Can private debt cause systemic risk?

A closer look at the underlying worries

The flow of credit from regulated financial institutions and relatively open public markets to the less transparent domain of private lending is increasingly viewed by financial regulators, international institutions and other players in the financial ecosystem as introducing potential risks. The resulting opacity and lack of readily available data coupled with the relatively vulnerable and weak credit profiles of many borrowers, use of leverage, liquidity mismatches, increasing integration with other financial players in the ecosystem, as well as stale valuations are among the key factors considered to have the potential to contribute to systemic risk. 

Compared to their public counterparts, private debt borrowers tend to carry higher risk. They are typically highly leveraged mid-sized companies with elevated debt-to-earnings ratios. Their predominant reliance on floating-rate debt further increases their vulnerability, especially during periods of rising interest rates, which amplify interest burdens and often lead to the widespread use of payment-in-kind (PIK) interest arrangements.

Industry research suggests that companies with subpar financial performance, characterised by low or negative earnings and high leverage, are increasingly turning to private debt. This trend is largely driven by their limited access to traditional bank financing and their insufficient scale to issue public bonds. Additionally, these firms are typically excluded from the syndicated loan market due to their smaller size and lack of high-quality collateral, which makes them less attractive to conventional lenders. Elevated debt levels among these companies are often driven by private equity sponsors, who seek to maximise investor returns by increasing leverage on the balance sheets of the firms they acquire.

Another point of concern is the use of leverage. Private credit funds may employ leverage at multiple levels, within the fund structure, at the borrower level and even among investors using borrowed capital to gain exposure. In times of market stress, this layering of debt could amplify losses and trigger a broader unwinding of positions.

Moreover, the liquidity profile of private credit vehicles has come under scrutiny. Some funds offer periodic liquidity to investors despite holding illiquid assets, creating a potential mismatch that could lead to redemption pressures during periods of volatility. 

The structure of private credit funds inherently ties them into a broader network of financial market participants. First, many private debt funds are backed and significantly influenced by private equity sponsors. Second, banks play a central role as the primary provider of leverage to these funds. Finally, large institutional investors, such as pension funds and insurance companies, hold substantial exposure to private credit. According to the 2024 IMF study, nearly half of the increase in average Level 3 assets among selected pension funds (with over USD 7 trillion in AUM, representing 17.5% of global pension assets) is linked to the growing allocation to private credit since 2016. This interconnectedness is critical, as vulnerabilities in one segment of the private financing landscape can easily spill over into others, amplifying systemic risk.

Even the issue of stale valuations is believed to be among the potential risks, although this concern seems more theoretical than grounded in observed market behaviour. 

The growing trend of “asset democratisation” also implies that individual investors who are new to the industry and may not fully grasp the liquidity characteristics could become prominent participants, potentially triggering collective behaviour toward withdrawals during periods of market stress.

In defence of stability 

Despite these concerns, private credit may in fact contribute to financial stability.  

Advantages are largely associated with a low volatility profile, a consistent stream of income, protection against interest rate risks in the form of floating rates as well as diversification of return drivers. 

While some may argue that the lower volatility observed in private credit stems from the absence of daily mark-to-market pricing, the reality is that the floating-rate structure of private credit significantly reduces exposure to interest rate duration. This structure also insulates private credit from rising interest rates when fixed-income holders will see their capital value eroded. Moreover, the illiquid nature of the asset class, combined with long-term fund structures, limits the potential for irrational investor behaviour during periods of market stress. This structural design helps prevent panic selling, fire sales, and the premature crystallisation of losses, contributing to a more resilient investment profile. 

When it comes to the fragile nature of borrowing companies cited by critics, such issuers are indeed typically smaller and more narrowly focused.  However, information provided directly by them is often more detailed and of higher quality than what is typically available in public markets, allowing lenders to conduct thorough due diligence and tailor financing solutions more precisely. 

Valuation is another controversial topic, often flagged as a concern due to doubts over whether it accurately reflects the fair market value of the underlying debt.  While the absence of standardised valuation methods in private credit may frustrate those accustomed to public markets, its practical relevance is limited. Loans are typically originated at or near par, with a modest original-issue discount, and are expected to be repaid at par upon maturity. As such, interim market valuations have little bearing on either entry or exit except for the default risk, where losses can be crystallised.  Minimising this risk requires careful asset selection, rigorous credit underwriting, and thoughtful loan structuring.

A key advantage of private credit over many other alternative assets is that it does not typically rely on secondary-market sales for exit. Unlike private equity, where valuations may appear strong but fail to materialise at sale, private credit positions are generally held to maturity, with repayment terms contractually defined. This structure insulates exit values from broader market volatility.

Finally, it's worth noting that private credit offers several built-in investor protections, such as collateral or covenants that enable early enforcement before a default occurs, facilitated by typically bilateral or small-group loan structures that ease consensus. 

As a result of the above advantages, the recovery rates from private loans in the event of default lead to much better outcomes than those seen in traditional fixed-income markets. Statistics further support these advantages, showing that private debt experiences lower credit losses compared to high-yield bonds and bank loan losses. Additionally, private debt has demonstrated greater resilience, with lower default rates during periods of market dislocation.

Closing thoughts 

While private credit is not without risk, we believe that such risk is confined and does not currently pose a systemic threat. The key to maintaining this stability lies in continued vigilance. Regulators and market participants should work together to improve transparency, enhance data collection, and ensure that risk-management practices keep pace with the sector’s growth. With these safeguards in place, private credit can continue to thrive as a valuable and resilient component of modern finance; one that supports economic growth without endangering financial stability.

To navigate this evolving landscape with confidence, explore Vistra’s private credit services and fund administration expertise designed to support fund managers and institutional investors worldwide.