The International Monetary Fund called attention to several potential risks associated with private credit and the sector’s rapid growth, in a report earlier this month.
These risks stem from factors such as multiple layers of leverage, relatively fragile borrowers, a lack of liquidity and stale valuations that aren't based on market prices.
While these risks pose no imminent threats, Fabio Natalucci, the deputy director of the IMF’s monetary and capital markets department, said they still deserve attention and could become more significant should sudden stresses arise such as a rapid market decline or sudden economic slump.
Covid-related disruptions were relatively brief and the Federal Reserve shored up a number of markets, Natalucci said. After more than a decade of expansion, private credit hasn't been put to the test of weathering a deep and prolonged recession, he noted.
Because of this, several safety measures designed to mitigate risks have yet to be tested.
One such measure comes in the form of sponsored loans, which are viewed as a backstop against economic downturns. These loans support companies that are backed by private-equity firms, which typically want to preserve the value of their investments.
Sponsor firms may choose to inject fresh capital into their portfolio companies, thereby reducing the chance of a default.
However, firms that add liquidity through borrowing amplify attendant risks by increasing leverage. That can lead to leverage ratios that would be considered excessive by banks, according to the report.
Fund investors, or limited partners, also add to the multilayered leverage issue. LPs, like insurers and pension funds, can also leverage their fund investments, making them vulnerable to economic and market stresses as well, the IMF said.
While the organization offered no remedies, it cited the opacity of private-credit operations and called for greater regulatory scrutiny as a way to better identify sources of potential systemic risks.
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