Private debt has recently come under the regulatory spotlight, whether justified or not. When policymakers express concern about the risk that the asset class poses on the basis of being overleveraged, the Alternative Credit Council’s global head Jiri Krol believes they may be barking up the wrong tree.
“I can understand why [regulators] would want to take a look under the hood, but 90 percent of funds will have leverage that’s less than 1.5 to 1 in terms of debt to equity. So that means you’d have to have extremely high loss rates in your portfolio with very low recoveries to endanger the creditor,” he says. Such an outcome would seem unlikely, at the very least.
This hasn’t stopped various influential organisations from putting private debt under the spotlight lately, with the International Monetary Fund, the Federal Reserve Board, the European Central Bank and the Bank of England all expressing varying views on private debt – with the Fed’s being the most positive and the IMF the most negative (see accompanying table for a comparison of views held on private debt by these organisations).
In a recent article for Private Debt Investor, Alex Di Santo, group head of private equity at Crestbridge, the asset management administration specialist, said “the IMF views private credit as a potential source of instability in the global financial market, particularly during times of stress”. Krol can justifiably claim to understand the mindset, having started out as a regulator himself – initially within the Czech government and then for the European Commission, where he became involved in asset management regulation, including the Alternative Investment Fund Managers Directive (AIMFD).
He then effectively switched sides, joining the Alternative Investment Management Association (AIMA) to provide the organisation with an insider’s perspective as it sought to protect members against any potentially negative implications arising from AIFMD.
Perhaps because of his background, he certainly isn’t inclined to dismiss regulators’ concerns. “One interesting question is if private credit becomes really big, not $2 trillion but, let’s say, $20 trillion. What happens if there is then a macro shock? How does it service its borrowers, and will it act in a way that makes it as pro-cyclical as the previous system has been? It’s difficult to answer, and private credit’s way too small for it to matter at this stage. But it’s a valid question.
“The regulatory instinct is, before it gets to $20 trillion, we’d better create safeguards so we don’t have to worry about it when it gets to that size – and that’s basically the reason for the discussion we’re having now. At the moment, we’re saying we’re economically significant but not systemically important and they’re saying ‘yes we get that, but let’s be safe rather than sorry’.”
It’s not the first time the regulators have had private lenders in their sights. In the aftermath of the global financial crisis came a wave of banking regulation, including the Basel reforms, in an attempt to ensure that banks could no longer be a home for casino capitalism. But attention then turned to so-called ‘shadow banking’, the unregulated areas of lending where private debt was just beginning to make its mark.
More data needed
In 2011, the Financial Stability Board, a Basel-based body that monitors and makes recommendations regarding the global financial system, produced an exploratory report into shadow banking that contained some high-level recommendations, including the need for more data gathering to gain a better understanding of what appeared to be a heterogenous area of the investment world.
AIMA’s members at this point were mainly hedge funds but there was an increasing migration into liquid and illiquid credit. This growth of members specialising in credit led to AIMA’s formation of the Alternative Credit Council in 2014, with Krol initially becoming deputy chief executive, a position he already held with AIMA. The ACC, Krol reflects, “was based on our ignorance of the market and the fact that we needed managers to give us more data and more of an understanding of what their universe entailed”.
This thirst for knowledge gave rise to ACC’s Financing the Economy report, which has become one of the must-read updates of private debt’s progress on an annual basis and which it produces alongside law firm Dechert. Last year’s fifth version of the report included input on a range of credit-related topics from 60 credit managers representing almost $400 billion in investments.
Krol says one of the main motivations for Financing the Economy was to provide information that would help both the industry to understand more about itself and regulators to gain greater insight into a relatively opaque asset class.
“Managers wanted to know what everybody else was doing but we also wanted to educate the policymakers. One of the principal goals was to help them understand what basic structures are being used, what are underwriting standards like, how much leverage is there, etc.”
Based on the findings of the report, Krol quips that regulators should be reassured by the “boring” nature of private debt.
“From the first report to the most recent, leverage levels have stayed broadly the same, the way debt is distributed has not changed much and most capital is still held in closed-end, fixed-maturity vehicles. The features of the market that have created a robust nature have remained the same.”
“Sometimes, as a market grows in the way private debt has done, there is a lot of excitement and dynamic developments that result in changes, including a loosening of standards. We’re not seeing that.
“So, is there no risk? Of course there is, but the point I would make is that, when economic and other headwinds are encountered, you’re seeing the market reacting in an ‘anti-fragile’ way, to borrow a phrase from Nassim Taleb. Stress sees the market continue to strengthen rather than weaken.”
Despite the recent noise around systemic risk, Krol makes the point that private debt has grown up in a broadly supportive regulatory environment. “It was pleasantly surprising how quickly Europe moved to allowing non-banks to lend,” he says.
“Around 2014-15 you had France, Germany and Italy all at more or less the same time moving to allow funds to lend. Even though it was under heavily restrictive conditions, some of which found their way into the AIFMD II review, it was nonetheless a seismic shift in the mentality of regulators. They realised you needed to have multiple sources of funding.”
That acknowledgement of the requirement for broader sources of finance goes back a long way. Even before the global financial crisis, capital markets funding was growing – more so in bank-centric economies where the need for diversified funding was most pressing. Following on from the maturation of capital markets funding, Krol describes private debt as “the final piece of the puzzle that Europe was missing. I would have expected much stronger resistance to adopting it, but there was very little”.
Krol has not been the only one surprised at the extent to which private debt has taken root. He laughs at the recollection of a PDI conference some years ago at which he presented the results of an ACC survey indicating that Germany was likely to be private debt’s next big market. One view from the audience was that the banking culture within the country was so deeply ingrained that change seemed unlikely. Borrowers, the audience member said, would struggle to wrap their heads around this shiny new thing.
“The next year what we found out was that all these German banks were making arrangements with private lenders, and all of a sudden it took off out of nothing,” says Krol. “We see now that private debt has become much more mainstream among European borrowers, who have seemed to get used to it. Part of it is that private debt now has a track record of simply being a good partner to companies.”
Non-banks are vital
This is one of two main reasons that accounted for regulators’ willingness to encourage private debt. One was the acknowledgement of how much healing was needed within the financial system following the GFC and the fact that non-bank lending promised to be a vital tool for the real economy. The other was a growing partnership with private equity, which was demonstrating that private debt could be applied in a manner that would benefit corporates at the same time as appearing to be relatively safe and controlled in the way it was being applied.
Perhaps the biggest challenge to private debt’s reputation with regulators is lack of data. At a basic level, it’s hard to know exactly what data qualifies as private debt data since a definition of the asset class is difficult given that it covers so many apparently disparate areas of activity. This creates what Krol acknowledges is a “fuzziness around the numbers”.
This goes against regulators’ desire for precise quantification. “It’s going to be one of the main challenges for the industry in future because the regulators are clamouring for more data,” says Krol. Whether they get the data they want is open to question.
“You have to be pragmatic and accept the fact that if you go for too much precision then you’re just going to miss the big picture,” says Krol. If anything, he thinks private debt is becoming even harder to define as the growth of large, club deals blur the distinction with the broadly syndicated market. Krol describes this phenomenon as “asset managers that sell – leading and underwriting and then hiving positions off to co-investors or other asset management firms”.
Give private debt space to work
This blurring of the lines adds to the sense that private debt is uncomfortably opaque and certainly doesn’t make the relationship with regulators any easier. Another challenge for the asset class, according to Krol, is the temptation for regulators to intervene at the first sign of trouble rather than to give markets time to work out their problems – something which he feels private debt proved it could do in the wake of the initial covid waves.
“Money that was channelled through state support networks to large corporates and small enterprises was missing for the mid-market in the US and UK and, for a while, things looked very bleak,” recalls Krol. He says emergency liquidity was injected by private equity and debt firms, some of it through hastily raised dislocation funds. “It was about making sure companies survived until they had more visibility.”
The key point is that private debt did indeed find a way to make sure the mid-market lending ecosystem remained intact. “What it showed is that even in those pockets of the market where you didn’t have direct intervention, you could find solutions. That was really in doubt for a while but people look back at it through a different lens now: where the vaccine came along, economies reopened and all was fine.”
A few years on from that initial covid onslaught, private debt now faces another – albeit different – threat from the pressure that high interest rates have put borrowers under. Krol believes that, as they did during covid, fund managers need to confront any problems head on and prove that their own actions mean regulatory interventions are unnecessary.
“The more a financial system allows the can to be kicked down the road, the greater the trouble you store up, and I think the industry will have to deal with problems early and as effectively as possible,” says Krol. “If we see the emergence of a soft budget constraint in whatever form it takes, I think that’s not a good sign for private credit.”
He will be observing the actions of the asset class in the coming period very closely and – with regulatory scrutiny arguably at a peak – it seems safe to say he won’t be the only one.
An open and closed case
Closed-end funds ‘compartmentalise risk’ and should not be abandoned for the open-end model, Krol believes
Jiri Krol is a firm believer in the benefits of the closed-end fund model. “One of the benefits of closed-end funds is that you effectively compartmentalise risk and you don’t have one very large balance sheet where, if it gets impaired, you’re in big trouble. One fund in isolation may perform badly but it won’t impact other funds and it won’t lead to cross-contagion.”
The significance of this is that the open-end fund is gaining in popularity in private debt, as it is in other areas of alternative assets, partly to accommodate retail investors. “If the closed-end fund disappears because everyone starts offering open-end funds then I would say the private credit system is going to change in a meaningful way and there will be risks arising from that,” he says.
Krol believes the dry powder that accumulates through fundraising cycles acts as a bulwark against challenging market scenarios, as it did during the initial phase of the global pandemic. “It means you can keep deploying capital when everyone else is heading for the hills,” says Krol.
He thinks the pursuit of liquidity that seems to drive many investors these days has the potential to backfire: “We see that sometimes investors want more liquidity than is actually good for the system or even themselves. They’re notoriously not good at timing the market, to the extent that there are liquidity mismatches – you’re going to have to find tools to deal with it.”