Private-Credit Funds Need More Scrutiny, Fed’s Cook Says

Lisa Cook, governor of the U.S. Federal Reserve, says she is taking a close look at business development companies as a source of potential problems. (Aaron Schwartz/Bloomberg)

Key Points

• A Federal Reserve official is calling for closer examination of private credit funds due to their ballooning assets and ties to banking.
• Business development companies (BDCs) under management increased 34% year-over-year to $503 billion in the second quarter.
• Low default rates in private credit may mask distress, as payment-in-kind agreements can signal a higher ‘shadow’ default rate.

As private-credit assets balloon and grow increasingly entwined with the banking system, a Federal Reserve official is calling for a closer examination of the funds that make the private-credit industry run.

Lisa Cook, the Federal Reserve governor who chairs the central bank’s committee on financial stability, said Thursday that she is monitoring the private-credit boom as a source of potential vulnerability.

Though private-credit investments have generated high returns and low default rates, Cook said in prepared remarks at Georgetown University’s Psaros Center for Financial Markets and Policy in Washington, D.C., “we should expand the lens and inspect this funding vehicle more closely.”

Cook was referring to vehicles such as business development companies, or BDCs, popular structures used by private-credit managers to extend loans. BDCs’ under management rose 34% from a year ago to $503 billion in the second quarter, according to LSEG. The broader private-credit market is some $3 trillion, up from $2 trillion five years ago.

At their best, Cook said, those vehicles conduct due diligence and closely monitor their loans to privately held companies for signs of distress on their investors’ behalf. Their model “has the potential to enhance financial stability and expand economic growth,” Cook said, with private credit acting as a source of funding for businesses.

“I do not currently see the potential for private credit to contribute to an unexpected credit crunch in the same way that the asset-backed commercial paper market did in 2008,” she said. “However, it is well worth keeping a close eye on developments here.”

Cook cautioned that while defaults are low, they are backward-looking. They may also reflect more lenders and borrowers turning to measures to mitigate distress, such as payment-in-kind agreements, she said.

Those arrangements can act as a way to provide borrowers flexibility when they are structured at a loan’s origination, but when they are introduced as part of a troubled company’s restructuring, they may “signal a higher ‘shadow’ default rate and lead to an eventual increase in non-accruals and losses,” Fitch Ratings said in a report this week.

Write to Rebecca Ungarino at rebecca.ungarino@barrons.com