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Industry Opinion
Is Private-Credit Echoing the Subprime Meltdown?
By Nironjan Roy, CPA, CMA — Certified Anti-money laundering Specialist and Banker
During the last few months, discussion on private credit has captured an important area in the U.S. financial market where analysts and experts are speculating on this issue from different perspectives. The U.S. financial market has emerged as the largest and most efficient investment hub in the world, where a wide range of sophistication and diversification in developing financial products has taken place.
This development has opened multiple avenues of investment with potential growth, but at the same time, placed the industry on a highly risky pivot. Although there are stringent regulations, the diversification in multiple avenues exposes multilayer risks.
Situation
The situation is such that if one avenue is tightened, the other avenue explodes, as is likely to happen in private-credit lending. After the subprime mortgage meltdown in 2008, banks were put under strict regulation, but private credit is now about to explode.
Media
As per media reports, many private-credit companies have resorted to understate their exposure to the technology companies, which are mostly impacted following the AI rollover. Their concern is that if high exposure in the IT sector spreads, a contagion impact may be caused in the whole financial market. According to the report, four large private-credit companies, which include Apollo Global Management, Ares Management, Blackstone, and Blue Owl Capital, have officially reported less exposure to softwire companies than their actual exposure to this sector. One local media investigation found that four large private-credit companies have 25% exposure in the softwire sector, as opposed to their official reporting 19% exposure in this sector, which is a clear instance of how private-credit companies are understating their risky exposure.
Reporting requirements
As per reporting requirements, non-deposit taking financing companies, which are involved in private lending to business firms and startup companies operating in different sectors, are required to submit a report depicting sectoral exposure, e.g., softwire, healthcare, education, auto-industry, technology, etc. However, the methodologies applied by private-credit companies in categorizing sectoral exposure vary from company to company. Although some private-credit companies strictly follow the independent Global Industry Classification Standard, most follow different methods. So, it appears that the methodology followed by private-credit companies to categorize their exposure is not uniform.
While categorizing private credit in different sectors, there is scope for ambiguity in what can easily be maneuvered in switching the exposure between two sectors, because software is used by almost all companies operating in different sectors. So, funds lent to one sector can either be categorized as loans to the softwire sector or to that particular sector. When the technology sector, specially softwire sector, was in booming condition, the private credit was also enjoying tremendous growth, and understating or overstating the exposure was not a concern at all. AI rollouts across various sectors at scale have been rapidly replacing the applications of most software companies.
This sector has been exposed and, as such, categorized as a high-risk portfolio. Since serious concerns about AI replacement have crushed the stocks of public software companies in the last few months, many private credit companies have resorted to understating their exposure in software and thus trying to turn the spotlight on competitors.
This sector has been exposed and, as such, categorized as a high-risk portfolio. Since serious concerns about AI replacement have crushed the stocks of public software companies in the last few months, many private credit companies have resorted to understating their exposure in software and thus trying to turn the spotlight on competitors.
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It is learned from media reports that the software companies in private-credit portfolios have the highest debt compared with their earnings, on average, than companies in many other sectors. However, many private-credit companies have been denying this speculation and saying that they believe the fears about loans in softwire companies are overblown and that they are confident about the quality of their portfolios.
Although their source of funds lent to various sectors of the economy is not public, many of their loan portfolios will not spare the deposit-taking commercial banks, which might have heavily loaned to the private-credit companies. If private credit really explodes, there will be a contagion impact in the entire financial industry, as many commercial banks may sustain significant losses from private credit chaos. As learned from media reports, investors, analysts, and experts are assessing the banks’ lending volume to the nonbank financial institutions, particularly private-credit companies, which have recently experienced substantial withdrawals. As experts opine that loans disbursed to the softwire companies are at high risk of non-recovery due to the massive disruption of this sector’s business due to the full-scale AI rollover. The fear of banks’ suffering losses has already started reflecting in the stock market performance, as many banks’ stocks have underperformed in recent trading. During the current year trading, the KBW Nasdaq Bank Index is down around 6%, whereas the S&P 500 has experienced around 4.5% decline.
Post 2008
After the financial crisis in 2008, banks were put under stringent regulation and control with additional capital requirements, so banks restricted their direct lending to the businesses and sectors where risk rating seemed very high, and small and medium businesses, startup companies, and software companies were categorized under this risky sector. However, banks’ lending activity was not limited, but rather continued in a different form to keep their revenue growing. Most banks changed their lending strategy, diverting loan portfolios to the private-credit companies, non-depository financial institutions, mortgage lenders, consumer lenders, and private equity funds, instead of directly lending to the end-user businesses. Through this lending maneuvering, commercial banks were able to keep their credit business growing with a sharp rise in banks’ exposure in non-bank financial institutions. The media has reported that the banking sector has raised its loan portfolio from $1.1 trillion three years ago to $1.9 trillion in non-bank financial institutions, which mostly include private-credit companies.
Sensing the massively rising exposure in private-credit companies, the Fed has put a close watch on banks' portfolios, compelling them to disclose more details on their nonbank lending. Although the present situation is not the same as it was in 2008, because the financial market is under strict regulation, well-positioned with strong resilience, and the banks' capital base is very strong. So, a recurrence of the 2008-type financial crisis is very unlikely, yet the way software companies are struggling due to AI rollover, private credit seems to be echoing the subprime mortgage meltdown.