Series 8 Episode 6: Private credit at an inflection point - growth, risk and regulatory scrutiny

Transcript

Tessa Norman: Hi everyone, and welcome to Risk & Regulation Rundown, the podcast where we explore the latest issues shaping financial services risk and regulation. I'm your host, Tessa Norman, and in today's episode we're exploring private credit, an asset class that's been attracting increasing regulatory attention as it continues to grow and become more interconnected with the wider financial system. We'll be discussing how the private credit market is evolving, and the opportunities and risks that creates. And we'll also share perspectives on what firms can do to prepare for the next phase of the market's development.

I'm really pleased to introduce two brilliant guests to help us unpack all those important implications: Sajan Shah, a PwC Director specialising in private credit and Conor MacManus, a PwC Managing Director and leader of our Financial Services Regulatory Insights team and a return guest to the podcast. So welcome both, and I should just say that Sajan is joining us remotely, so please note there might be a slight difference in sound quality.

Sajan, private credit has been one of the fastest growing areas of financial services over the past decade or so. Could you start by sharing a bit of context with us in terms of what do we mean when we say private credit and what have been the key factors that have driven its growth?

Sajan Shah: Thanks Tessa, and great to be here. Private credit, in its very simplest form, think about it as an alternative to bank funding, which is not listed. And historically, it's been focused on either distressed debt from banks across Europe and globally, to direct lending to sponsor-backed businesses in a very low interest rate environment. And that's what it's really been to date, but it has scaled up massively. And I'll talk about a couple of the reasons why. We're at over 2 trillion today in terms of private credit globally in dollar terms. The expectation is that's growing to $3.4 trillion by 2030. And ultimately because private credit is going to operate alongside traditional banking, is addressing an approximate $50 trillion bank market. And the UK, as we sit here today, is at the centre of that because 64% of European private credit is from the UK. So we have a big role to play. But as you say, it's in every part of our economy, mortgages, credit cards, day-to-day real estate, even going to sports financing and music royalties. So it is very broad.

Why has it grown? A few reasons. Higher interest rate environment, is the main factor. The banks retrenching because of increased costs and regulation. And also the borrower preferences as customers seek more structured solutions from their originator or lender of products, alongside investors saying we want to diversify and search for yield. So that's where it's grown. And it's not just credit funds investing, it's insurance companies, pension funds, etc. And it's really growing and here to stay.

Tessa: Thank you, that's helpful context. A lot of those themes that you spoke to really came through in a recent global private credit survey, which PwC carried out. So that surveyed over 120 credit portfolio managers. And it described private credit as being at something of an inflection point. It'd be great if you could tell us a bit more about that and what do those findings tell us about how the market's changing?

Sajan: Thanks, it's the first time we've done this survey and it's been super interesting to hear views across the globe, just not from the UK and Europe. And there's probably three things that resonate in terms of the survey. The growth aspect is one, because over 80% of respondents were increasing allocations over the next 12 months. It's not just corporate sponsor backed lending, it's infrastructure debts relevant for the economy, real estate debt, asset backed finance, all growing. So growth is number one. The second one is the pressures that the market is facing, with competition and margin pressures. There's an increased emphasis on designing the right product, innovating that product. To my earlier point around customers want a more bespoke solution for their borrowers. So how do you generate that alpha on your returns and structure it is important. And the third one is, the inflection point is valid because there has been some more focus on it in the market that people are reading in the press. But it is a tougher credit cycle we face ourselves in. Defaults are coming, regulatory scrutiny is going to be there. So, the message there is actually investment selection, performance, governance and downside protection, there'll be a lot more emphasis on to navigate the period that we are in private credit as a whole.

Tessa: You've mentioned regulatory scrutiny there and Conor it’d be great to get your perspective and bring you in here. What are the key concerns from the regulators’ perspective? And can you tell us more about why we've really seen that moving up the regulatory agenda recently?

Conor MacManus: Of course, thanks Tessa, and great to be here and having this conversation, as it’s a super timely topic. Sajan has done a brilliant job in terms of explaining the importance of private credit, the growth of private credit, the role that it plays in the economy in the UK and globally. And as a consequence of that, it is normal and natural that central banks and regulators are increasingly focused on the sector because of its growth. I don't think that in of itself is a concern to the regulators. Actually this is a positive story in many, many ways. It's provision of credit, that's a really important role that needs to be fulfilled. But I think there's a few things which are clearly attracting regulatory interest, which Sajan has already talked about, this is probably the first meaningful credit cycle that we've gone through in private credit. So there is focus on credit quality, although I think if you read the survey and you look across the sector, that's a relatively contained concern. I think the other area that the regulators and central banks are very focused on is the relative opacity of the sector, particularly compared to the banking sector, which is obviously much more intensively supervised and has much more significant reporting and disclosure requirements. And then I think finally, but really importantly, is this interconnectedness that private credit has with other parts of the financial ecosystem. Clearly, the asset managers are fully embedded in the market, but the banks are providing financing, have other interconnectedness with private credit. That's become more complex in some situations. Insurers are also providing increasing amounts of capital to the sector. So it boils down to three things. One is a focus on credit quality, risk management within private credit. Two, a better understanding of what's going on within that sector. And three, the level of interconnectedness that private credit has with the rest of the system.

Tessa: Sajan, it would be great to get your perspectives on that interconnectedness point in particular. How are you seeing private credit changing the way that banks, insurers and asset managers interact with one another?

Sajan: I mean, this is where it really is; what do you define a particular type of party to be now? Because are they an originator? Are they an investor? Are they a partner? Every one of those parties can be any one of those categories. And so, from my perspective, convergence and partnerships are the two big things to draw out here. So if I take the convergence point first, if you take the insurance point that Conor has mentioned, credit funds are using insurance capital now. Insurers are buying credit asset managers, so there's more consolidation, as one point where the line's a little bit blurred between who does what and where you can invest across the capital stack.

And then on partnerships, banks want to serve their customers better, but private credit is complementary to that rather than necessarily a replacement to it. So whether it's a capital consideration, whether it's being more relevant to the customers by offering a slightly higher risk product, or it's solving for concentration limits that they might have at the bank, whether it's infrastructure debt, corporate direct lending or real estate debt, there are different reasons why banks end up partnering with private credit. And it's not always insurance companies, it's pension funds and other traditional asset managers, people who want exposure to something that they want to work with someone who's already been in that space. And so either you're a manufacturer of a product to map against capital that you have, or you invest or partner. And the interconnectedness is important because private credit is not just a niche alternative allocation now. And how do you work together with other parties in this space to provide a better solution for borrowers, sponsors and alike in the market?

Tessa: Given all of that context, clearly we're seeing regulators respond with a number of initiatives, most significantly the Bank of England’s system-wide exploratory scenario, known as the SWES. Conor, could you share your thoughts on what are the key regulatory initiatives that firms should be aware of and what impact you expect those initiatives to have?

Conor: Certainly, I suppose there’s probably two lenses, well, at least two lenses, probably more, but let's go with two to apply to this. One is the macro-prudential system-wide interconnectedness point, and the other is more firm-specific micro-prudential risk management considerations. So, in the first bucket, the macro-prudential, the SWES is a great example of that. That's a unique exercise that the Bank of England is undertaking to understand how any shock in private credit markets could move around the system and impact other participants. And that will be a very helpful exercise, hopefully, to understand those interconnections and to give more visibility to the Bank of England as a macro-prudential organisation to understand the landscape and how and where the risks might sit.

But then there's for all of the organisations within the ecosystem that Sajan set out, micro-prudential firm-specific supervisory and regulatory considerations. So, for the private credit firms themselves, the FCA is looking again at the AIFMD, the UK version of AIFMD, which is the regulatory framework which covers many of the private credit firms themselves. They're also planning some supervisory activity, focusing on the sector around risk management capability. But then for the banks, for example, there has been a big, big focus from the PRA and from other prudential regulators globally around understanding the level of exposure that they have to private credit and being able to manage those risks where they might sit. So there's quite a lot going on in the UK and to come quite soon, but also globally, we've seen the Financial Stability Board focusing on private credit for a little while now. They put a report out earlier this year focusing on the topic. There's a lot of consistency in the areas of focus, as I said. A big part of it is about understanding those interconnections between the different parts of the sector and getting greater visibility.

Tessa: And as the regulators progress those pieces of work, I imagine there's quite a challenging balance for them to strike between managing potential systemic risk but also doing that in a way that remains proportionate. Sajan, what's your perspective on how they should approach that balance, particularly as the market continues to grow?

Sajan: Regulation is going to be more in this space. I suppose it's thinking about which direction it's really going to go. In very simple terms, what are the risks that private credit is creating? And then how do you regulate that? Do you need to go as far as what the banks are doing? I think there's a real balance to be struck here. Private credit is massively important for the economy as we think about going forward. But there are certain areas where we do need certain scrutiny over to make sure that participants have robust approaches to things like valuation, liquidity planning, and credit risk management, more so than they've done to date, to make those super watertight. And that would just support the confidence in the market rather than being hopefully not an overburdensome regulation piece, but it's evolving and we'll have to see which direction the regulator in each market decides to go, depending on how fast private credit evolves as well.

Tessa: Conor, what's your take on those points around proportionality and managing the burden on firms?

Conor: I agree with everything Sajan’s said. I don't think we're going to see a bank-like regulation of private credit, and I don't think it would be appropriate because fundamentally banks play a different role in the financial system and in the economy than private credit. Now, clearly, private credit is playing an increasingly important role in the provision of credit. But they don't, for example, take deposits from the public, which is obviously something which is of critical importance and needs to be protected. And that's why, to some extent the banks have a unique role in the system and are regulated in an according way.

What we're seeing is the regulators doing their job, having a look where they see growth and where they see potential risk. I think there will be a big focus on more visibility of the risk. And I think if you speak to the regulators and they're being relatively thoughtful about this in saying, the more visibility they have, then the more comfort they will get and the less hopefully need there will be for more intrusive regulation. But then the other thing is, you know, part of it is about the rules, part of it is about supervision. I've already mentioned the FCA's got some supervisory work planned in this area. Like all sectors in financial services that grow quickly, there's always a risk that risk management, governance, compliance, all of those capabilities that the regulators want firms to have doesn't grow as the same pace as the business growth. We've seen that across financial services throughout history. I wouldn't be surprised if the supervisors start looking at those areas. And it’s good business for firms to invest in those capabilities as they grow. It will help manage risk. This isn't just about a compliance burden. It's also about making sure that they have the capabilities to grow in a sustainable way, which is just good business.

Tessa: As we think about some of the practical steps that firms can take as they navigate both the risks and opportunities, I think that point about, as you say, ensuring that risk management and governance grows in a way that's commensurate to the risk is really important. Are there a couple of practical tips or steps that you would encourage firms to focus on at the moment, Conor, as they think about that?

Conor: Again, we're talking about a varied ecosystem of firms which are interacting with each other in different ways. So for the banks, for example, clearly understanding the counterparty exposures which are, as I say, complicated and multifaceted, and how they might behave in a stress is something that's going to be really important and that the regulators are expecting them to do. As I said, for the private credit funds themselves, building those capabilities as they grow will be really important, from a regulatory perspective, but also from a business perspective.

But then the final point, and this really cuts across all of the considerations here, is around data, the ability to have the right data, to be able to cut it in the right way. Both to do risk management for firms themselves, but also to be able to get ahead of that regulatory scrutiny in this area. We've seen across financial services the challenge of data accuracy, regulatory reporting. And I do think from a strategy perspective for the sector, engaging on that point and getting ahead of it to be able to show to the regulators that these risks are being managed, that there's visibility about those risks will be helpful in terms of pre-empting potentially more intrusive regulation.

Tessa: Sajan, are there any additional points you'd make, particularly around, where do you see the greatest pressures as investor expectations and regulatory scrutiny continue to evolve?

Sajan: I'd say Tessa, to build on Conor's point, it's not just about the regulator, actually it's also about the board, their own investment committees, because if you take a basic example, a number of private credit investors invest through managers, sometimes not directly. And they sit back and you have a 10% return, but you don't fully understand where that return is coming from. I think you can get 10% in different ways. And what's the underlying risk? And so I think the backdrop of all of this is that you need to have a very successful operating model to be able to be doing well in this in the future, because private market, private credit allocation is maybe a smaller component of certain investors to date, but it won't be and it will be a more material point later on. And so, you know, there's a few things that if you think practically what needs to change or just more enhance, if you like, their existing model is ratings. So how comparable are those ratings that you're getting even if it's kind of implied on what you're investing. How often are you valuing or getting some independent valuation or challenge in terms of the things that you are invested in? And that's a focus area. And that downside protection, private credit's got very good downside protection built into a lot of the covenants and mechanics of the product. It works through the credit cycle. But actually, to Conor's point, how are you able to explain this to the regulator and board? Where's stress going to be? How are you mitigating that? Our survey talked about auto, consumer, retail and hospitality as the sectors for defaults, but it could come from anywhere and it's how you plan for it, manage it. And then probably the last thing is, manager selection. As I said at the start, what is the strategy for that manager to achieve those returns? Is it aggressive? Is it more passive? And what's the underlying performance? Because then you can plan forward, think about how you are going to be successful with the right portfolio management, underwriting capabilities.

Tessa: Brilliant, thank you both. I think that's been a fascinating discussion and great to end on some of those practical points for firms to think about as we look further ahead. And I'm sure this is a topic that we'll be returning to as private credit continues to mature and evolve. To our listeners, I hope you found this conversation useful. If you’d like to find out more about private credit, please do get in touch. You can also explore the full PwC private credit survey findings that we've referenced, which we'll link to in the episode description. And finally, if you enjoyed this episode, please do consider subscribing and leaving a rating or review, as it helps other listeners to find us. Thank you.