Retail push into private markets adds to systemic risks: Moody’s

By James Langton | May 9, 2022 | Last updated on May 9, 2022
2 min read

The growth of private credit has provided access to funding for mid-sized companies, but it now represents a growing systemic risk, says Moody’s Investors Service.

Following the global financial crisis, mainstream banks retreated from riskier corporate lending, Moody’s said. Investors in search of yield have emerged as an alternative source of funding to that segment of the market, taking on heightened credit and liquidity risks in exchange for higher returns than other fixed-income assets can provide.

As a result, Moody’s estimated that private credit in North America now amounts to US$1 trillion compared with US$1.4 trillion for the syndicated loan market.

“As private credit has flourished, risks have also grown,” the report said. “In this highly interconnected and deeply opaque market, a broad deterioration in borrower credit quality has the potential to cause cascading disruptions across the capital markets and broader economy.”

The interconnected nature of private credit stems, in part, from the fact that many of the large alternative asset managers that engage in private equity investing are also targeting lending to those same companies — creating potential conflicts of interest and growing systemic risks.

“The opacity and growing scale of the private credit market make it possible for asset quality deterioration to advance rapidly – below the regulatory radar – and build to such an extent that cascading risks cannot be easily or quickly remediated,” the report said.

Regulators monitor these kinds of risks in the traditional banking sector, with oversight of banks’ leverage and risk asset exposures, along with liquidity and capital stress tests. However, the report noted, “there is no such oversight in the private domain, with risk assessment and mitigation left at the discretion of a few very large and rapidly growing asset managers.”

Moreover, the private credit market remains highly opaque to regulators and the rest of the market.

When private credit managers run into issues with portfolio companies, they don’t have to provide much disclosure, “meaning the broader market could remain unaware of accumulated risk until it has already reached proportions with implications for the broader funding markets,” the report said.

Alternative asset managers also have fewer ways of offloading these risks, it added.

“If one of these large asset managers comes under duress, it could opt to suspend capital investments to the many smaller and mid-sized companies that rely on these funds to operate,” the report said.

The providers of capital to private equity and credit are usually insurance companies and pension funds and, to a lesser extent, endowments and family offices. However, the report also noted that retail investors are increasingly supplying capital to private credit managers — which is helping to drive growth, but also adds to the risk.

“A push to ‘retailize’ the private markets late in a credit cycle, with inflation and interest rates on the rise, could increase the transmission of growing private credit risks to the broader financial markets,” the report warned.

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James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.