The private credit market has grown 10-fold from 2009 to 2023. The industry added $1 trillion in the last 18 months alone. It has $3 trillion in AUM (Assets Under Management) and is one of the fastest-growing segments of the financial system over the past 15 years, according to American multinational strategy and management consulting firm McKinsey.
The primary reason is the retrenchment from traditional banking that followed the 2007-2008 global financial crisis. The phenomenon led to a shift away from legacy lending, while debt markets and shadow banking took centre stage.
Since then, we have seen global economic uncertainty in the form of the COVID-19 pandemic, the Russia-Ukraine war, geopolitical volatility in the Middle East and more recently, whenever United States President Donald Trump says something on social media or is in front of a camera.
The reductions in workforce are not solely a result of market volatility; they are also influenced by increasing regulatory pressures. This includes proposals related to the Basel III Endgame, which will require banks to strengthen their capital reserves across various lending sectors. Additionally, liquidity regulations are likely to reduce banks’ willingness to extend longer-term loans, noted McKinsey.
Sensitive to market shocks and stymied by policy, private credit has come in, with a recent EY report suggesting that “Europe accounts for roughly 30% of the private credit market.” Investment in infrastructure and energy is an important driver of growth across the continent, and private credit is “likely to be a key enabler of the global green energy transition” with “estimates suggesting that between $100 trillion and $300 trillion will be needed by 2050,” the EY report said.
Private credit has seemingly become a staple of the financial landscape, a counter-cyclical hero in economic downturns, but what happens when private capital encounters jurisdictions with geopolitical instability, and to what extent are financial markets exposed to risks that remain invisible to them?
Private credit explosion
After the global financial crisis (GFC), the collapse and near collapse of some of the too big to fail banks served to kickstart the Great Recession, the worst global downturn since the Great Depression, during which millions lost their homes, their savings and their jobs.
Although the economic downturn impacted private credit, the data show that historically, private equity portfolios have generally shown shallower peak-to-trough declines than the public markets, and while the banks had to curtail their exposure, the private deal-making environment rebounded in the second half of the recession, in 2009.
The post-GFC environment was the first true stress test for private equity, and it barely passed. A 2019 study of private equity during the Great Recession outlined that despite the increase in deals, fund managers in private equity “failed to take advantage of opportunities to buy high-quality assets at steep discounts.”
Analysts point to three characteristics that explain why private credit grew so rapidly in the past. Unlike the banks, PE has easier access to capital and more freedom to deploy it, and as a result, PE can grow market share and assets faster during a crisis. Active management is also the norm in most global funds, and value creation is heavily weighted.
This gave funds the green light to build new capabilities and initiate transformation projects. Finally, private equity is not very liquid, which can help insulate investors from the panic selling that usually occurs in times of economic downturns, when it often brings losses of 5-10% higher. The combination of higher yields, bespoke terms and less oversight makes private credit very attractive.
While private credit has exploded over the last 15 years, the success story contains reasons for caution, most notably the illiquidity risk (the ability to get money out of an investment quickly is normally a good thing, but it can be especially helpful in a downturn).
And with geopolitical instability rarely priced in adequately, cracks could develop very quickly, especially when it comes to geopolitical risks, which are particularly hard to hedge against due to the sudden and severe effects of political instability, trade disputes, war, cyberattacks, climate change and natural disasters.
Just weeks before Russia invaded Ukraine, Horizon Capital, the largest private equity group in Ukraine, had launched its fourth flagship fund. Sarah de St Croix, head of private funds at law firm Stephenson Harwood, said that it was essential to have provisions in place to allow fund managers to react to geopolitical events.
For example, “managers affected by a geopolitical event could lean on their common law right to force an investor to exit the fund where their continued participation violates law or regulation.”
Although these clauses had not been written with specific timing in mind, funds were able to “handle the situation of having a sanctioned investor in a commingled pool after widespread sanctions against Russian individuals were imposed in 2022.”
The GFC came after private credit went global, and geopolitical risk was not top of mind, but Weijian Shan, executive chairman and co-founder of investment firm PAG, said that “the geopolitical risks are very real now, you used not to have to think very much about it. Now you really need to think about decoupling risks; you really need to think about restrictions to the international flow of goods, people and capital.”
Resource nationalism
This is a fairly hard-edged way to look at it. Still, it does come into sharper focus about sanctions risks, political instability or local capital controls that would strand foreign investments, or populist governments reneging on investor protections.
Indonesia, a key global exporter of coal, palm oil, copper, gold and other minerals, produces 37% of the world’s nickel and has been pursuing a form of resource nationalism for a decade.
This has overlapped with heavy demand from China, and as Dr Eve Warburton of the Australian National University explains, “over this same period, the Indonesian Government introduced increasingly nationalist policies: new divestment obligations for foreign miners, a ban on the export of raw mineral ores, stringent new local content requirements and restrictions on foreign investment in the oil and gas sector, and observers noted increasing court cases and popular mobilisation against foreign companies.”
This matters given the key role nickel plays in the batteries of electric vehicles and in renewable energy storage, making Indonesia a central part of the global energy transition.
If the private credit market is not to become a victim of its own success, it will have to surmount some significant hurdles. Rapid growth has pushed funds into new niches, often in emerging and frontier markets where yields and risks are highest.
According to the Institute for Economics and Peace, “Today geopolitical risks are higher than at any time during the Cold War due to greater military spending, stalled nuclear disarmament, and a reduction in the power of multilateral institutions such as the United Nations,” and this is coupled with active wars in Ukraine and Gaza, US-China decoupling, growing political instability and polarisation, misinformation, and an increase in cross-border sanctions and capital controls.
Another issue for the industry is the risk of financial contagion. As any investor who has taken on private credit knows, that means anyone who has loaded up on private credit, whether pension funds, sovereign wealth funds or insurers, has more of their capital in opaque, illiquid private deals that are more vulnerable to losses that were neither expected nor fully priced for. A crisis in the private credit market would pose a systemic threat to the wider financial system.
The greater the reach of private credit funds into higher-risk jurisdictions to satisfy expectations for higher yields, the more the potential for sudden, catastrophic losses increases. Access to capital, flexibility, and the ability to go where banks will not go are the hallmarks of private credit’s success, but in an unstable world, those advantages can rapidly turn into liabilities. The next market crisis is unlikely to begin on Wall Street or in the bond markets. But it is a must in a foreign ministry, a war room, or a populist parliament. Private credit needs to be ready.