Clarifying the Risks in Private Credit

Risk vs Reality: Our Perspective on Private Credit

The striking growth of private credit over the last decade has attracted significant attention, with much of the focus on the perceived potential risks arising from its rapid adoption.

In particular, analysts and policymakers have raised questions about whether private credit could become a source of systemic risk, due to the credit expansion that private markets have facilitated and the lack of public transparency in private credit portfolios given the nature of private investments.

Amid economic uncertainty and market volatility, questions about “the next systemic risk” are drawing attention from investors and the media alike, as well as prompting calls for enhanced regulation of private credit markets.

As a pioneer in private credit and one of the largest managers in the market, we firmly support stronger regulation and standardization, and believe it’s important to shed light on and address some of the dynamics fueling these concerns.

The Growth–and Transformation–of Private Credit

Over the last 10 years, private credit has undergone a major transformation. Market observers often focus on the sector’s rapid growth over that period. We think it is equally important to recognize that this growth has been accompanied by structural improvement in credit quality.

Historically, private credit focused on direct lending to smaller, middle-market companies. Smaller businesses were able to access capital that they lacked in the public markets and investors could earn higher interest rates by lending to them. However, given the relatively small size of the borrowers, credit risk could be a significant factor.

Over the last decade, private equity firms have increasingly adopted private credit as a solution for financing their largest companies. Historically, sponsors would have relied on the public markets to access credit for companies of this size. This is a meaningful shift. At the same time, institutional and private wealth investors with long-term investment horizons have increasingly looked to private credit as a potential source of downside-protected income.¹ 
 

Figure 1 The $1B Direct Lending Deal Has Become Increasingly Common²

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That pairing has generally proven effective. The private credit investor base seeks exposure to stable and predictable income-generating assets to meet funding ratios and long-term pension obligations. Additionally, investors in private credit generally aren’t seeking capital gains and often place less emphasis on secondary market liquidity. Instead, they are investing on long time horizons and typically prefer to minimize the impact of mark-to-market volatility, which can occur in public credit markets during shorter-term dislocations. Private credit allows these investors to lend, long-term, to a diversified set of large, stable companies that are sponsored by large private equity investors with significant skin in the game.

This virtuous cycle—whereby a growing investor base allows managers to lend to larger and stronger companies, driving a structural improvement in credit quality that attracts more investors—has not just driven growth in private credit, it has transformed the asset class.
 

Figure 2 Percent of Leveraged Buyouts Financed by Private Credit³

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What if Everything Goes South?

As private credit has grown and become more integrated into the broader financial system, market observers have reasoned that this combination could amplify economic and market volatility in a crisis.

Assessing “systemic” risks in private credit is complicated by a lack of suitable historical market events for comparison. COVID was a serious economic and market crisis. The US economy almost ground to a halt. While the COVID shock was severe, policymakers took extraordinary measures and were able to restore order in the financial system relatively quickly. As a result, COVID may be considered inadequate as a stress test due to the brevity of its impact on capital markets. Still, private credit performed well throughout a period of financial shock, illustrating the limited effect of short-term volatility on the long-term performance of the asset class.

The 2008 financial crisis provides an example of how systemic risks can arise from excessive credit creation within an interconnected financial system. But the housing crisis is not comparable to the growth and transformation in private credit. In 2008, banks were directly exposed to over-levered individuals. Mortgage credit risk was securitized, transformed and transferred to investors seeking AAA-rated assets that were ultimately backed by highly leveraged, poorly underwritten loans.

In contrast, private credit generally lends to large companies at loan-to-value ratios of 30-40%; implying sponsors have more skin in the game than lenders do and provide very significant equity cushion. Furthermore, private credit does not have the asset liability mismatches or risk transfers typical of traditional banking. At Blue Owl, we underwrite our loans with the intention to hold them to maturity, matching the longterm and/or permanent nature of our investors’ capital. Because private credit investments are not publicly traded, they are generally insulated from short-term market volatility, ratings downgrades, or forced sales by investors seeking liquidity. This matching of long-term capital with less liquid private credit assets substantially reduces the potential for liquidity-driven dislocations, which has been prevalent in previous market crises.

In today’s environment, we believe concerns about systemic risk stem from fears around a potential recession. The US economy has performed well post-COVID, providing an attractive backdrop for companies and for fundraising by private credit managers. Should the economy fall into a recession, it’s reasonable to expect that there may be challenges to credit after what has been a period of credit expansion.

However, we think a recession scenario is far more likely to result in the dispersion in the performance of private credit managers rather than a broad-based deterioration in the asset class. Leverage in private credit funds is relatively modest, at about one turn of leverage, compared to banks that can be 10-20 times levered. But in the world of investing, not all managers are created equal, and some may underperform in an economic slowdown.

In our portfolios, we aim to finance stable companies in non-cyclical, recession-resilient sectors, but we acknowledge that a prolonged economic downturn could eventually impact companies across all sectors. We believe that our portfolios – and most wellperforming ones – are positioned to absorb modest losses with the potential for returns to outweigh the impact overtime, limiting the effect on investors.

Conclusion

Today, the companies we are financing represent some of the highest quality opportunities we have seen in private credit.

They are generally larger, more diversified and have more sophisticated management teams. We aim to underwrite loans to stable, defensive companies and hold them to maturity. If credit issues arise, we can work directly with companies on a long-term time horizon to maximize value for our investors. Many of our investors are focused on the predictable, diversifying income generated by the asset class and are not seeking capital gains. Many investors prefer the stability of holding less-liquid assets that are generally insulated from short-term mark-to-market volatility, ratings fluctuations, or forced selling.

In sum, we believe private credit is a well-constructed asset class that aligns the needs of its investor base with the needs of large companies sponsored by highly sophisticated private equity investors in sensibly leveraged, long term investment vehicles. We support the goal of making it easier for policymakers to assess risks in private credit markets and believe that valuation processes are an area that would benefit from increased standardization. However, we believe private credit is very unlikely to be the nexus of the “next crisis”. If problems arise due to recession, we think dispersion in manager performance and loan valuations is the most likely result. We believe this process would underscore the strength of larger players in the market.

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1 References to “downside protection” or similar language are not guarantees against loss of investment capital or value.
2 Source: KBRA DLD Scorecard.
3 Source: Pitchbook, LCD Data. Represents percentage of number of leveraged buyouts financed via private credit and broadly syndicated loan markets.

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