Risks to watch as private credit’s growth outpaces oversight

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The private credit market has expanded rapidly in recent years into a US$3 trillion industry. Its growth has provided a vital financial alternative for many organizations — particularly smaller, fast-growth companies, such as software firms, that were often underserved by highly regulated traditional banks in a generally low-interest environment.

This rapid growth, however, is currently attracting considerable scrutiny from both regulators and insurers. As questions have arisen, private credit firms have struggled to manage requests for redemptions and are still working to provide disclosures about their portfolios.

Rapid growth raises oversight challenges

The primary concerns center around private credit having potentially outpaced regulatory oversight, raising questions about lending standards, risk management practices, the accuracy of market-to-market accounting for portfolios, and transparency levels compared to traditional lenders.

These concerns intensified following the high-profile collapse of a small number of private companies that were unable to repay private credit loans. Borrower defaults have led to bankruptcy filings and civil litigation against privately held companies, while securities class actions have been filed against the lenders of publicly traded business development companies (BDCs) for allegedly understating unrealized losses and misrepresenting loan valuations.

Growing focus on lending standards and transparency

These developments have raised fears of a systemic crisis similar to the 2008-2009 financial meltdown that was driven by poor lending standards in an overheated subprime lending market. It is important to note that private credit differs in a fundamental way from subprime lending. Private credit investors are typically long-term, institutional participants that agree upfront to limit withdrawals to 5% of their capital in a given quarter. In contrast, subprime lenders targeted mostly retail investors and were much more exposed to classic bank runs. Despite these distinctions, concerns about the systemic risk imposed by private credit has only increased.

A key issue is the opacity of many private credit portfolios, sometimes referred to as “black boxes” by market observers. With regulatory oversight at the federal level limited, many directors and officers liability (D&O) and general partners liability (GPL) insurers are taking a closer look at the industry. The risk of claims arising from borrower defaults, fraud, or loan valuation disputes is driving heightened insurer scrutiny and tightening market conditions for private lenders, BDCs and some privately held companies. This is happening at a time when GPL coverage for alternative asset funds is already experiencing pricing pressures, and the market for private companies is showing pockets of unprofitability in some insurers’ portfolios.

Practical actions to mitigate risks

In this environment of high-demand and amid rising risks, it is important for lenders to consider a number of actions, including:

Align underwriting practices with those of traditional banks and avoid excessive risk-taking that could increase the potential for defaults.

Implement rigorous governance frameworks that can help prevent fraud and put in place practices that enable responsible loan origination and management.

Provide clear, comprehensive disclosure of loan portfolios and valuation methodologies to help build investor and insurer confidence and reduce uncertainty.

While there are no indications that increased regulatory scrutiny is imminent, continue to monitor regulatory developments and be proactive in adapting policies and procedures to comply with any emerging federal or local requirements.

Work with your broker or insurance advisor to review your existing D&O and GPL program and determine whether it provides sufficient coverage to protect against claims arising from borrower defaults or litigation.

Key considerations for borrowers

While the focus currently lies mostly with lenders, private credit borrowers should also exercise caution and due diligence. It is imperative to carefully evaluate the terms and conditions of private credit agreements, understanding the potential implications of loan covenants, interest rates, and repayment schedules.

It is advisable for borrowers to conduct thorough due diligence on prospective lenders, including assessing their reputation, transparency, and financial stability, to avoid partnering with entities that may pose undue risk. Borrowers should also maintain strong corporate governance and financial controls to ensure compliance with loan agreements and to mitigate risks of disputes or defaults.

Additionally, borrowers should consider the potential impact of lender instability on their financing arrangements and plan accordingly, including exploring insurance options that may protect against disruptions arising from lender defaults or litigation. Maintaining open communication with lenders and advisors can help borrowers navigate the complexities of private credit and safeguard their growth objectives.

Balancing opportunity with caution

Private credit offers a valuable financing avenue for many companies, especially ones that have traditionally been underserved by traditional borrowing. However, lenders and borrowers alike must exercise caution and diligence. By focusing on transparency, governance, and risk management, private credit providers can mitigate risks, meet growing market expectations, and contribute to a more stable and trustworthy lending environment.

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