The private credit industry’s expansion into the wealth market is increasing liquidity risk and conduct risk, the International Monetary Fund (IMF) has warned.
In its latest Global Financial Stability Report, the IMF outlined the risks it sees from the fast-growing $1.7tn (£1.5tn) private credit market.
Typically the preserve of institutional investors, the private credit market has tapped into the wealth channel in recent years to diversify its sources of funding.
However, individual investors have greater demands for liquidity which has led to an increase in semi-liquid private credit funds. The increased popularity of these types of structures “raises concerns”, the IMF said.
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“Although securities regulators have introduced requirements for liquidity management tools to reduce liquidity mismatch risks, many countries still permit open-end structures and frequent redemptions (sometimes even daily) for private credit funds that invest in highly illiquid assets,” the report said.
“This permits existence of structures with a high potential of liquidity mismatch, and the mitigating tools used by semiliquid funds have not been tested by a systemic event. The ‘retailisation’ trend, moreover, means that individual investors new to the sector who do not fully understand the liquidity features may become significant investors, potentially creating herd behaviour toward redemption during stress episodes.”
The IMF also raised concerns that increasing retail participation in private credit markets could increase conduct risks. It noted that the current regulatory framework has applied a relatively light touch to investor protection safeguards, as it assumes that investors are sophisticated.
“Although existing regulatory requirements cover conflicts of interest in detail, conduct risks will increase if the investor mix moves toward more retail participation, considering that more frequent redemptions may exacerbate conduct concerns regarding valuations and follow-on investments,” the IMF said.
“Conduct supervisors should closely monitor conduct risks and enhance disclosure requirements, particularly relating to conflicts of interest. Regulatory requirements for conduct with retail investors should be stringent.”
The IMF said that supervisors should monitor private credit funds’ distribution channels and marketing practices, and tailor suitability tests to prevent mis-selling.
They should also ensure that retail investors fully understand the risks involved in private credit investments and their limitations on redemptions, the IMF added.
Some of the largest names in private credit are investing heavily in growing their wealth market channel.
Apollo Global Management managing director Veronique Fournier has said that the alternative asset manager is “well on track” to raise $50bn (£39.8bn) from the wealth market for its private capital products by 2026.
Data and defaults
The IMF report also said that the private credit market has not been properly tested in a downturn and noted that a lack of data transparency makes it harder to assess potential risks.
“If the asset class remains opaque and continues to grow exponentially under limited prudential oversight, the vulnerabilities of the private credit industry could become systemic,” the analysis said.
As most private credit facilities tend to be floating rate, this could lead to a spike in defaults, creating significant capital losses for some end investors such as insurers and pension funds, the IMF said.
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Other risks cited in the report included the use of multiple layers of leverage that could create interconnectedness concerns, and uncertainty around asset valuations that make it hard to assess potential losses.
The IMF has urged authorities to consider “a more intrusive supervisory and regulatory approach” to the sector, including tougher reporting requirements to help monitor risks more comprehensively.
It also said that regulators should closely monitor liquidity and conduct risks in funds – especially retail – that may be faced with higher redemption risks.
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