Let's not be lulled into complacency by today's calm. It’s time to demand more transparency and insist on regulations that don’t stifle innovation but ensure private credit doesn’t trigger the next global financial crisis.
• Avery, a financial journalist and broadcaster, produces BDTV's Business Watch. Contact him at Badger@businesslive.co.za.
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