The Biden administration and foreign regulatory bodies are threatening to hinder investment in midsized American businesses and everyday products such as credit cards, auto loans, and student loans. The unwarranted scrutiny of private credit, or loans to private businesses, is a threat to the free market’s response to government’s intrusion in credit allocation.
Private credit provides integral financing to about 200,000 middle market businesses that make up the backbone of the U.S. economy. Middle market companies, “with revenues between $10 million and $1 billion,” employ about 48 million people and make up over 30 percent “of private sector GDP.”
Securitizations, such as collateralized loan obligations (CLOs), enable financing for middle market loans. Since the 1990s, only 0.3 percent of U.S. CLO tranches have defaulted. The underlying assets are primarily senior secured floating rate middle market loans. In the event of a default, investors in these loans would be first in line to get their money back. The floating rate nature of these loans is also advantageous for borrowers since the Federal Reserve is almost certainly going to start lowering rates in September.
Other asset-backed securities enable financing for consumer financial products such as credit cards, auto loans, and student loans. All types of private credit, including asset-based private credit, offers higher yields and lower default risk compared to public fixed income, such as high yield bonds. Private credit loans are stable investments that do not pose any systemic financial risk.
Compared to public debt, private credit covenants are generally stronger. Contentious jockeying between creditors “in private credit is comparatively lower than the [broadly syndicated loan] market.” According to other data, “only about 20% of direct lending deals” have weaker covenants. On the other hand, “about 90% of syndicated loans are covenant-lite.” Additionally, “[l]everage on new direct lending deals has declined.” Investors are less exposed to risk in private credit.
Despite lower risk and higher yields, U.S. and foreign regulators seem determined to intervene in private credit. The head of the Financial Stability Board (FSB), which is an intergovernmental entity based in Basel, Switzerland has wrongly criticized private credit. The Bank for International Settlements (BIS), which is the parent entity of the FSB, the International Monetary Fund (IMF), and the Financial Stability Oversight Council (FSOC) have also made unfounded accusations of private credit’s “opacity” and “illiquidity”—neither of which necessitates more regulation.
Critics of private credit complain that it is too opaque. However, private credit transparency is designed to differ from public equities and debt. Private credit uses investments from accredited investors, such as pension funds, endowment funds, or wealthy individuals. The U.S. Court of Appeals for the Fifth Circuit recently struck down the Securities and Exchange Commission’s private fund adviser rule primarily because Congress never intended for institutional investors to receive exactly the same disclosures as individual investors.
Private credit’s illiquidity is a benefit to investors because they can earn higher returns in the form of an “illiquidity premium.” Illiquid funds also protect investors against volatility and are not as susceptible to rapid redemptions, or fire sales.
Regulators are putting the U.S. financial system between a rock and a hard place. The proposed rules for the U.S. implementation of bank capital requirements arbitrarily limits banks’ exposures to securitizations. The rules also make it more expensive for banks to lend to private companies compared to publicly traded companies. The market has adjusted to these types of regulations by creating private credit funds to fill the financing gap. Regulating private credit similarly to banks would reduce credit allocation and make credit access more costly.
Private credit is a free market manifestation of the status quo. For example, KKR and Carlyle purchased Discover’s portfolio of student loans. The loans may be used in asset-based private credit, which would offer debt and equity tranches to potential investors. Even some banks are adapting and launching their own private credit funds to provide “non-bank private capital to the middle market.” When government-mandated capital requirements prevent banks from holding certain assets, nonbank financing allows borrowers to continue to access affordable credit. If private credit is further regulated, the continuation of this financing will become much less affordable or terminate entirely.
Scrutinizing private credit will inevitably hamper capital allocation to midsized American companies and individuals who rely on credit cards and other consumer financial products. Private credit has a role to play in the U.S. economy. Instead of criticizing new and innovative methods of private financing, policymakers need to embrace it and refrain from shortsighted interventions.
