(Bloomberg) — Private credit more than doubled in size from 2019 thanks to interest rate hikes that made its floating-rate debt more attractive to investors. Now, a Federal Reserve interest-rate cut is adding to the headwinds hampering the breakneck growth of the $1.7 trillion industry.
Lower benchmark rates will make fixed income, which locks in returns, more attractive to investors than variable rate. That’s set to become a more pressing issue after the Fed projected further easing later this year.
Regulators also have the industry in their crosshairs after growing concerned about the spillover impact any crisis could have on banks, which provide loans to private credit managers to add more firepower to their pools of investor commitments. On the fundraising side, institutional capital allocations are flatlining, falling oil prices may affect inflows from the Middle East and new US measures could make it harder for insurers to invest in the asset class.
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The other big potential threat is a US recession. A soft landing for the economy is the central case, but a deeper slowdown would spell trouble, squeezing the pipeline of money, reducing the appetite for deals and increasing the risk of borrowers failing to repay.
According to Patrick Dennis, co-deputy managing partner at Davidson Kempner Capital Management, defaults in private credit are about 3-5%, partly due to covenant breaches and modifications.
“Defaults are kicking up in all three areas of the market that we focus on,” he said at the Milken Institute Asia Summit Thursday. “From a severity perspective, this is the biggest risk in the market that we’re trying to evaluate.”
Oil Money
Private markets fund managers have been flocking to the Middle East in recent years in an attempt to raise additional capital to deploy. That effort could become more challenging if oil prices continue to slip lower.
“A prolonged spell of depressed oil prices would inevitably weigh on the rate at which institutional investors in the region deploy capital into private markets,” said Cameron Joyce, head of research insights at Preqin. However, he noted there will still be appetite because many private credit allocations are below long-term targets.
Read More: Private Credit Titans Pack Middle East Flights Chasing Billions
One upside to lower rates is that they may encourage more dealmaking, which would provide more opportunity to deploy capital, as long as that’s accompanied by a soft landing that doesn’t lead to widespread defaults.
But there’s competition for business as traditional lenders fight to steal back buyout business after private credit made inroads into that area, which had long been a lucrative source of fees for investment banks such as Goldman Sachs Group Inc. and JPMorgan Chase & Co.
Tougher Scrutiny
In the regulatory area, the Financial Stability Board is examining how private markets interact as part of wider investigations into shadow banking. The European Central Bank is pressing top lenders for details of their exposure to private credit firms and their funds, while the Bank of Japan is also keeping an eye on the links.
“The exposure of Japan’s financial institutions to global private credit funds are increasing, with a concentration towards some big players,” Hirohide Kouguchi, an executive director at the Bank of Japan, said in an article in Eurofi magazine. “We need to remain vigilant,” he added, citing systemic implications.
Read More: Banks’ Exposure to Private Credit Faces Fresh Scrutiny From ECB
In the US, new rules from the National Association of Insurance Commissioners that go into force in 2026 will give regulators more leeway to discourage insurance companies from investing in private investments and other assets viewed as excessively risky.
The measures allow the NAIC to effectively assign its own ratings to a wider range of bonds and other securities owned by insurance firms — which could mean stricter assessments. That’s a blow to insurers, which depend on those ratings in order to invest in everything from slices of corporate debt to pools of consumer loans.
To help it with the work, the NAIC plans to enlist outside expertise so it can accurately assess ratings, according to draft documents circulated last month.
The rules are “going to give insurance companies pause in investing in some of the more aggressive forms of rated note structures for private credit or asset based credit,” said Manish Valecha, head of client solutions at Angel Oak Capital Advisors.
Any pullback by insurers would be a blow to direct lenders’ growth ambitions. The average allocation by an insurance firm to private credit has doubled since 2019 to 4%, according to data compiled by Preqin.
Insurance capital has been one of the drivers of private credit markets, although the quality of triple B portfolios, which are popular with that industry, can be variable, according to Dennis.
“If you start to see defaults in those portfolios, you could risk a regulator or regulators overreacting in the other direction which could create some technical market disruption that frankly we would welcome but could create some risk of contagion a little bit more broadly,” he said.
