Private equity-backed companies are struggling to pay back loans, leaving regulators concerned that banks will be exposed should private credit funds collapse.

Highly leveraged companies are being hit by rising interest rates, stubborn inflation and tough trading conditions. Banks are weathering the downturn for now, largely because private credit funds offering better terms have overtaken banks on lending to individual buyout deals over the past decade.

But while leveraged lending on a company-by-company basis is down, banks have started to lend more to private credit funds themselves on a portfolio basis, experts say. While this allows credit funds to ‘juice’ higher returns, this, along with bridging loans, could leave banks at risk.

Private credit gives rise to public concerns

• Banks are less exposed to downturn in fortunes of private-equity backed companies than they were during the global financial crisis
• But new risks are emerging with question marks over bank portfolio lending to private credit funds
• Regulators are concerned over the systemic importance of private credit to the global financial system and banks’ rising exposure to private credit funds

Despite strains in the leveraged loan market, there is no let up in bank lending to credit funds, says Lee Doyle, a partner at law firm Ashurst. “If anything, it’s potentially increasing”, he says. 

However, Doyle argues that banks are feeling relatively relaxed for now, believing that their exposure is limited and that most portfolio companies can weather tough economic conditions.

“The banks have managed to broaden their risk by taking portfolio as opposed to sole-asset risk,” he says. “It’s all subject to further, future macroeconomic issues, but I think the banks would take a view at that stage that they feel reasonably well-protected.”

NBFIs are ‘where the weaknesses are’

But there could be a potential domino effect. Doyle says: “If you had a couple of funds go down, I think that the investor community could find itself cash strapped. The non-bank financial services sector is potentially where the weaknesses are right now.”

While larger multi-strategy private credit funds may be well protected, there are question marks over how smaller and newer private credit funds will fare if some of their investments default or struggle to service their loans.

If funds collapse, it would put a strain on banks, but the bigger threat may be the pressure it puts on investors.

“A lot of the money that’s been invested in private debt and private equity is pension money. You and I are exposed to this,” says Andrew Cruickshank, a director at advisory firm Deloitte. “Risk has been shifted to another part of the market — albeit that part of the market is structurally different.”

This could have stability implications for the wider financial system. The interconnectedness of banks and non-bank lenders is increasingly worrying regulators. 

In March, Pablo Hernández de Cos, chair of the Basel Committee on Banking Supervision, said that rules around this interconnectedness may not be “sufficient”.

The stresses that cash-strapped investors can put on the financial system were illustrated last year, when the Bank of England had to prop up the UK bond market to prevent pension funds collapsing.

‘Someone else’s problem’

Over the past decade, private credit funds have stepped in to provide the riskiest forms of financing for buyout deals. 

Banks now typically provide only the safest forms of financing, such as super-senior loans or working capital facilities. This means that when companies struggle to pay their loans, banks are some of the first in line to have their debts repaid.

Private credit funds have already started to take control over some struggling private equity-backed companies in deals known as ‘debt for equity swaps’. 

During the last financial crisis, banks typically drove these changes in ownership. But updates to regulatory capital rules mean that it is now much more expensive for banks to take equity stakes in companies. Reputational risk also means that banks are loath to take ownership of private companies.  

Bain Capital recently ceded ownership of German manufacturer Wittur to KKR’s credit business and Carlyle is expected to cede ownership of security company Praesidiad to a group of lenders including Bain Capital’s credit business.

David Morris, head of UK restructuring at FTI Consulting, says banks are “probably less exposed than during the last financial crisis as they’re holding a lot less of the debt”.

But he cautions that risk has just been shunted to a different part of the market. “Effectively, it’s now someone else’s problem.”