Han Dieperink: The added value of private debt

January 7, 2025

_{This column was originaly written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

The private debt market is growing fast and now has a size of many billions of euros. The growth rate has been around 50% a year over the past few years, but is set to accelerate to 90% a year in the coming years.

Until now, much of this growth was accounted for by private equity parties who started financing companies under the banner of ‘direct lending’, partly because banks were no longer able or willing to do so after the financial crisis for various reasons due to stricter regulations. Meanwhile, private equity works with banks. For instance, Apollo and Citigroup work together, Oaktree and Lloyds, Brookfield and SocGen, AGL and Barclays, and Centerbridge and Wells Fargo. Private equity has the cash and banks the access to the deals. Regulations from Basel do the rest.

More debt, not more risk

Whenever credit markets grow rapidly over a short period of time, financial markets are quick to sense that risks are mounting. But the growth of private debt is offset by the shrinkage of debt on bank balance sheets. A bank's balance sheet is inherently unstable due to the fact that it is overwhelmingly funded by debt and only a small amount by equity. A bank always has a poor balance sheet. Private debt is not part of the bank balance sheet, but is held by end investors. These are by definition better capitalised.

After the Great Financial Crisis of 2008, measures were taken to regulate the activities of the financial sector. Large institutions were tackled and requirements were increased. While risk-averse banks re-evaluated, small and medium-sized enterprises (SMEs) were given fewer options in their search for capital. SMEs are an important part of the economy and they need flexible, scalable capital to survive. You can no longer get that from the bank, but you can get it through private lending.

Lower interest rates and diversification from public markets boosted initial demand. Meanwhile, private loans excel in their flexibility and speed of deployment. Companies can no longer afford to depend on public markets. As an investment vehicle, private lending offers robust underwriting standards, asset-backed structures and robust due diligence, aided by technology. The flexible and scalable financial solution has unlocked growth potential in SMEs and continues to do so elsewhere.

Regulatory failures create systemic risks

It is often argued that the Great Financial Crisis was caused by inadequate supervision. Rather, the problem was that there was too much supervision and mistakes were made in that supervision. Mistakes in laws and regulations quickly increase systemic risks. After all, everyone has to comply with them.

The mistake regulators make time and again is not thinking through the consequences. The main mistake with regard to the US housing market in particular is that it is seen as the ideal transmission mechanism for monetary policy. When the economy is doing badly, policy interest rates go down, allowing more people to buy homes and house prices to rise. The multiplier on the economy of buying and building a house is huge, so lower interest rates have a positive effect on the economy.

However, the problem is that if interest rates are much lower than the natural growth rate, those too-low interest rates create excesses in the form of bubbles. On the other hand, if interest rates are too high, capital is quickly destroyed in the form of recession. Actually, central banks should not interfere with interest rates, but should automatically keep interest rates 0.25 per cent above the natural growth rate. That way, it makes no sense for existing companies growing in line with the economy to raise debt capital. Only companies growing more strongly (thanks to innovation) benefit from leverage. So only these interest rates contribute to innovation.

Another policy mistake is that public housing is important to governments and regulations are made so that everyone can buy a house. Early this century, the American Dream Downpayment Act was introduced so that every American could buy a house. No more downpayments for poor Americans, including many minorities. Sometimes, the first two years of a mortgage did not even have to be repaid anything.

For Wall Street, this was enough reason to come up with creative solutions, which eventually led to the crisis. Mistakes were also made in Europe. For instance, banks did not have to hold equity for European government bonds. That might still be understandable for German government bonds, but without this rule, the Greek crisis could not have become a euro crisis.

Banks take too much risk by nature

The big difference between private debt and bank financing is the moral hazard problem. This allows banks to pass risks on to the citizen (society), but those who try to do so on the private debt side only have themselves to blame. Consider also that a bank constantly tends to push the risk limits, because if one does not, the competitor will run off with it. Since it can take a long time for banks to face the losses of taking too much risk, banks that do pay attention to risk are competed away or taken over.

Private debt is a form of disruptive innovation. The private sector is increasingly offering cheaper (due to the lack of costly supervision) and more efficient lending, thanks in part to the use of new technologies. At the same time, many banks keep savings rates artificially low, even after recent interest rate hikes. As a result, credit spreads remain limited, and investors looking for an appropriate risk return are increasingly finding their way to private debt. This asset class has proved resilient in a high interest rate environment.

Rapid private debt growth good for economy

While there are legitimate concerns about the rapid growth of private debt and its divergent regulation from traditional banking, this alternative asset class deserves recognition as a stabilising force within the portfolio. Private debt has quickly emerged as a mature and almost indispensable investment option. Instead of viewing it as a risky and temporary lending solution, the financial system should embrace this category as an innovative method that fills essential gaps in today's markets. While no asset class is completely risk-free, private debt is taking an increasingly central place.

Non-bank lending offers a crucial financing option for SMEs and seamlessly addresses the gaps left by traditional banks. It is not a threat to the system, but rather a fundamental part of a healthy, diversified financial landscape.

More columns by Han Dieperink