Gabriel Yomi Dabiri, global head of private credit at Squire Patton Boggs, highlights regulatory gaps that should be addressed in a targeted way
Private credit has seen incredible growth since the GFC, but now faces a new challenge: navigating increasing regulatory pressure and questions about its resilience to stress. Squire Patton Boggs recently published an outlook on the private credit market, analysing the collapse of major players in the asset-backed finance market, such as MFS, and the scrutiny the industry has faced over widespread redemption calls.
Q: In your report, you refer to the recent downfalls of MFS, First Brands and Tricolor as a test for the market, rather than a systemic crisis. What would happen for it to become a systemic problem?
A: First Brands, Tricolor and MFS were the first shots across the bow when it came to private credit. There are large players in those facilities that historically built a reputation on solid, conventional underwriting, which should have ferreted out much of the alleged fraud that was occurring there, which is why people were very concerned when it came to light.
In our practice, we are not seeing evidence of widespread fraud, so on this basis, we feel relatively comfortable that these are relatively isolated, idiosyncratic events. Furthermore, these events were not limited to private credit. Large traditional lenders were also in these deals, so it was not accurate for the reporting to make this appear to be solely a private credit issue. These events were more underwriting and diligence issues that impacted traditional lenders and private credit lenders alike.
Q: Can you explain why there has been so much market concern over loans to software companies and how this has impacted the private credit market?
A: Between 2020 and 2023, software companies that had received high valuations were leveraged based on certain revenue projections. The projections for many of these software companies that produce easily commoditised software are now proving flat-out wrong due to the powerful rise of AI, which is disintermediating these applications. As a result, the ability of these software companies to service their loans was called into question, adversely affecting the underlying value of the managers' portfolios, which the market viewed as overweight in software.
These developments have been alarming to retail and institutional LPs; however, redemptions from these retail funds are usually capped at around 5% per quarter. These caps came as a surprise to some investors.
While the impact on those investors is clear, those concerned that these outflows will lead to contagion in the broader economy should derive some comfort from the fact that these managers can rely on these gates. They limit capital outflows during this vulnerable period and, in some cases, help prevent a run on the fund.
It is also worth noting that this is exactly how these funds are designed to operate, and in most cases, is completely consistent with the terms these investors agreed to at the outset. It was also not a tool that traditional banks had in the lead-up to and during the global financial crisis.
Although we are seeing material outflows, albeit capped, we are also seeing tremendous inflows into private credit during this same period. Much of these inflows are being reallocated from areas like software to more tangible asset private credit financings, such as infrastructure and asset-based loans.
Q: Looking at the liquidity mismatch you describe in retail private credit, do you think this is an education issue for retail investors, or do you think the structure of semi-liquid funds should be looked at more closely?
A: Both. There are two types of business development companies (BDCs) used to provide investors with exposure to the private credit market: institutional private credit BDCs and retail private credit BDCs. The concerns often raised in the news pertain almost entirely to retail private credit. 80% of the private credit market is held by institutional investors who, by and large, understand the illiquid nature of their investment. Retail private credit accounts for only 20% of the private credit market, and there is reason to believe many investors did not fully understand or appreciate the terms of their investments.
In my view, you have a choice when it comes to retail private credit. You either significantly increase education, disclosure and transparency for these retail investors to ensure that they fully understand what they're investing in, or you don't permit it at all.
This middle ground - where the level of education, disclosure and transparency has clearly fallen short of the standard necessary to help retail investors fully understand what they're investing in - is clearly a problem, but one that can be fixed. Doing so would be a net positive for the safety and sustainability of retail private credit and the reputation of the wider private credit industry.
Q: Are semi-liquid funds currently relying too heavily on the assumption that not all investors are going to ask to redeem the assets at the same time?
A: In my view, it is not helpful to a manager when any of their investors do not fully understand their investment. I’m sure the attempts by retail investors to withdraw the entirety of their investments, when that wasn’t the deal they signed at the beginning, have been unpleasant and disruptive to say the least for everyone involved. Ensuring, as best as possible, a full understanding by those investing in retail private credit benefits managers and investors alike, because it should eliminate the information asymmetry about how these funds are supposed to operate and reduce the need to impose a gate that will inevitably create uncomfortable headlines.
Overall, additional targeted prudential regulation ensures that retail investors understand what they're signing on to and enjoy greater transparency of what they're investing in, which can only benefit the retail private credit industry.
Q: Do you think increased red tape and new regulatory structures might damage the attractiveness of private credit to investors?
A: It depends on the nature of the red tape. I don't support a full-scale bureaucratic overlay of the private credit market because I do not believe that is what this moment calls for. Part of what makes private credit such an attractive option is its speed, but at the same time, I think it is important for the market to operate sustainably.
This recent market dislocation has highlighted some regulatory gaps – specifically in the relatively smaller retail private credit segment of the market - that I feel should be addressed now, but in a targeted way; fix the leak rather than shut off the water supply.