This opaque, lightly regulated corner of Wall Street is growing by leaps and bounds. Some worry it will eventually deliver a shock to the financial system.

By Steve Gelsi

Millions of Americans have exposure to private credit, which often outpaces stock-market returns but also poses risks

Your retirement savings are probably invested in it. But many Americans have little or no knowledge of private credit, an 800-pound gorilla of an asset class that has rapidly grown into a $1.5 trillion market.

Private credit refers to the opaque, and thinly regulated, business loans to publicly traded and privately held companies made by financial entities outside the banking sector.

With banks and insurance companies increasingly investing a portion of their balance sheets in this asset class, millions are exposed to it through their insurance policies and even bank accounts.

If yours is one of the estimated 16.5 million U.S. households with investments in insurance-company annuities, or if you're among the roughly 34 million members of a public pension fund, you already have money tied up in private credit.

Even as regulators and policy makers warn of the risks associated with private credit, Wall Street is barreling forward with investments in the asset class, thanks to its outsized returns.

So what do you need to know about the potential benefits - and risks - of this mushrooming asset class?

A market with potential to grow to $3.5 trillion

For one, it's large and growing. And it's nearly everywhere.

Asset-management firm BlackRock Inc. (BLK) estimates that private-credit assets under management are expected to increase to $2 trillion in 2024 from $1.5 trillion in 2023, with further growth of up to $3.5 trillion by 2028.

In 2023, private credit raised $251 billion in commitments from institutional investors such as pension funds and insurance annuity managers that handle a big chunk of Americans' retirement and annuities savings.

The quick expansion of private credit over the past decade has drawn comment from Federal Reserve Chair Jerome Powell as to whether it "raises financial-stability questions."

The International Monetary Fund's 2024 Global Financial Stability Report said, "If the asset class remains opaque and continues to grow exponentially under limited prudential oversight, the vulnerabilities of the private-credit industry could become systemic."

Sen. Elizabeth Warren, a Massachusetts Democrat, introduced the Stop Wall Street Looting Act in 2021 to close tax loopholes and other rules that allow private-equity firms to separate companies and their assets, "loading them up with debt, and vacuuming up the profits so rich executives can buy their second yacht."

Part of the concern is the lack of transparency surrounding private credit, which operates in the more thinly regulated world of nonbank lenders. The companies backing private-credit loans are typically private-equity firms or financial-service providers that specialize in direct lending to companies but sit outside of the federally insured banking system.

The companies involved in these credit transactions mostly police themselves.

Regulators have a much lighter touch on private credit and alternatives in general, with some private-fund filing requirements enforced by the Securities and Exchange Commission alongside a mandatory Form ADV filing that discloses the names of firm executives and other major data points.

But the specifics of the private-credit loans themselves are seen only by law firms that work for lenders and borrowers, as well as investors in the private funds that provide the credit, with little or no transparency to regulators.

Meanwhile, traditional banks are monitored closely by the U.S. Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., not to mention state-level government entities.

Due to its strong returns, private credit is being used to generate higher yields for retirement funds and their members.

That means the savings of tens of millions of Americans may be, with little or no awareness, availing themselves of private credit's track record of returns.

As it grows, private credit is moving into new silos in the multitrillion-dollar world of corporate and business lending and allocating capital in bigger chunks, such as $1 billion-plus loans to blue-chip companies.

While private credit started out in the realm of private-equity firms, it's more recently attracting alliances and other activities among the largest names in financial services. such as JPMorgan Chase & Co. (JPM), State Street Corp. (STT) and BlackRock Inc. (BLK).

Private credit stepped in during the 2023 regional-bank crisis as a rush of deposit withdrawals put Silicon Valley Bank and First Republic Bank out of business. While banks grew more conservative toward business debt, private credit provided an alternative path for companies seeking loans.

Although private credit hasn't caused systemic problems to date, any asset class of this size that has been untested in a major global financial crisis could pose a risk, experts say.

That means that a significant portion of the trillions set aside to support Americans as they age may, in a worst-case scenario, face steep or even total losses. Or, alternatively, Americans could just keep earning better returns by making their money work harder for them without any glitches - which has been the case so far.

But with an aging U.S. population and a need for retirement funds to provide promised benefits for Americans, private credit continues to grow as a means to pursue diversification and steady income.

How does private credit work?

Private credit ranks as the second-largest subset in the world of alternative investments, which are generally defined as money put into assets outside of traditional stocks and bonds.

Also read: Private equity: Everything you always wanted to know about this $12 trillion asset class but were afraid to ask

Private credit is, in a way, very similar to Treasury bonds or corporate bonds. They're all investments in debt, and they all offer income streams in the form of interest payments from borrowers.

Treasury bonds and private credit are deemed to be safer than equity such as stocks, because most debt is backed by either by the U.S. government or by collateral held by borrowers.

If a company goes bankrupt, for example, the value of its stock goes to zero. But debt holders split the remaining assets of the failed company or are in line for partial repayment in a bankruptcy process.

On the other hand, if a company does exceptionally well, the upside is greater for shareholders than it is for debt holders, typically.

Money from retirement funds and annuities customers that's earmarked for private credit typically goes into credit funds, where their money is locked up typically for at least 10 years.

These funds generate returns by making loans at a profit to companies looking to make acquisitions or restructure their balance sheets and thereby grow their businesses.

As those companies are often sub-investment grade - meaning they may have trouble getting loans from banks or on the public markets - and so there's a risk that they will be unable to repay a loan. For that reason, private-credit investors demand higher interest rates than they would get by investing in bonds and other debt instruments.

The traditional bread-and-butter deals in private credit have been loans of less than $100 million to middle-market private companies across the economy - many of which are portfolio companies of private-equity firms.

In 2023 private-credit funds and other investment pools drew in roughly $251 billion in commitments, while private-equity funds drew in about $800 billion among the six major types of private-capital funds - natural resources, infrastructure, real estate, private credit, venture capital and private equity.

'If the asset class remains opaque and continues to grow exponentially under limited prudential oversight, the vulnerabilities of the private-credit industry could become systemic.' Global Financial Stability Report from the IMF

When interest rates hovered near zero from roughly 2010 to 2022, private credit gained momentum as a source for yield.

When interest rates rose, private credit continued to outperform other asset classes and, at the same time, provided investors a way to diversify.

It's also boosted returns for pension funds and insurance annuities, to the benefit of Americans invested in these entities. At last check, the annuities business handled about $3.9 trillion, or roughly 9% of U.S. retirement savings.

Between 2014 and 2023, private credit generated an annualized return of 8.8%, according to data compiled by JPMorgan Asset Management.

In 2022 private credit generated a return of 6.3%, while the S&P 500 SPX dropped by about 18%. And in 2023 it returned about 12.1%, less than half the 26.3% gain of the S&P 500.

These consistent gains have attracted bigger investments from pension funds and managers of insurance annuities.

The largest U.S. public pension fund, the California Public Employees' Retirement System, or CalPERS, reported $14.3 billion in private-credit investments as of July 31. That's about 2.8% of its total portfolio of traditional and alternative investments.

CalPERS earlier this year hiked its allocation target for private credit to 8% from 5%, in a demonstration of continued growth for the asset class.

The American Investment Council, a trade group for larger private-equity firms, estimated that companies that have taken out private-credit loans employed 545,000 U.S. workers in 2022. Companies with private credit generated $90 billion of U.S. gross domestic product, the AIC said.

As private-credit deals grow larger, banks may benefit

The asset class has evolved to the point that private-equity firms like Apollo Global Management Inc. are moving into corporate loans - including to investment-grade borrowers.

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