A record 80% of new European private credit funds used bank borrowing in 2023, raising concerns about potential risks and interconnections within the financial system.
Risks of Bank Borrowing by European Private Credit Funds
European private credit funds are increasingly relying on bank borrowing to boost their performance, raising concerns about potential risks and interconnections within the financial system. According to research by MSCI Private Capital Solutions, a record 80% of new European private credit funds used bank borrowing in 2023. These funds utilize ‘subscription lines’ that allow them to lend money before receiving cash from investors.
( Credit to: Reuters )
The use of subscription lines by credit funds aims to enhance returns, particularly for newly established funds. However, regulators, including the Bank of England (BoE), are investigating the potential risks lenders face from their exposure to credit funds. Credit funds are loosely regulated and provide financing to companies that struggle to borrow directly from banks or bond markets.
The rise of private credit funds, often referred to as shadow banks, has raised concerns about the possibility of new asset bubbles that could undermine financial stability. Chris Naghibi, Chief Operating Officer of First Foundation Bank, warns that the increased engagement of banks in the private credit domain brings them closer to the inherent risks associated with this sector.
Adding Leverage and Potential Risks
In addition to borrowing from banks, some private credit funds are also adding leverage to their loans. While this maximizes returns, it also amplifies potential losses. Over 20 industry sources and fund filings reviewed by Reuters confirm this trend. These developments are occurring at a time when corporate distress in Europe has reached its highest level since the start of the COVID-19 pandemic.
European private credit funds currently manage an estimated $460 billion, according to UBS. Their growth coincides with an economic slowdown, raising concerns that private lending may be delaying decisions to restructure struggling businesses. However, since these funds are not required to disclose detailed information about their loans or bank leverage, regulators and bank investors find it challenging to assess the potential risks associated with credit fund lending.
Mitigating Defaults through Flexible Lending
Several sources reveal that private credit funds have managed to avert defaults through flexible lending and complex refinancing structures. Deloitte estimates that nearly 70% of European private debt deals involve only one lender, giving them sole control over the terms and interest rates charged. Some funds have been altering loan terms, such as covenant headroom, to defer stress and potential defaults. However, experts warn that this approach may result in lower loan recoveries in the future.
Payment-in-kind facilities (PIKs), where firms defer interest payments to later years, have become more prevalent in European private lending deals. Credit intelligence provider Reorg found that PIKs were involved in 3.5% of direct lending deals across six European countries in the last quarter of 2023, nearly double the figure from the first quarter of the previous year. Additionally, a fifth of European private credit deals in the final quarter of 2023 were debt refinancings that extended loan repayments, according to Deloitte. This trend helps to postpone the day when businesses will face the higher cost of debt.
The Need for Regulation and Monitoring
The reliance of European private credit funds on bank borrowing and the addition of leverage to their loans raises concerns about the potential risks and interconnections within the financial system. Regulators and industry experts are calling for further regulation to ensure the stability of the banking ecosystem. As the private credit market continues to grow, it is essential to monitor these developments closely and address any potential risks proactively.
A recent study by the Bank of England acknowledged that participants in the private credit market have reported minimal defaults compared to the wider market of lending to riskier borrowers. However, ratings agency S&P Global predicts that defaults by European speculative borrowers could reach 3.75% by June.
Peter Marshall, co-head of European restructuring at investment bank Houlihan Lokey, notes that many are questioning why corporate restructurings have not been more prevalent given the current economic climate. He believes that private credit funds’ flexible lending practices have helped to avert some defaults. However, experts warn that this approach may delay the necessary restructuring of struggling businesses and ultimately result in lower loan recoveries.
