Private Lending and Banks Becoming More Interconnected as Default Risk Rises in Europe

European private credit funds are increasingly borrowing from banks to improve their results, raising concerns about the broader risks posed by this interconnection.

A record 80 percent of new European private credit funds were borrowed from banks through ‘subscription lines’ in 2023, which is financing that allows them to borrow before attracting money from their investors, according to research from MSCI Private Capital Solutions shared with Reuters.

Subscription lines are used by some credit funds to enhance returns, a separate MSCI study showed. MSCI studied so-called pools that have been recently established as funds are likely to use subscription lines when they start operating.

Regulators, including the Bank of England (BoE), are already investigating the potential risks posed by lenders’ exposure to credit funds, which are poorly regulated and typically finance companies struggling to borrow directly from banks or in bond markets.

The boom of so-called shadow banks has also raised alarms among some financiers, who point to the possibility of new asset bubbles that could undermine financial stability.

– Increasing engagement in the private credit space… brings them (banks) closer to the inherent risks of the sector – said Chris Naghibi, Chief Operating Officer of First Foundation Bank.

Some private credit funds are also adding leverage to their loans, maximizing returns while simultaneously increasing potential losses, more than 20 industry sources told Reuters, and some fund documents have shown. These moves come at a time when corporate challenges in Europe are reaching unprecedented levels and opening a new chapter since the onset of the Covid-19 pandemic.

Flexible Borrowing

European private credit funds, although a fraction of the size of bank loans, now manage $460 billion, according to UBS. Their growth coincides with an economic slowdown that raises concerns that private lending could delay corporate restructuring decisions.

Since such funds are not required to disclose detailed information about their loans or the bank leverage they use, other than informing their own investors, regulators and investors in banks find it difficult to know if crediting by credit funds is deteriorating.

A recent study by the Bank of England (BoE) indicates that participants in the private credit market have so far reported minimal defaults compared to the broader market for riskier borrowers.

Credit rating agency S&P Global expects defaults among European speculative borrowers to reach 3.75 percent by June.

– Everyone is asking why we haven’t yet gotten bogged down in corporate restructuring – said Peter Marshall, one of the heads of European restructuring at investment bank Houlihan Lokey.

More than a dozen sources told Reuters that private credit funds have managed to prevent some defaults through flexible borrowing, sometimes using complex refinancing structures.

Deloitte estimates that nearly seven out of ten European private debt contracts have only one lender, meaning they have exclusive control over the terms offered and the interest charged.

Some funds, said Patrick Marshall, head of fixed income for private markets at Federated Hermes, have changed loan terms such as contract space to remove stress from the equation.

– But what will happen is that the returns (on loans) will also be lower – he said.

Alvarez & Marsal Director Chris Johnston said that some funds have collaborated with business owners to avoid crystallizing losses.

Payment-in-kind (PIK) arrangements, where companies accumulate interest payments to be made in later years, were seen in 3.5 percent of 167 direct loan agreements in six European countries in the last quarter of 2023, revealed credit data provider Reorg.

This is nearly double the 1.9 percent of deals involving PIKs in the first quarter of last year, Reorg said.

Separately, one-fifth of European private credit deals in the last quarter of 2023 were debt refinancings that extended loan repayment, Deloitte found, marking the highest share since 2020.

– This helps push out the day when there will be a reckoning with higher debt costs – said Andrew Wilkinson, senior restructuring partner at law firm Weil Gotshal.

Banks can also extend maturity dates, but they are required to reflect this in reported data, such as metrics on credit quality and estimated credit loss.

Contagion

Marshall from Federated Hermes said that American and Asian investors have also sometimes sought European funds to increase financial leverage, which is already common practice in the U.S.

Ares Management Corporation announced that last month its fund Ares Capital Europe VI raised €11 billion in capital and would have over €16 billion in capital to invest, including expected leverage.

Although access to leverage does not always mean it will be deployed, Reuters sources say such structures could quickly unwind during periods of market stress.

– There could be some kind of contagion event when a fund cannot refinance its short-term debt and is forced to call capital from (its) investors – said Keith Crouch, CEO of MSCI’s private equity unit.

Private debt funds are now ‘part of the banking ecosystem,’ Marshall said, adding that further regulation ‘would not be a bad thing.’