Once a niche corner of global finance, private credit has exploded into a $2 trillion market, making it one of the fastest-growing and most talked-about investment sectors. Just over a decade ago, in 2010, this industry sat at a modest $250 billion. Today, it has expanded nearly tenfold. Wherever you look, private credit is making headlines, and for good reason.
What’s fuelling this meteoric rise? Why has private credit become the go-to funding source for businesses and a lucrative asset for investors? More importantly, what risks does its rapid growth pose to the broader financial system?
In today’s breakdown, we’ll explore how private credit works, why it’s booming, the risks it presents, and what the future holds for this financial juggernaut.
Wrapping your head around Private Credit
At its core, private credit is non-bank lending. Instead of borrowing from a traditional bank, companies turn to private credit funds. Like hedge funds or private equity houses, these firms pull money from institutional investors, like insurance companies, pension funds and asset managers to, issue loans. Unlike banks, these funds don’t rely on depositor money, nor are they bound by strict banking regulations. This flexibility allows them to lend where banks can’t or won’t.
Private credit funds generate revenue through interest payments on their loans. Most of these loans have floating interest rates, meaning they adjust based on market conditions. Additionally, they charge a liquidity premium, which is a higher interest rate to compensate or the fact that private credit loans aren’t easily tradeable like bonds or stocks.
Since these loans don’t trade on public markets, investors can’t exit positions easily. This illiquidity makes private credit riskier but also more lucrative for those willing to commit long-term capital.
Types of Private Credit
Direct lending is the most common type, where private lenders provide loans directly to businesses that struggle to secure bank financing. These loans are quick, flexible, and tailored to borrower needs.
Mezzanine financing is a hybrid of debt and equity, where lenders charge high interest and may take a small ownership stake in the company.
Distressed debt involves buying up the debt of struggling businesses at a discount, hoping to profit from a turnaround.
Another structure, unitranche loans, combines different types of debt into a single financing package, simplifying the borrowing process
Private credit fills a critical funding gap left by banks. Small and mid-sized companies often struggle to secure traditional financing due to strict lending rules. Private credit offers an alternative option, and in return, their investors get access to higher-yielding opportunities than conventional fixed-income investments.
What’s Driving Private Credit?
The 2008 Financial Crisis: A Catalyst for Private Credit
To understand private credit’s rise, rewind to 2008. The global financial crisis exposed how recklessly overleveraged banks had become. As a result, regulators clamped down imposing strict rules that limited banks’ ability to lend, particularly to riskier borrowers.
The result? A funding gap that private credit funds rushed to fill. Being free from bank regulations allowed private credit funds to offer customised, flexible loans to businesses banks turned away.
Interest Rate Cycles: A Double Win for Private Credit
After the crisis, the US central bank slashed interest rates to near zero and kept them there for over a decade. This left investors starved for returns, forcing them to hunt better yield in alternative assets like private credit.
Then came the Fed’s aggressive rate hikes from 2022 to 2023, pushing rates to a peak of 5.5%, as they attempted to wrangle post-covid inflation. You’d think this would hurt private credit, however, it supercharged the sectors profits. Higher rates meant private credit funds could charge more interest, increasing their revenue while still offering competitive yields to investors.
Private credit funds have the flexibility to thrive in both high and low-interest rate environments, adapting their strategies to capitalize on changing economic conditions.
The Private Equity Connection
Private credit goes hand in hand with another Wall Street golden child, private equity. Private credit plays a key role in private equity buyouts, providing the funding needed to acquire companies. In leveraged buyouts (LBOs), private equity firms rely heavily on debt to acquire companies, but the stricter bank regulations we previously mentioned have made it harder for private equity firms to secure this funding. Private credit has stepped in to finance these deals that otherwise wouldn’t be able to happen. With the booming private equity industry driving demand for buyout financing, private credit has expanded alongside it, becoming a crucial source that enables more deals to take place.
Private Credit: Are We at Risk?
Private credit’s impressive 11% average annualised returns over the last six years has caught investor attention. But as with any booming asset class, there are serious risks lurking beneath the surface
Unregulated and Opaque: The Shadow Banking Dilemma
Private credit operates in the shadow banking sector, meaning no Basel III style regulations, no strict leverage limits, and minimal transparency. These funds can take on higher leverage, lend to riskier borrowers without restriction, and operate with little regulatory oversight. This lack of transparency makes it difficult to gauge how much risk these funds are really taking on, eerily similar to the mortgage-backed securities crisis in 2008.
Illiquidity: The Inability to Exit
Unlike stocks or bonds, private credit loans can’t be easily traded. Investors are locked into long-term commitments, which becomes a serious problem if they need liquidity during a period of financial distress.
Rising Defaults & Weak Underwriting
With private credit booming, competition among lenders is fierce. This can lead to weaker underwriting standards, covenant-lite loans (fewer borrower protections), and more loans to non-investment grade companies. Sounding familiar? This is strikingly similar to the lax mortgage lending that led to the 2008 meltdown. If defaults spike, private credit could become the next big financial headache.
Contagion Risk: Could Private Credit Trigger a Crisis?
If these private credit funds are interconnected with traditional banks, distress in this sector could spill over into the broader financial system. A surge in defaults combined with high leverage and illiquidity, could trigger forced asset sales, amplifying market stress.
The Future of Private Credit: Sink or Swin?
Despite the risks, private credit is still growing fast. BlackRock forecast the industry will hit $3.5 trillion by 2028. Demand for alternative lenders remains strong as businesses continue to seek non-bank financing, and institutional investors remain hungry for higher yields. At the same time, retail investors are beginning to gain access to the sector. Recently the world’s first private credit ETF started trading, giving retail investors direct access to a diversifies portfolio of private credit assets.
This shift has already drawn scrutiny from regulators. The SEC is now closely monitoring the private credit industry, particularly as it becomes accessible to the general public. Given the increasing resemblance between private credit operations and the practices that led to the 2008 financial crisis, tighter oversight is likely on the horizon.
Private credit has transformed from a boutique lending strategy into a $2 trillion giant, driven by banking regulations, interest rate cycles, and private equity demand. But its lack of regulation, illiquidity, and rising default risks could pose serious systemic challenges.
So, is private credit a permanent fixture in modern finance, or a ticking time bomb waiting to go off? Only time will tell. One thing is for certain, private credit is here to stay, but its evolution will be shaped by both opportunity and oversight.
