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What is private credit and why is it raising concerns?
Private debt is therefore preferred as it offers access to 'patient capital' without sacrificing control, as would be the case with equity investments.
Private credit has grown in prominence since the 2009 financial crisis that prompted banks to tighten lending standards.
Following recent high-profile defaults in the US – notably Tricolor Holdings and First Brands – combined with concerns over company valuations, private credit has come under intense scrutiny. Many investors and analysts now view this upheaval as early warning signs of the next financial crisis.
Private credit can be broadly defined as lending that takes place outside of the traditional banking system. It includes elements such as trade financing, venture capital, infrastructure financing, and development finance institutions (DFIs). Private credit is more commonly associated with lending directly to medium-sized companies to facilitate growth.
How big is private credit?
As an asset class, private credit is valued at Sh219.6 trillion (Sh1.7 trillion) globally. However, direct lending in Africa is relatively small, with assets under management estimated at Sh258.3 billion ($2 billion).
While there is no specific estimate of the value of private credit in Kenya, direct lending to upcoming and mid-sized companies is dominated by institutional investors such as venture capital (VC) and private equity (PE) firms, as well as development finance institutions.
In contrast to private lending in advanced economies, where individual investors have invested in private credit funds, retail investor exposure to private credit in Kenya is negligible.
Why do start-ups, mid-sized companies favour private credit over bank credit/equity funding?
Traditional bank financing is often out of reach for start-ups and mid-sized companies, which, in most cases, have yet to turn a profit and lack collateral. This forces such entities to seek alternative sources of funding, including private credit.
Founders and business owners prefer to maintain control of their enterprises and will therefore avoid parting with equity, which often involves giving up board seats and voting rights. This effectively hands control from founders to funders.
Private debt is therefore preferred as it offers access to 'patient capital' without sacrificing control, as would be the case with equity investments.
What are the lending margins involved in private credit?
While the terms of private debt are usually confidential, direct lending to firms attracts a margin of between nine and 12 percent for dollar-denominated facilities.
These margins can reach 15 percent at the riskier end of the market. Owners of private debt receive periodic payments from the recipient of the funding, similar to conventional bond coupons.
However, at the recoupment of the principal amount, investors will most likely receive enhanced reimbursement, including payment in kind (PIK), which ranges from two to three percent of revenues or pre-tax profits achieved.
Where are concerns on private credit coming from?
The fear that advanced AI could disrupt enterprises in advanced economies has caused investors to become anxious, as they believe that many companies could go out of business and default on loans, some of which are held as private credit.
The recent collapse of US entities First Brands and Tricolor Holdings, which are described as subprime borrowers with private loans, has only served to exacerbate these concerns.
JP Morgan Chase CEO Jamie Dimon, has warned that there could be ‘cockroaches’ in the US economy – suggesting that the two defaults could signal more to come. In context, seeing one cockroach usually suggests that there are more in the vicinity.
How have investors in private credit reacted?
Although no major lenders have collapsed and a wave of defaults has not materialised, investors have been pushing to get their money back. This has resulted in a liquidity mismatch for the asset class.
Some of the leading names in private credit have restricted investors’ ability to withdraw funds, although limits on withdrawals are standard practice for preventing a run on the bank. Firms such as Blue Owl Capital have been forced to close one of their retail-focused funds after investors became alarmed and demanded refunds.
What are the potential public and far-reaching consequences of a crisis in private credit?
Private creditors may be considered shadow banks, issuing loans on terms known only to those involved. However, minimal exposure among lenders providing capital to private credit providers could result in tighter lending across the financial industry.
Insurance firms with exposure could raise premiums, while underfunded pensions could result in a wider crisis.
How would the unravelling of private credit hit closer to home?
Experts expect private credit markets in economies like Kenya to be largely sheltered from the shocks projected in advanced economies. The region, for instance, features fewer funds that are largely institutional and anchored by development finance institutions (DFIs).
Private credit funding is also seen as supporting real economic growth in the region by supporting enterprises in sectors like manufacturing, green energy and electric mobility.
In sharp contrast, private credit in advanced economies like the US is seen backing more speculative opportunities like artificial intelligence, which are deemed riskier.
Private debt in Africa and Kenya is also often backed by significant equity cushions and other collaterals minimising risks for investors in the eventuality of an implosion.
The effect of an implosion on private credit inflows from abroad would, however, remain to be seen.
