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Patrick: Welcome to the Barclays Brief podcast. Now, recent high profile bankruptcies have heightened concerns about credit stress, especially with private credit lenders. To unpack what is going on and explain a complex interconnectivity between traditional banks and non-banks, I'm joined by Pete Troisi, who covers US high grade bank, insurance and non-bank financials. Pete, thanks a lot for joining me on the podcast today.

Peter: Hi. Great to be here, Patrick. And, you know, I was just thinking about as you listed out all those sectors that I cover that, you know, they really used to be discreet industries, but those lines are getting very blurred now in the financial services sector. And I actually think it's private credit. That's a big reason for that.

Patrick: Yeah, exactly and ‘Blurred Lines’ could easily be the title of this podcast. Now clearly private credit is described as opaque and complex. But I don't want to talk generalities today. I want to just dive into the intricate ways in which private credit is interwoven into the broader financial system. We've only got ten minutes, but let's just start with the basics, Pete.

What is private credit? How large is it and what's the growth potential?

Peter: Sure, if I just use the most common definition of private credit, the size of the market is approaching $2 trillion. That's doubled over the past five years. But that is a fairly narrow way of thinking about private credit given its growth. It's really become much more expansive. So we do have to use a, a more broad definition.

And I think the total addressable market (TAM) here is in excess of $20 trillion, actually based on our research. Now, look, private credit might only capture a portion of that number, but it does give a sense for the growth potential.

Patrick: Okay. So it's big. It's fast growing and lending is clearly moving outside of the banking system. And into the private credit market.

Beyond the obvious concerns like transparency and regulation. And we read about that in every article about private credit, you've highlighted interconnectedness as a less obvious risk. How does that play out Pete?

Peter: Sure, what's really allowed private credit to grow here is the tighter regulation of banks coming out of the great financial crisis. So in short, banks did less leverage lending, and the slack was picked up by the private credit market.

And the two coexisted with minimal connectivity between the two. But now that's changed. The private credit market is so large that it needs to partner with banks for funding and leverage, and private lenders are now very large clients of banks and are actually borrowing from them to help grow their businesses. And this is what we refer to as ‘Non-bank Financial Institution’ lending, or NBFI, which is an acronym that I'm getting a lot of questions about from clients.

NBFI loans establish the connection between banks and private credit.

Patrick: Right. So that's the first acronym today. I'm sure we'll hear more. It seems natural that as one market grows, it spills into another. Back in July, Pete, you were on our sister podcast, “The Flip Side”, you were arguing the NBFIs were fairly well positioned. So how is your thinking evolved over the last few months, and what are the risks you see with NBFI lending today?

Peter: Well, for one, these NBFI loans are growing quickly in the banking system. There's more than $1 trillion of these loans that have been funded to NBFIs. That's over 10% of total loans in the banking system. Now that is a material exposure for banks. And the one of the issues is we really don't know how much more appetite they have to keep growing it.

We'd be more comfortable if we knew there were limits.

Patrick: Okay. So banks and private credit markets are more connected because of the growth in NBFI lending. Why does that matter for systemic stability, Pete?

Peter: Well, I think it's the nature of the risk. As I said, banks are effectively lending against the assets that private credit companies originate themselves. Now, banks are doing this on a collateralized basis, so there are protections in NBFI loans. And that makes banks in a senior position when they lend this way, they only are taking second loss exposure. But this still does indirectly expose banks to the higher leverage that resides in the private markets.

Patrick: Okay so traditional banks have exposure. You’ve talked before about insurers playing a critical role also in backstopping private credit. That seems a bit less intuitive to me, so can you kind of walk me through that linkage?

Peter: Sure, so the key to operating any kind of lending business is to have access to stable and abundant funding. So with banks, of course, they have that. They have trillions of deposits and they use those to fund loans. Now, participants in the private markets don't have the same access to deposit funding, so they need an alternative.

And that's where the insurance industry comes in. Life insurers have what many refer to as ‘sticky liabilities’. That means when a life insurer sells a policy or an annuity, the customer is likely to stay with them for a long time. And many participants in the private market at this point have either purchased or partnered with a life insurer, which gives them the access to that stable and long term funding.

Just put some numbers around it. Total policy liabilities in the US life insurance market exceed $4 trillion. So this is a really big opportunity for the private credit market to tap into.

Patrick: Okay, so again, another huge number. We've got private credit tapping into this $4 trillion of stable funding via insurers. But Pete, is that a new phenomenon. How's that been growing in the last few years, and where do you think that will kind of go to in the future?

Peter: It is relatively new. The trends been accelerating with the Fed's, lift off post-Covid. Annuity sales in particular, are benefiting from the higher rate environment, and volumes have been at or near all time highs since 2023.

Patrick: Okay, so private credit companies are using those annuity inflows to increase their assets under management. It's got to be some risk to what are they Pete?

Peter: Sure I'd say there's really two of them: As I mentioned these annuity sales, are correlated with interest rates, so if we get more Fed cuts that could dry up some of the funding for the private credit market.

But I think there's a bigger risk here, though: insurers traditionally have been risk averse when it comes to their investing. And these private credit exposures on their balance sheets could have higher risks than their traditional investments. And this is an area actually that the US regulators are looking into, which suggests that there could actually be marginal risk growing in their portfolios because of their connectivity with private credit.

Patrick: Okay I'd love to dig into that more. Maybe, maybe another podcast. But in front of me right now, I have your notes from last week, which was one of the most read notes on Barclays Live. It's called ‘Private credit and business development companies taking fundamental cues amid uncertainty’. Now those business development companies, BDCs, are seen as some as a kind of blind pool of private credit risk.

What's going on in that space right now Pete, and why is everyone talking about it?

Peter: Sure. Just to start with some numbers. So BDCs are large participants in the private credit market, BDCs have nearly $500 billion of assets under management. And you're right there, there's a transparency issue. We don't know much about the private credit assets on the balance sheets of BDCs.

And that lack of transparency has effectively caused fear of the unknown. Just given the recent increase in credit events, in the market, I think it's also caused event investors to look past the fact that BDCs themselves don't use much leverage, even though their assets have leverage in them. And what that means is there is a lot of equity capital in these BDC structures to absorb potential credit losses in their portfolios if they were to materialize.

And I do think that is an important point from my perspective as a fixed income analyst

Patrick: Understood. Now, most of these BDCs reporting a bit later in the cycle, the traditional banks have reported earlier for Q3. What were the traditional banks saying, and what were they disclosing about their exposure to private credit?

Peter: Yeah. So the traditional banks are fully done with, reporting of third quarter earnings.

And I would if I had to characterize it in one word, I thought the results were really fine without really major red flags. If I think about larger cap banks earnings grew quarter over quarter, almost 10% for asset quality metrics were stable across consumer and commercial portfolios. And now we're starting to see BDCs report results, and we're seeing somewhat similar trends with stable asset quality.

Patrick: Okay, so we've got investors, you know, really interrogating those BDCs right now. Another acronym, ‘PiK’ – payment in kind is coming up a lot with your investor conversations. I know when we were talking prior to, speaking today, what's going on with, with PiKs Pete? And, is that another warning sign?

Peter: Right. And you're right, Patrick. I mean, PiKs can be a warning sign here.

And really, this comes back to the flexibility that BDCs and private credit provide to borrowers that, that banks don't do as much. And this is being able to defer interest through payment in kind coupon instead of paying it in cash. Now we have seen PiK rates of BDCs steadily grow the past 5 or 10 years. However, we've the slope has really stabled off recently.

The concern that investors have with PiK is it could be allowing BDCs to kick the can down the road when it comes to their more vulnerable borrowers. Now, again, this hasn't been a particular earnings issue for BDCs, but it is a portfolio trend that many investors are focused on.

Patrick: Right. Yeah. Again, kicking the can down the road seems a fairly accurate description of that to me.

But if we put it all together, clearly private credit adds leverage to the economy. At what point Pete, does this shift from idiosyncratic risk to something more systemic, even sort of 2008-esque . And what pieces of data and what announcements are you looking at? In the next sort of 6 to 12 months, to understand how that risk profile is shifting?

Peter: I'm glad you brought that macro point up, Patrick around leverage in the system. I think, you know, the more leverage there is, the more likely a severe and correlated credit shock would be. And I really think it's that kind of stress that it would take for private credit to be a systemic issue to regulated sectors. Now, I don't think the credit events that have happened recently are an indication that we're moving towards that.

But I am really going to look out for three factors: The first is growth, because as we've, presented, private credit continues to grow, grow quickly. The second is asset quality trends, which right now are not concerning. But if we get an inflection point, there, that would be more concerning. And then the last are flows into and out of BDCs and other private credit funds.

Patrick: Fantastic. Normally I, I finish this podcast with, a summary of the key three points. You seem to have done it for me,

Peter: Absolutely. Patrick, thanks very much for having me,

Patrick: Pleasure, thanks for joining.

For more reading on the private credit market, check out the show notes and clients can learn lots more about this topic by looking at the Private Credit Hub on Barclays Live. Remember to get notified when new episodes of The Barclays Brief come out, hit subscribe wherever you're listening right now.