AIFMD II amidst the debate on private credit market growth and financial stability

A spotlight was shone on the issue recently with comments made by Elizabeth McCaul, a member of the Supervisory Board of the European Central Bank (ECB), as well as by Klaas Knot of the Financial Stability Board.

Growth of private credit

Before the global financial crisis (GFC), banks were generally the first port of call for businesses that needed a loan. In the years since the crash, that position has evolved, with businesses now having many more options for raising capital.

A reason for this is that the GFC spurred a wave of new regulation in relation to bank liquidity, risk management and capitalisation which has served to reduce banks’ appetite or ability to take on loans they perceive as too large or risky. Non-bank financial intermediaries (NBFIs) stepped in to fill the gap and were willing to provide credit to businesses that some banks were no longer able – or willing – to. 

Private credit providers, including private equity houses and investment funds, are just a sub-set of NBFIs, providing direct loans to businesses. Investment funds are a common vehicle for these arrangements, with private credit – or private debt as is it sometimes also referred to – becoming significantly more popular in recent years.

In Luxembourg alone, the Association of the Luxembourg Fund Industry (ALFI) reported last November that the total value of assets under management of private debt funds in the country had increased by 51% in a year, to €404.4 billion as of June 2023. The previous year, the market grew 45.4%. According to the International Monetary Fund (IMF), the value of assets and committed capital in the private credit market in 2023 “topped $2.1 trillion globally”.

A report published last year by the Alternative Credit Council (ACC) highlighted how sectors like business services, healthcare, software, climate and energy transition, and financial services, as well as maintenance and repair companies, have been popular with private credit managers.

In its report, the ACC also highlighted traits of the private credit market that indicate why it has grown in popularity with corporate borrowers and investors alike: “Flexibility, speed of execution and direct relationships with borrowers remain key features of private credit. During the past year, these attributes have come to the fore for borrowers in need of finance partners they can rely on, and ones who are able to adapt to their needs. For investors, these attributes also continue to be an important driver of returns, with private credit fund managers able to address stress more proactively and effectively than other lenders.”

However, regulators around the world have flagged how the growth of the private credit market might impact financial stability.

The concern of regulators

In its annual report released late last year, the Financial Stability Oversight Council (FSOC), which sits within the US Treasury, described private credit as “a relatively opaque segment of the broader financial market that warrants continued monitoring”.

The FSOC said financial stability risks can arise from the private credit market “when unexpected financial or economic events negatively affect firms’ ability to service or refinance their debt and the financial sector cannot absorb losses from associated downgrades and defaults”. It added that the “overall health of the economy” can be adversely affected if those issues become widespread and cause “difficulties in servicing or refinancing outstanding debt”, highlighting also that it could also spur “an associated reduction in investor risk appetite” leading to “significant declines in asset prices”.

The Bank of England too has highlighted concerns, stating that it is “important that, alongside banks, the non-bank system can absorb, and not worsen, any shocks that may arise”. It has identified ‘microfinancial vulnerabilities’ and ‘macrofinancial vulnerabilities’.

Microfinancial vulnerabilities, it said, arise at the level of individual firms and might materialise where firms have insufficient liquidity to meet long-term liabilities, requiring assets to be liquidated quickly at times of stress, or where funds are exposed to losses because of the way they have been leveraged against other assets. In respect of ‘macrofinancial vulnerabilities’, the Bank of England described these as “risks inherent to the structure of markets, or the collective behaviour of individual firms within them”. An example of such a vulnerability is where there is so-called “correlation risk”, which the Bank of England said is where market participants hold “common positions” and respond in the same way to events, like deciding to sell assets at the same time, causing a market-wide fall in prices.

In a recent interview, the ECB’s Elizabeth McCaul flagged similar concerns.

McCaul said: “It can be via the correlation of exposures where, especially given the growth in the private credit and private equity markets, maybe we have the same exposures as ones on bank balance sheets and where risk can spill over in various ways. It may also be the case that there are hedging strategies to the same exposures in both the regulated banking market and the NBFI market. And finally some of these funds, especially certain hedge funds, are becoming so big that they can partially move the market by themselves and are not likely to act as shock absorbers in the same way banks have sometimes acted. This matters also for liquidity dynamics in the system.”

McCaul added that the ECB lacks “a fully clear line of sight from the banking supervisory standpoint about the level of exposures that may be correlated to risk on NBFI balance sheets from banking industry lending arrangements”.

A problem regulators have is transparency over the problem. The FSOC said it “supports enhanced data collection on non-bank lending to nonfinancial businesses to provide additional insight into the potential risks associated with the rapid increase in private credit”, while the Bank of England has acknowledged there are “challenges in gathering the data needed to build a picture of the sector and risks”.

A major reason for this opaqueness is that providers of private credit often fall outside the scope of direct regulation.

According to ALFI data, the majority of investors in private debt funds, at 81%, are institutional investors, with the most popular vehicle for doing so being the reserved alternative investment fund – 53%, with 38% being structured as specialised investment funds (SIFs). Where private credit providers are regulated, they face less stringent liquidity and capitalisation requirements than banks, which can only provide regulators with part of the market picture through their own regulatory reporting.

In this context, a call for action was issued by the IMF in April. It said it is “imperative to adopt a more vigilant regulatory and supervisory posture to monitor and assess risks in this market” and that authorities should “consider a more active supervisory and regulatory approach to private credit, focusing on monitoring and risk management, leverage, interconnectedness, and concentration of exposures”.

Change coming in the EU

In the EU, revised legislation was finalised earlier this year that will stiffen obligations on the managers of alternative investment funds (AIFs) that provide private credit to businesses. Indeed, the preamble to AIFMD II referenced “the fast-growing private credit market” as the driver of new rules to “address the potential micro-prudential and macro-prudential risks that loan origination by AIFs could pose and spread to the broader financial system”. As the pandemic also revealed, investments funds can contribute to broader market stress where there is a structural mismatch between the fund’s liquidity – illiquid assets – and substantial redemption pressures.

AIFMD II, which will largely take effect in April 2026, will impose leverage limits on loan-originating AIFs, with managers of ‘open-ended’ AIFs also, subject to limited exception, required to implement at least two liquidity management tools (LMTs) provided for in the directive to help them “deal with redemption pressures under stressed market conditions”. Examples of the liquidity management tools listed include temporary suspensions on the ability of investors to redeem or purchase shares in the fund, as well as the operation of notice periods for the redemption of shares and charging of redemption fees.

The European Securities and Markets Authority (ESMA) recently opened a consultation on draft regulatory technical standards which will specify the characteristics of the various liquidity management tools provided for in the legislation. Notably, it sought to mention that LMTs are not to act as “backstop” for the purpose of addressing issues arising from failures in management vis-à-vis investment decisions or risk management but rather to manage the fund’s liquidity risk in both normal and stressed market conditions.

Under ESMA’s proposals, LMTs are to be selected based on an assessment of the tools as against the fund’s strategy, distribution policy, liquidity profile and redemption policy, while it also cited the Financial Stability Board’s recommendation that “a balance” be achieved between the use of anti-dilution tools (ADTs) and “quantity based LMTs”. AIFMs should “calibrate and activate” LMTs depending upon the unique attributes of the fund and prevailing market conditions, ESMA said, in what is intended to be a significant step towards addressing liquidity mismatch risk.

Whether the AIFMD II rules change much in practice is open to debate, however. A survey run by the ACC revealed that private credit fund managers are “already making extensive use of liquidity management tools to align the liquidity profile of open-ended funds with the needs of investors and underlying assets”, and further found that an “estimated 58% of capital invested in private credit strategies is done so through closed-ended structures”.

AIFMD II also provides for a lifting of limitations on the data that regulators can collect from managers about the AIFs they manage. Managers will be expected to report, among other things, on “the exposures and assets of each AIF”, including “the current risk profile of the AIF, including the market risk, liquidity risk, counterparty risk, other risks including operational risk, and the total amount of leverage employed by the AIF”. The finalised regulatory technical standards will specify the data reporting obligations in more detail.

It may well be that the data reported will give ESMA the further opportunity to address some of the concerns regulators have expressed about the opaqueness in the private credit market and in turn help alleviate associated concerns about how this important market impacts on financial stability, at least in the EU.