Private Credit: Wall Street’s $2.7 Trillion Gamble Raising Eyebrows—And Red Flags

Private credit is Wall Street’s new favorite asset class, with the market size skyrocketing from less than $500 billion a decade ago to over $2.7 trillion by 2023, and projections suggest it could reach $3.5 trillion by 2028. While this asset class offers high returns that have attracted institutional investors, including private equity giants, pension funds and insurance companies, some top financial voices—such as the IMF and UBS Chairman Colm Kelleher—warn it may be the next big financial bubble.

Private credit generally refers to loans issued by non-bank entities, such as private equity funds, that lend directly to businesses. This financing method filled a gap left by traditional banks, which, after the 2008 financial crisis, were constrained by stricter regulations on high-risk lending. With fewer restrictions and a willingness to serve riskier borrowers, private credit funds moved swiftly into sectors where banks feared to tread, lending billions to companies in industries ranging from manufacturing to retail. This sector, however, is not as closely regulated as traditional banking, sparking concerns about whether investors are fully prepared for the risks involved.

Industry leaders have warned that the call is coming from inside the house. “There’s been an evolution into private markets; before the global financial crisis, the risk was inside the banks, now it’s outside,”  Jamie Weinstein, a managing director at PIMCO helping lead $170 billion in alternative investments, told Bloomberg TV in November 2023. “There’s been this big transfer of risk to investors. The question is when will the regulators start looking,” he added. Kelleher put forth a similar view: “There is clearly an asset bubble going on in private credit,” he told investors at the FT Global Banking Summit in November of last year.

Data backs their concerns. A study by Bloomberg and Solve, a fixed-income analysis firm, found that private credit managers often assess their holdings as significantly safer than comparable publicly traded investments managed by major banks. Moreover, valuations of the same asset can vary widely across different private credit funds, highlighting substantial inconsistencies in how these firms gauge risk. For instance, a loan issued to Magenta Buyer, the financing arm of a cybersecurity company, was valued at 79 cents on the dollar by the most optimistic private lender, suggesting a relatively strong recovery expectation. However, another lender marked the same loan at just 46 cents on the dollar, placing it firmly in distressed territory.

Evidence is starting to mount that private credit valuations may not hold up. On average, private credit firms recovered just 48 cents on the dollar after a default, compared to 55 cents for loans issued by bank syndicates. Consistently worse recovery rates among private credit loans reveal higher-than-expected risk among their holdings. Notably, private credit managers tend to value their loans far more optimistically in the lead-up to defaults. Six months before a default, private credit loans were valued at an average of 76 cents on the dollar, compared to 67 cents for bank-led loans. Three months before default, the gap narrowed slightly, with private loans marked at 70 cents versus 61 cents for bank loans. Private credit funds, it seems, try to keep their investments’ valuations inflated, giving a false sense of safety to investors.

For institutional investors, private credit is an enticing investment. It promises higher risk-adjusted returns than equities and government bonds and is relatively insulated from the volatility of publicly traded markets. However, the industry may be standing on shaky legs.