(Bloomberg) — Private equity doubled in size from 2019 thanks to rising interest rates that made its floating-rate debt more attractive to investors. Now, a Federal Reserve interest rate cut is adding to the headwinds hampering the $1.7 trillion industry's formidable growth.
Lower benchmark rates will make fixed income, which locks in returns, more attractive to investors than variable rates. This is set to become a more pressing issue after the design of the Fed further relief later this year.
Regulators also have the industry in their crosshairs as they grew concerned about the ripple effect any crisis could have on banks, which lend to private credit managers to add more firepower to their pool of investor commitments. . On the fundraising side, institutional capital allocations are low, falling oil prices could affect inflows from the Middle East and new US measures could make it harder for insurers to invest in asset category.
Read more: Private debt requires growth like traditional capital
The other major potential threat is a US recession. A soft landing for the economy is the central case, but a deeper slowdown would cause trouble, squeezing the cash pipeline, reducing the appetite for deals and increasing the risk that borrowers will default.
According to Patrick Dennis, co-deputy managing partner at Davidson Kempner Capital Management, private loan defaults are around 3-5%, partly due to breaches and modifications to agreements.
“Defaults are starting in all three areas of the market that we focus on,” he said in Milken Institute Asia Summit Thursday. “From a severity perspective, that's the biggest risk in the market that we're trying to assess.”
Oil money
Private markets fund managers have flocked to the Middle East in recent years in a bid to raise additional capital to deploy. That effort could become more challenging if oil prices continue to fall lower.
“A prolonged period of falling oil prices would inevitably weigh on the rate at which institutional investors in the region deploy capital in private markets,” said Cameron Joyce, head of research insights at Preqin. However, he noted that there will still be appetite because many private loan allocations are below long-term targets.
Read more: Private Loan Titans Packages Middle East Flights Chasing Billions
One of the advantages to lower rates is that they can drive more deals, which would provide more opportunities for capital deployment, as long as it's accompanied by a gentle downgrade that doesn't lead to widespread bankruptcies. .
But there is competition for the business as traditional lenders struggle to regain buyout business as private lending enters the area, which had long been a lucrative source of fees for investment banks such as Goldman Sachs Group Inc. and JPMorgan Chase & Co.
Tougher review
On the regulatory front, the Financial Stability Board is examining how private markets interact as part of broader investigations into shadow banking. The European Central Bank is pressing major lenders for details of their exposure to private credit firms and their funds, while the Bank of Japan is also monitoring the links.
“The exposure of Japan's financial institutions to global private credit funds is increasing, with a concentration on a few large players,” said Hirohide Kouguchi, executive director at the Bank of Japan. article in Eurofi magazine. “We must remain vigilant,” he added, citing systemic implications.
Read more: Banks' exposure to private credit faces fresh scrutiny from the ECB
In the U.S., new rules from the National Association of Insurance Commissioners that take effect in 2026 will give regulators more leeway to discourage insurance companies from investing in private equity and other assets seen as excessive dangerous.
The measures allow the NAIC to effectively assign its ratings to a wider range of bonds and other securities owned by insurance firms — which could mean tighter ratings. That's a blow to insurers, who depend on those ratings to invest in everything from corporate debt tranches to consumer credit pools.
To help it with the job, the NAIC plans to get outside expertise so it can accurately evaluate the ratings, according to draft documents circulated last month.
The rules “will give insurance companies pause in investing in some of the more aggressive forms of rated credit structures for private loans or asset-based loans,” said Manish Valecha, head of client solutions at Angel Oak Capital Advisors .
Any withdrawal by the insurers would be a blow to the lenders' direct growth ambitions. The average allocation by an insurance firm to private credit has doubled since 2019 to 4%, according to data compiled by Preqin.
Insurance capital has been one of the drivers of the private credit markets, although the quality of the triple B portfolios, which are People with that industry, it can be variable, according to Dennis.
“If you start to see defaults on those portfolios, you could run the risk of a regulator or regulators reacting in the other direction, which could create a technical market disruption that frankly we would welcome, but could create a little more contagion risk widely,” he said.