Overview
Private debt has grown faster than most other capital sources over the past couple of years, inviting scrutiny from regulators. While some concerns are valid, some perspective is needed to properly evaluate the risk.
Some Perspective
The private markets have been with us for ages; some argue the Rosetta Stone was used to record evidence of ancient commerce¹. However, the private debt market has grown recently because of the confluence of several factors:
Bank Pullback — Historically, bank deposits were considered long-term, stable assets by banks. With the development of mobile phones and computer-based banking apps, massive sums could be moved in seconds, unlike the previous model of waiting in line at a local bank. Following the Silicon Valley Bank run, both banks and their regulators pulled back from longer-term commitments thereby encouraging borrowers to seek alternatives. Additionally, banks appear to be “de-risking” their balance sheets to address the impending “Basel III endgame” capital standards, to which only banks are subjected.
Search for Yield — Many institutional investors have little need for immediate liquidity (provided by the public markets) and therefore gladly accept the premiums offered by private investment.
Filing Burdens — Just as the number of publicly traded firms has declined over the past forty years², firms often have similar concerns regarding the public debt markets. Perhaps pricing is somewhat higher, but the speed and convenience have been appealing to many issuers. As a result of the quarterly filing burden, companies are staying private longer.
Some Complexity
To address the risks, it is helpful to dive deeper into the various segments of the private debt market:
Bank Loans — This is the largest segment of the private debt space; according to the Fed of St Louis, the total loans and leases in all commercial U.S. banks were valued at $12.6 trillion as of Dec. 4, 2024³, compared to the approximate $1.5 trillion direct lending market⁴.
From a regulatory perspective, this space presents the most acute concerns, as bank deposits beyond $250,000 are not guaranteed by the FDIC and ultimately the taxpayer. Many firms and individuals depend on banks for regular liquidity and commerce. Furthermore, during the 2008 credit crisis, the Fed injected massive amounts of capital into the banks via TARP and a variety of other programs.
The risk to the banks can be both on the credit side and the interest rate side. In our view, Silicon Valley Bank invested in relatively safe (from a credit quality perspective) agency securities (i.e., Fannie Mae and Freddie Mac), but was burned when overall interest rates rose, and the value of securities declined. Silicon Valley Bank’s equity capital was insufficient to absorb the book losses, resulting in a liquidity crisis following a bank run.
Broadly-Syndicated Loans — This segment is valued at approximately $1.0 trillion⁵ and is comprised of obligations typically originated by banks and placed mainly with independent debt managers, who then place them in CLOs (Collateralized Loan Obligations or Collateralized Debt Offerings). The CLOs are typically purchased by institutional investors via non-SEC registered Rule 144A offerings to Qualified Institutional Buyers.
If there are concerns about asset quality or market conditions, the issuance of new CLOs typically dries up and the subordinated debt tranches are exposed to possible losses. However, during the 2008 Credit Collapse, CLOs performed better than other classes:
“According to Standard & Poor’s, CLO 1.0s (CLOs that were issued before the GFC) exhibited strong credit performance during the financial crisis and produced a very small number of lifetime defaults…Only 67 out of nearly 21,000 CLO tranches rated by the firm have defaulted, a rate of 0.3%.” ⁶
Furthermore, after the 2008 credit crisis (i.e., the GFC), CLO 2.0s are generally viewed as having stronger credit characteristics. Hence, in the event of market disruption, the holders of subordinated classes take losses, and the availability of new funding is restricted.
Private Placements to Insurance Companies — Insurance firms have been involved in providing long-term, private funding for decades. Typically, firms view private market investments as a complement to their public market investments and have teams evaluating the credit quality of their exposures.
If the risks are improperly measured, the insurance firm absorbs the loss, and in rare cases, might impair their ability to meet obligations to policy holders. However, given that (i) exposures are typically reviewed and rated by SEC-registered rating firms and (ii) portfolios are typically diversified with few investments comprising more than a percentage point or two of holdings, the greater risk is typically on the operational side. For example, mispriced or miss-assessed risks are typically the most relevant.
Retail-based Offerings — Retail investors take on exposures to private debt via Business Development Companies (BDCs), mutual funds, private partnerships, and other similar vehicles. These investors typically are less sophisticated than institutional investors and have less access to relevant information. While the risk to the economy is less than it is in the case of banks, this area is probably the fastest growing and likely carries with it the largest nascent risk. Rarely is there an independent check on the credit quality of the exposures, and investors are dependent upon information from the sponsors. Regarding liquidity, liquidity lines are typically provided by the banks, which, in the event of a significant market downturn, might force managers to limit withdrawals. Note that of the vehicles mentioned at the top of this section, only BDCs typically have equity cushions, meaning assets need to exceed liabilities by 33% or more.
Measuring Risk
A key part of any investment process is measuring risk and whether, as an investor, you are being properly compensated for that risk. Measurement should be made both at the outset and over time. For example, if the weighted average credit quality of a portfolio is “B” (using the rating scales used by the typical rating firms), the weighted average loan life is 5 years, and the related probability of default is 3%, if the portfolio has more than a 3% default rate, then perhaps the risk was underestimated. Similarly, the public markets can and often are used as a proxy for the appropriate pricing of risk.
Because of diversification, the risk from any one exposure is typically minimal; the key is overall portfolio risk. Regarding portfolio risk, while defaults have risen over the past 18 months due to the after-effects of increased interest rates, recent indications are encouraging. Below is a promising economic forecast from Goldman Sachs:
“The US economy is in a good place,” writes David Mericle, chief US economist in Goldman Sachs Research. “Recession fears have diminished, inflation is trending back toward 2%, and the labor market has rebalanced but remains strong.” Goldman Sachs Research predicts US GDP will grow 2.5% on a full-year basis.” -Nov 20, 2024 ⁷
Regarding the relative risk of the various forms of private debt, the chart below provides a comparison:
Conclusion
Inherent in any investment process is risk. The key is the proper assessment of risk and in turn, the management of risk. To streamline the provision of capital to support the growth of the economy, private debt with some safeguards is likely to be an effective avenue for the foreseeable future. From a historical perspective, private debt might be viewed as the most recent wave of bank disintermediation.
Sources
[1] Google AI Overview: ancient commerce evidence rosetta stone
[2] https://www.nber.org/reporter/2018number2/shrinking-universe-public-firms-facts-causes-and-consequences
[3] https://fred.stlouisfed.org/series/TOTLL
[4] https://www.capitalmarketassumptions.com/
[5] https://www.alliedmarketresearch.com/press-release/syndicated-loans-market.html
[6] S&P Global, “Default, Transition, and Recovery: 2021 Annual Global Leveraged Loan CLO Default and Ratings Transition Study,” October 31, 2022
[7] https://www.goldmansachs.com/insights/outlooks/2025-outlooks