The real risk of private credit does not lie in misbehaviour on Wall Street

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Since the 1980s, private equity firms have used billions of dollars of borrowed money to rewrite the rules of American industry. Now the financial industry’s chief disrupters are turning to their home turf, shaking up the debt markets that are at the core of Wall Street itself.

The turn to private debt, which began in earnest after the 2008 financial crisis, has transformed private equity firms into complex financial machines that play a far more pervasive financial role than the corporate raiders whose antics have been seared on to the public consciousness.

Brookfield’s offer this week to buy American Equity Investment Life for $4.3bn is a case in point. It follows a long line of deals in which private equity groups have sought access to the balance sheets of annuity life insurers. These annuity providers buy bonds and other credit assets and try to profit by earning investment returns that are more than large enough to cover the promises they have made to policyholders.

Unlike traditional private equity funds, which hand money back to investors according to a pre-determined schedule, insurance balance sheets have a permanence that is allowing buyout groups to become enduring franchises ingrained in the financial system.

The consequences are disputed. Some see the emerging category of “private credit” as a mechanism for removing risky lending from the banking system. Others fear the US economy’s growing reliance on loosely regulated financial firms with still-evolving business models.

Big private equity groups are certainly looking more like banks. Consider the services that Apollo Global Management, one of the biggest, now provides. Its sprawling lending arm does everything from leasing out airliners to financing the cars that sit on dealership lots. As the Financial Times reported this week, Apollo — along with rivals such as Blackstone, Carlyle Group and KKR — is taking over from banks and bond markets as a source of credit for the world’s biggest corporations.

This surge of lending by private equity firms and other unconventional credit providers has left the people in charge of institutions as JPMorgan Chase trying to articulate what makes them special.

“The new reality is that some things — for example, holding certain types of credit — are more efficiently done by a non-bank,” Jamie Dimon conceded in his letter to shareholders this year. But he warned of the consequences of allowing some financial activities to move outside the regulatory system. “Would non-bank credit-providing institutions be able to provide credit when their clients need them the most?” he asked. “I personally doubt that many of them could.”

The most pressing concern is not that private equity firms will harm investors by acting recklessly as lenders, even if their record as borrowers has not always inspired confidence. True, excessive leverage almost certainly played a role in the failure of some big private equity-owned companies. But buyout groups invest money on behalf of sophisticated institutions that can make their own decisions about whom to trust. Anyway, whatever their frailties as borrowers, there is no evidence that private equity firms have been improvident lenders.

A bigger risk is that private credit firms could unwittingly transmit financial distress from the clients who invest with them to the economy at large. Private equity executives say the risk is minimal. They point out that their lending funds typically bar investors from pulling money out quickly, and use far less leverage than even the most conservatively run thrift. It is common for private credit funds to raise $1 of equity from investors for every $2 of assets they buy, allowing them to withstand losses with far less trauma than the average US bank, which levers $1 of capital into more than $9 of assets.

Still, doubts persist. Locking up client capital can help the staying-power of an individual fund, but it does not insulate the private sector as a whole from the risk of sharp reversals. Private credit funds typically have finite lives, meaning that asset managers must constantly replenish their capital or watch it dwindle. Even the longevity of so-called permanent capital vehicles, a category that includes closed-end funds and the balance sheets of annuity life insurance companies, can be overstated. After all, it was the losses on a portfolio of junk bonds — many of them linked to private equity deal making — that triggered the run on the Executive Life Insurance Company that was among the most damaging financial panics of the 1990s.

In short, the biggest risks inherent in the rise of private credit are the ones that critics most easily miss. They arise, not from the misbehaviour of anyone on Wall Street, but from replacing parts of an imperfect banking system with a novel mechanism whose inner workings we are only just discovering.

mark.vandevelde@ft.com