Is private credit in a bubble?

Asset managers and investors from across the world have been asking the question posed in the title of this article with increasing focus in recent months. The answer is far from a simple “yes” or “no”. As with most things in finance, the private credit situation is nuanced.

A story of growth

Private credit has been in the news a lot lately. What has attracted this increased attention? Partners Group writes in a recent report: “Concerns around redemptions, valuations, and software exposure due to AI disruption have driven a sharp shift in sentiment, at times framing the asset class as facing systemic stress.”

How did we get here? The conventional story is that private credit, as an asset class, rather than a niche function of the financial world, was born in the aftermath of the 2008 global financial crisis (GFC). Following the GFC, bank regulations curtailed bank lending, leaving space for asset managers to step in and provide credit to businesses. As Goldman Sachs puts it, this change “reshaped the lending landscape”.

Since 2007, private credit has expanded to around $3.5trn. However, as the chart above shows, the private credit universe, as it grew, became more diversified in terms of strategies. As data from the Bank of Japan shows, when it comes to geographical regions, private credit remains a U.S.-centric story,  with growth outside the U.S. only occurring over the last six or so years.

This exponential growth has been, at least indirectly, a reason why some market commentators have been worrying about a potential bubble. However, the story is more nuanced. Let’s look at what recent activity data shows us.

A review of recent activity

Northleaf Capital Partners in a recent quarterly update wrote:

“The first quarter of the year was characterized by a volatile and more uncertain backdrop mainly due to broader concerns around geopolitical tension, commodity prices and the potential for artificial intelligence (“AI”) disruption across a range of industries. Private credit saw a multi-year peak in investor redemption requests from retail-oriented structures, notably U.S. Business Development Companies (“BDCs”).”

That BDCs are heading towards risky territory is not new news. However, what are BDCs? Mawer Investment Management explains:

“BDCs provide loans to middle-market companies, typically with EBITDA ranging from $10 million to $200 million, that fund growth initiatives, acquisitions, or debt refinancing. Their loans are usually senior secured, floating rate, and structured with covenants, amortization, and occasionally equity co-investments.

Most BDCs use moderate leverage to increase returns in their investment portfolio, capped by regulation at roughly 2:1 debt-to-equity. BDCs generate returns through net interest income, fee income, and occasionally realized gains. The result is a portfolio meant to produce steady yields, while providing investors with quarterly disclosure of portfolio composition, asset quality, fair value marks, and non-accruals—data that is rarely available in the private credit world.

This transparency is why BDCs are often used as a proxy for the broader private credit industry.”

Lately, BDCs have experienced massive growth, as S&P Dow Jones Indices has noted in a recent article. It is here within the private credit universe that many redemptions have been concentrated, as PGIM’s data shows.

Moreover, private credit and traditional lending are increasingly crossing paths. Goldman Sachs wrote: “Currently, banks provide financing to private credit managers in the form of working capital facilities and fund-level leverage.”

Given how fast things are evolving, what should investors make of all of this? Is private credit in a bubble or not?

What does this mean for investors?

Adam Street Partners noted in a recent report that “sensational headlines attract attention, but they rarely capture the full picture. It is worth stepping back from the noise to assess the current state of the private credit market with greater perspective.” The report acknowledges that there are some risks, but it keeps a pragmatic approach to what these are:

“Recent concerns were sparked by a series of well-publicized bankruptcies, including First Brands, Tricolor, and UK-based Mortgage Financial Solutions (MFS). Because each case involved non-bank lending, they were broadly categorized as private credit and cited as evidence of emerging systemic risk. That conclusion does not hold up under closer scrutiny.”

The real issue, for Adam Street Partners, is concentration risk. This has been echoed by others, like Sona Asset Management (see the chart below).

As such, investors should reassess private credit’s propositions. AllianceBernstein suggests thinking about this asset class from a portfolio liquidity perspective and ask the question: “How much liquidity am I willing to give up for a higher expected return?” Perhaps this is the key to viewing private credit in today’s environment.