In a report released this week, the International Monetary Fund (IMF) has issued a stark warning about the burgeoning private credit sector, highlighting the necessity for enhanced regulatory oversight to mitigate burgeoning risks within this rapidly expanding market. The IMF›s analysis underscores the critical liquidity demands of funds and the questionable quality of the borrowers underpinning these financial instruments as particularly troubling elements.
According to the IMF›s advisers, “rapid growth of this opaque and highly interconnected segment of the financial system could heighten financial vulnerabilities given its limited oversight.”
The organisation, which hosts its annual meeting in Washington next week, is calling on regulatory bodies to assert a more vigorous stance, advocating for enhanced transparency among market actors to facilitate a more precise assessment of risks. The IMF proposes the augmentation of reporting obligations alongside the fostering of supervisory collaboration that transcends national borders and market segments.
During the rapid expansion of private markets over the last ten years, Luxembourg has emerged as a key player in the alternative investment funds industry, including the credit industry, notably thanks to its Lego-like toolkit of fund vehicles that provides tailored products to managers to set up a private debt fund. Luxembourg has established itself as number one jurisdiction for credit funds with an EU investment strategy and oriented to EU investors. The IMF blog post did not address Luxembourg directly.
Outpacing other asset classes
The private credit domain, characterized by specialized non-banking financial entities — including investment funds — extending credit to corporate borrowers, has seen its assets worldwide surpass the 2,100 billion dollar mark last year. Notably, the United States dominates this landscape, with its market share nearing that of syndicated loans and high-yield corporate bonds, accounting for three-quarters of these loans.
To place Luxembourg’s role in this market into context, the 2023 KPMG-Alfi Private Debt Survey showed that private credit assets under management in Luxembourg grew by 51 percent, from 267.8 billion euro in June 2022 to 404.4 billion euro in June 2022.
Despite the undeniable economic advantages conferred by this long-term financing model, the IMF cautions against the potential hazards associated with the migration from traditional, regulated banking institutions to the more opaque private credit sphere.“
“Overall, although these vulnerabilities currently they do not pose a systemic risk to the broader financial sector, they may continue to build, with implications for the economy. In a severe downturn, credit quality could deteriorate sharply, spurring defaults and significant losses. Opacity could make these losses hard to assess,” said the IMF.
‘Insufficient asset valuations’
The IMF points to the challenges posed by insufficient asset valuations, the ambiguity of credit quality, and the intricate web of connections linking private credit funds, private equity firms, commercial banks, and investors, all of which may threaten the stability of the wider financial system.
A particular area of concern for the IMF is the elevated levels of leverage often employed by small to medium-sized entities within the private credit market. The resilience of these loans during economic downturns remains an open question, with the potential for significant repercussions for institutional investors heavily invested in these assets. In the event of a severe recession, the market could see a sharp decline in credit quality, leading to defaults and substantial losses, with the sector’s opacity further complicating the evaluation of such losses.
This could trigger a series of adverse effects across the financial landscape, including banks curtailing lending to private credit funds, substantial redemptions facing retail funds, and liquidity crises for private credit funds and their institutional backers. Moreover, the extensive interconnectedness within the market could have knock-on effects on the public markets, compelling insurance companies and pension funds to liquidate more liquid assets.
Highlighting «severe data gaps,» the IMF has expressed concerns over the challenges these present in monitoring vulnerabilities across the financial markets and institutions. With the private credit sector’s unprecedented growth and the untested nature of many risk mitigation strategies, there’s an evident need for a more thorough understanding of the underlying loans’ performance. Without this insight, firms and their regulators could be blindsided by sudden shifts in credit risk classifications within this asset class, the IMF warns.
Further reading on Investment Officer Luxembourg:
- 45% of family offices want more private credit in portfolios
- Blackstone’s Solotar foresees structural shift to private credit
- M&G sees Eltif 2.0 opening up new era for private credit