The Fed - Private Credit - Characteristics and Risks

17/04/2024, 11:30 The Fed - Private Credit: Characteristics and Risks
FEDS Notes
Twitter Share RSS
February 23, 2024
Private Credit: Characteristics and Risks1

Fang Cai, and Sharjil Haque
On February 26, 2024, a correction was made to fix a typo for the data source from
Pitchbook to KBRA DLD in Figure 13.
What is Private Credit?

Private credit or private debt investments are debt-like, non-publicly traded instruments
provided by non-bank entities, such as private credit funds or business development
companies (BDCs), to fund private businesses.2 Private credit is typically extended to
middle-market firms with annual revenues between $10 million and $1 billion, but has grown
rapidly in recent years to fund larger companies that were traditionally funded by leveraged
loans.
Private credit typically involves the bilateral negotiation of terms and conditions to meet the
specific needs and objectives of the individual borrower and lender, without the need to
comply with traditional regulatory requirements. Such bilateral origination of a loan between
a single borrower and lender is often referred to as "direct lending" but deals that involve a
small group of lenders can be considered direct lending as well. Loans from direct lending
funds are typically senior secured while other private credit strategies can invest in more
junior parts of the capital structure; almost all private credit loans are floating rate.3
Given the absence of a liquid secondary market for many private credit instruments, lenders
typically hold these loans until maturity or a refinancing event. As a result, these loan
contracts can include features uncommon to traditional bank loans, such as a structured
equity component, high prepayment penalties, or a role in oversight or management of the
company.
Who Invests in Private Credit and Why?

Survey evidence from academic studies show that the largest investors, or Limited Partners
(LP), in private credit funds are pension funds, insurance companies, family office, sovereign
wealth funds and high net worth individuals.4 These institutional investors invest in private
debt due to various factors such as portfolio diversification, low correlation to public markets
and relatively high returns.
The Federal Reserve Board's Financial Stability Report (FSR) published in May 2023
showed that, based on Form PF data as of Q4 2021, public and private pension funds held
about 31 percent ($307 billion) of aggregate private credit fund assets. Other private funds
made up the second-largest cohort of investors at 14 percent ($136 billion) of assets, while
insurance companies and individual investors each had about 9 percent ($92 billion).5
https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-characteristics-and-risks-20240223.html 1/18
Over the past decade, the asset class, particularly direct lending, has generated higher
returns than most other comparable asset classes, including 2-4 percent over syndicated
leveraged loans. Borrowers have been willing to pay a premium for the speed and certainty
of execution, agility, and customization that private lenders offer. Additionally, private debt
funds have attracted highly leveraged borrowers that are unable to get adequate funding
from heavily regulated banks.
Market Size and Recent Growth of Private Credit and Direct Lending
Figure 1 reports the growth of private credit since 2000, including all private credit strategies
(left panel) and direct lending only (right panel). The left panel shows that total private credit
has grown exponentially in recent years, reaching nearly $1.7 trillion, comparable to those of
leveraged loans (roughly $1.4 trillion) and high-yield (HY) bond markets (about $1.3 trillion).
The right panel shows that the growth of private credit is most pronounced for direct lending,
which amounts to $800 billion, or about one half of the total.6 There is also growing amount
of committed but uninvested capital (or 'dry powder') in the industry, suggesting supply of
private credit funding is outstripping demand for private loans.
Figure 1. Growth in Private Debt Allocations
Note: ‘Dry Powder’ refers to committed but not invested capital. Invested capital is committed & invested
capital (typically in the form of loans). Assets under management is the sum of invested capital and dry
powder. Data as of June 2023. AUM data reported with a 6-month lag.
Source: Preqin
Accessible version
Figure 2 reports top 20 U.S. private credit fund managers including all strategies (left panel)
and direct lending only (right panel), based on total dollar value of assets under management
as of June 2023. The sector is heavily concentrated in a few large fund managers such as
Oaktree, Ares, Goldman Sachs, HPS Investment and Blackstone. A large share of dry
powder is also held by the top 5 fund managers, suggesting disproportionately high demand
for these fund managers by LPs. Staff estimate that top 10 U.S. private debt fund managers
hold about 40-45 percent of all dry powder in the U.S., across all private debt strategies.7
Figure 2. Top 20 Private Debt Managers
Note: This chart plots aggregate assets under management (split by called capital or invested capital, and
dry powder) sorted by private credit firm. For each firm, all fund level private credit funds are aggregated.
Source: Preqin
Accessible version
Characteristics of Private Credit using Loan-level Data

As private credit continues to grow rapidly as a new frontier for nonbank lending, the scarcity
of available data has made it challenging to assess risks in this market. Private credit funds
invest in loans with varying characteristics. These loans are generally senior secured and
floating rate. This section discusses some key characteristics of private credit loans, based
on a new sample of around 17,000 unique private credit loans originated by 718 private debt
funds and BDCs from Pitchbook, where both borrowers and private debt lenders are U.S.-
based. The sample covers all private credit strategies from 2013-2023.8
Figure 3 reports the number of loans and Figure 4 shows average loan and deal size. We
observe the average size of loans has increased in recent years and exceeded $80 million
since 2022, which is much larger than the standard loan size in bank-dependent borrowers
observed in the Federal Reserve's Y-14Q H1 collection on commercial loans.9 A single loan
is typically part of a loan-deal (with multiple credit facilities), and we also note that the
average deal size is much larger compared to the average loan size. For majority of these
loans, the data show that the borrower is backed by a private equity sponsor.10
Figure 3. Number of Loans in Pitchbook
Note: This chart reports the raw number of newly originated loans in a given year.
Source: Pitchbook
Accessible version
Figure 4. Average Deal and Loan Size
Note: This chart reports the mean deal and loan size across the loan-year distribution.
Source: Pitchbook and authors' calculations
Accessible version
Loan Type and Pricing

Figure 5 shows that more than two thirds of private credit is term loans. In addition, about 15
percent of private credit takes the form of hybrid loan pari passu, which is more junior in the
capital structure in the event of default and thus implies greater risk than senior secured
loans.
Figure 5. Loan Type
Note: Hybrid Loans refer to loan facilities where senior and subordinated debt is combined into one single
loan facility, with a blended interest rate that falls between the two debt types.
Source: Pitchbook
Accessible version
Figure 6 shows that the average loan spread declined in recent years before rising again in
2022, following the Fed's rate hike cycle. Comparing private credit loan spread with spreads
observed in institutional Term Loan B in the leveraged loan market, we observe that the
spread on private credit loans is generally higher, and the gap in spreads between the two
types of loans declined in recent years to below 200 basis points before widening again in
2023. The difference in spreads is consistent with the riskier profiles of private credit
borrowers relative to syndicated loan borrowers. Part of the difference could also be
attributable to private debt funds requiring additional compensation for holding these loans in
their books.
Figure 6. Credit Spreads
Note: This chart plots average spreads above a benchmark interest rate (LIBOR or SOFR, mostly SOFR
from 2022 onwards) in a given year for private credit and leveraged loans.
Accessible version
Rollover Risk
To examine rollover risk, we consider the maturity wall of private credit (Figure 7) and
observe that debt maturities are spread out evenly over the coming years, with around 16
percent of outstanding debt due in 2024. The average maturity in private credit has generally
been around 5 years (Figure 8).
Figure 7. Maturity Wall in Private Credit
Note: This chart reports the share of loans (in dollar value) that will mature, based on maturity date provided
for a single loan facility in Pitchbook.
Accessible version
Figure 8. Average Maturity in Private Credit

Accessible version
Figure 9 shows the top Deal Types (uses of proceeds) are for general corporate purposes
(e.g., working capital needs), debt refinancing and private equity deals (leveraged buyouts
and growth equity investments). It is worth noting many refinancing activities are also driven
by borrowers backed by a PE-sponsor. Examining private credit spreads by these different
deal types, we observe private equity deals (growth/expansions and leveraged buyouts)
experienced substantially larger increase in borrowing cost during the 2022 rate hike cycle
(Figure 10). Higher sensitivity to the rate hike cycle indicates PE deals generally involve
relatively riskier borrowers, for example, because they carry more leverage.11
Figure 9. Deal Types
Accessible version
Figure 10. Average Loan Spread By Deal Type
Note: This chart plots average loan spreads on private credit loans split by deal type.
Accessible version
Rise of Club Deals

An interesting trend is that, for a given loan facility, the average number of private debt
lenders has increased over time (Figure 11). This pattern suggests private creditors are
increasingly relying on "club deals" to share credit risk exposure to a single borrower. Higher
number of lenders in a single commitment also allows creditors to fund larger borrowers,
consistent with the rise in average loan size shown above.
Figure 11. Average Number of Lenders in a single loan facility
Note: This chart reports the number of lenders in a given loan facility, which are identified directly by looking
at the identity of each lender.
Accessible version
Interest Coverage
The average interest coverage ratio (ICR)––a key liquidity risk metric––displayed a
significant decline in recent quarters (Figure 12), indicating weakening debt service
capacity.12 With mean interest coverage of around 2.0x, a significant slowdown in economic
conditions could lead to further deterioration of cash flows (EBITDA) and greater difficulty in
making debt payments. For comparison, ICR in leveraged loan borrowers is slightly higher at
around 2.7x as of 2023, according to data from LCD.13
Figure 12. Interest Coverage Ratio has declined
Note: This chart plots average interest coverage ratio across the distribution of borrowers covered by KBRA
in a given quarter.
Source: KBRA DLD
Accessible version
Default Rate
Nevertheless, year-to-date default rates have generally been low, compared to the broadly
syndicated loan market or HY bond market, particularly in direct lending (Figure 13). Low
default rates can be attributed to (i) low interest rates for most of the past 10 years and (ii)
periodic monitoring of borrowers through loan covenants, as well as the ability to renegotiate
flexibly with a relatively small group of creditors when borrowers are in distress.14 However,
industry commentary suggest recent deals are devoid of financial maintenance covenants as
private credit managers look to compete with banks in the large corporate market segment.15
Moreover, a recent study by S&P Global finds that repeat-defaults were marginally more
likely in private credit funded borrowers, and the average time span between repeat-defaults
is shorter among borrowers with private credit compared to those without.16 It is important to
note that the industry has yet to go through a prolonged recession.
Figure 13. Year-to-Date Default Rate (As of Oct, 2023)
Note: This chart plots year-to-date default rates across various asset classes in 2023 as reported by KBRA
DLD.
Source: KBRA DLD
Accessible version
Loss Given Default

An important trend related to loss given default is that the share of private credit loans with
1st liens on the borrower's assets has increased significantly over time (Figure 14). Despite
this seniority in debt structure, private credit loans have relatively low recovery rate upon
default (or equivalently, exhibit high loss given default) compared to syndicated loans or HY
bonds, as shown in Figure 15. Post-default value of a direct loan is around 33 percent, while
those in syndicated loans and HY bonds are 52 and 39 percent respectively.
Figure 14. Share of Loans with 1st Liens
Note: This chart reports the share of loans with a 1st lien for a given private credit loan facility as reported in
Pitchbook in the navy blue line. The orange line reports the share of unsecured or 2nd lien loans. For a small
share of loans, Pitchbook only reports if the loan is secured or not, thus the total of the two line will not
necessarily add to 100 percent.
Accessible version
Figure 15. Recovery Rate
Source: KBRA DLD
Accessible version
The key reason for the low recovery rate upon default is that more than half of all value-
weighted private credit is provided to borrowers in sectors with relatively low collateralizable
or tangible assets such as software, financial services or healthcare services (Figure 16),
and thus have lower recovery rate for every dollar of defaulted loans. Higher loss given
default increases the likelihood of fund-level impairment and thus ultimately hurts investor
returns.
Figure 16. Share of Lower Collateral Sectors
Note: Pitchbook reports one primary sector for a given borrower. Staff made conservative assumption when
identifying sectors that likely have relatively lower tangible assets, and grouped all others into a category
called 'Industry with High Collateral'. Thus, for sectors where asset tangibility is not fully clear, staff
categorized it as a 'high collateral sector'.
Accessible version
Financial Stability Implications of Private Credit

The May 2023 FSR pointed out that redemption and fire sale risks posed by private credit
seems to be low, largely due to its long lock-up periods (as high as 10 years) and low
leverage or derivative exposures. However, there are other financial stability implications
worth to monitor for this relatively opaque sector as its footprint in nonbank lending continues
to grow.
Illiquidity
Private credit loans are illiquid due to the lack of a secondary market. There is limited market
discovery, and investors acquiring these loans should expect to hold them to maturity or face
steep losses in need of an emergency exit.
Rise in corporate leverage and default

Given relatively low collateralizable assets and high leverage, it is likely that a significant
share of borrowers would not be able to obtain adequate financing in the absence of private
credit. This view is consistent with persistently higher spreads in private credit relative to
syndicated loan borrowers in Figure 6. Therefore, an important implication is that private
credit raises overall corporate leverage, potentially making the corporate sector more
vulnerable to financial shocks. In the environment of inflation and rising interest rates, higher
interest payments on floating-rate debt could stress borrowers' balance sheets, leading to a
significant increase in defaults in an economic downturn.
Dry Powder and deterioration in credit quality

Excessive growth in dry powder and continued competition with banks could compromise
underwriting standards. Dry powder has grown tremendously in private credit, particularly in
direct lending. For example, relative to 2014, dry powder has nearly quadrupled. Since
private credit managers have a mandate to deliver high returns to LPs within a fixed
timeframe, fund managers might choose riskier deals, offer more covenant-lite loans, or
more generally reduce underwriting standards as opportunities dry up when the economy
slows down. Combined with high concentration of dry powder within a few funds, fund
managers run the risk of structuring deals poorly going forward in order to boost internal rate
of return. Deterioration in deal quality can raise future defaults, hurting fund performance and
investors' returns, given relatively low recovery.
Potential spillover to other nonbank institutions

Given that fund managers have the contractual right to obtain committed capital at any point
in time, investors such as insurance companies or pension funds run the risk of needing to
honor capital calls when credit conditions worsen, even when their own liquidity conditions
are under stress. For example, property & casualty (P&C) insurers can face a surge in short-
term claims stemming from exogenous liquidity shocks such as natural disasters. Since P&C
insurers are obligated to pay out short-term claims, exposure to private debt can exacerbate
liquidity problems if fund managers make capital calls at the same time.
Interconnections with banks

While bank lending to private credit funds appears moderate, there are growing
interconnections between these two types of lenders. First, banks are increasingly partnering
with private credit funds to fund new deals.17 Second, banks are progressively selling
complex debt instruments to private fund managers in so-called "synthetic risk transfers" in
order to reduce regulatory capital charges on the loans they make.18 Such instruments have
limited transparency and pose hidden risks to the financial system, especially as the industry
has yet to endure a prolonged recession. Relatedly, there is growing concern that tighter
regulations such as Basel III endgame could intensify migration of credit from banks to
private credit lenders. Considering borrower risk profiles, such substitution is less likely to
occur to bank-held loans, and more so with syndicated leveraged loans. In such cases,
banks stand to lose underwriting fees to private credit funds. These developments suggest
that private credit will become increasingly important to credit market functioning.
References
Block, J., Y.S. Jang, S. Kaplan, and A. Schulze, 2023, A Survey of Private Debt Funds,
National Bureau of Economic Research.
Brown, G., 2021, Debt and Leverage in Private Equity: A Survey of Existing Results and New
Findings, The Private Equity Research Consortium and The Institute for Private Capital.
Gompers, P., S. Kaplan, and V. Mukharlyamov, 2015, What do Private Equity Firms Say
They Do?, Harvard Business School working paper 15-081.
Haque, S., 2023, Does Private Equity Over-Lever Portfolio Companies, Finance and
Economics Discussion Series, Board of Governors of the Federal Reserve System.
Haque, S., Y.S. Jang, and S. Mayer, 2022, Private Equity and Corporate Borrowing
Constraints: Evidence from Loan Level Data, working paper.
1. Authors: Fang Cai and Sharjil Haque. We thank Siddhartha Lewis-Hayre for his excellent research assistance.
The views expressed here are strictly those of the authors and do not necessarily represent the views of the
Federal Reserve Board or the Federal Reserve System. Return to text
2. A private credit fund is a closed-end pooled investment vehicle that originates or invests in loans to private
businesses. It is not required to be registered or regulated as an investment company under the Investment
Company Act. A BDC is a closed-end investment company, created through the Small Business Investment
Incentive Act of 1980, to stimulate the flow of capital to small- and mid-sized private businesses. Return to text
3. Beside direct lending, other major private credit strategies include Mezzanine, Special Situations, Distressed
Debt, Venture Debt and Infrastructure Debt. Return to text
4. See Block et al. (2023). Return to text
5. See the box "Financial Stability Risks from Private Credit Funds Appear Limited" in Board of Governors of the
Federal Reserve System, Financial Stability Report (Washington: Board of Governors, May 2023), pp. 45–47,
https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf. Return to text
6. Preqin's definition of direct lending includes senior debt, unitranche debt, subordinated debt and
blended/opportunistic debt. It does not include loans provided by publicly-traded BDCs in its definition of direct
lending. Staff estimate total direct lending AUM inclusive of BDC-originated direct loans as of June 2023 to be
around $950 billion-$1 trillion. Return to text
7. This calculation is based on a 25-30 percent dry powder assumption and a 61 percent market share of U.S.-
based funds, which is sourced from Pitchbook. Return to text
8. This dataset at loan-issuance level is sourced from Pitchbook and contains private credit originated loans only.
The sample is restricted to the universe of private credit lenders and borrowers in the United States. Return to text
9. For a detailed description of loan characteristics of bank dependent borrowers, see Haque, Jang and Mayer
(2022). Return to text
10. Private equity (PE) sponsor 'backing' refers to PE funds owning equity in these companies, typically through
leveraged buyouts. Since sponsors control the equity in the firm, they are generally involved in making strategic
decisions related to the company's management, operations, and capital structure. See, for instance, Gompers,
Kaplan and Mukherlyamov (2015). Prior studies such as Haque, Jang and Mayer (2022) have also found that
PE sponsors inject equity into portfolio companies that are in distress. Return to text
11. See Brown (2021) and Haque (2023) for analysis on leverage in PE deals. Return to text
12. The interest coverage ratio is calculated as EBITDA/interest expense. A ratio below 1 indicates a borrower
does not generate enough cash flows from operating business to repay periodic interest payments. Return to text
13. See (https://www.lcdcomps.com/lcd/n/article.html?rid=170&aid=12504728&viewTracking) As rate pressure

bites, leveraged loans' loss-absorbing debt cushion weakens | Leveraged Commentary & Data (lcdcomps.com)
Return to text
14. Industry reports suggest that private debt funds, particularly direct lenders, use loan covenants more frequently
than banks and hence are able to better monitor their borrowers. This argument is inconclusive since greater
number of, or tighter covenants, is a natural response to the relatively higher risk profile of companies that borrow
from private debt funds. Low-risk borrowers that generate stable cash flows do not necessarily require tight
covenants or frequent monitoring. Return to text
15. See (https://www.bloomberg.com/news/articles/2023-10-26/private-credit-lenders-giving-up-protections-to-win-

bigger-deals) Private Credit Lenders Giving Up Protections to Win Bigger Deals - Bloomberg Return to text
16. See (https://www.spglobal.com/en/research-insights/featured/special-editorial/buying-time-post-default-with-
private-credit) Buying Time Post-Default with Private Credit | S&P Global (spglobal.com) Return to text
17. See (https://www.bloomberg.com/news/articles/2023-11-01/jpmorgan-jpm-is-said-to-seek-out-a-partner-for-

private-credit-push) JPMorgan (JPM) Is Seeking Out a Partner for Its Private Credit Push - Bloomberg Return to
text
18. See (https://www.wsj.com/finance/banking/bank-synthetic-risk-transfers-basel-endgame-62410f6c) Big Banks

Cook Up New Way to Unload Risk - WSJ Return to text
Please cite this note as:

Cai, Fang, and Sharjil Haque (2024). "Private Credit: Characteristics and Risks," FEDS
Notes. Washington: Board of Governors of the Federal Reserve System, February 23, 2024,
https://doi.org/10.17016/2380-7172.3462.
Disclaimer: FEDS Notes are articles in which Board staff offer their own views and present analysis on a range of
topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working
Papers and IFDP papers.
Last Update: February 26, 2024

The Fed - Private Credit - Characteristics and Risks

Uploaded by

Copyright:

Available Formats

The Fed - Private Credit - Characteristics and Risks

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Fed - Private Credit - Characteristics and Risks

Uploaded by

Copyright:

Available Formats

17/04/2024, 11:30 The Fed - Private Credit: Characteristics and Risks

February 23, 2024

Private Credit: Characteristics and Risks1

What is Private Credit?

Who Invests in Private Credit and Why?

Figure 1. Growth in Private Debt Allocations

Figure 2. Top 20 Private Debt Managers

Characteristics of Private Credit using Loan-level Data

Figure 3. Number of Loans in Pitchbook

Figure 4. Average Deal and Loan Size

Loan Type and Pricing

Figure 5. Loan Type

Figure 6. Credit Spreads

Source: Pitchbook and authors' calculations

Figure 7. Maturity Wall in Private Credit

Source: Pitchbook and authors' calculations

Figure 8. Average Maturity in Private Credit

Source: Pitchbook and authors' calculations

Figure 9. Deal Types

Source: Pitchbook and authors' calculations

Figure 10. Average Loan Spread By Deal Type

Source: Pitchbook and authors' calculations

Rise of Club Deals

Figure 11. Average Number of Lenders in a single loan facility

Source: Pitchbook and authors' calculations

Figure 12. Interest Coverage Ratio has declined

Source: KBRA DLD

Figure 13. Year-to-Date Default Rate (As of Oct, 2023)

Source: KBRA DLD

Loss Given Default

Figure 14. Share of Loans with 1st Liens

Source: Pitchbook and authors' calculations

Figure 15. Recovery Rate

Source: KBRA DLD

Figure 16. Share of Lower Collateral Sectors

Source: Pitchbook and authors' calculations

Financial Stability Implications of Private Credit

Rise in corporate leverage and default

Dry Powder and deterioration in credit quality

Potential spillover to other nonbank institutions

Interconnections with banks

4. See Block et al. (2023). Return to text

13. See (https://www.lcdcomps.com/lcd/n/article.html?rid=170&aid=12504728&viewTracking) As rate pressure

15. See (https://www.bloomberg.com/news/articles/2023-10-26/private-credit-lenders-giving-up-protections-to-win-

17. See (https://www.bloomberg.com/news/articles/2023-11-01/jpmorgan-jpm-is-said-to-seek-out-a-partner-for-

18. See (https://www.wsj.com/finance/banking/bank-synthetic-risk-transfers-basel-endgame-62410f6c) Big Banks

Please cite this note as:

Last Update: February 26, 2024

You might also like

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.