Lowering lending standards is a factor that keeps private debt fund managers awake at night because it can lead to increased risk and potential losses. Here are some reasons why:
1. Pressure to Close Deals: With so much investor interest in private debt funds, there is pressure on fund managers to close deals and put money to work. This can lead to a temptation to lower lending standards in order to approve more loans and generate more income[1][2].
2. Weakening Credit Environment: As banks increasingly tighten lending standards, private debt funds may be forced to sell underperforming positions that can no longer be included in their leverage facilities[4]. This can lead to a situation where funds are more willing to take on riskier loans in order to maintain their target yield distribution to investors.
3. Concentration and Vintage Risk: Some direct lenders have been easing lending standards, increasing loan sizes, and relaxing covenants for years[3]. While these lenders may have recently adopted a more defensive posture to reduce risk in current deals, stricter lending standards could hamper the availability of private credit more broadly, potentially cutting off a critical source of funding for some borrowers.
4. Regulatory and Systemic Risk: Policymakers and regulators are increasingly interested in the role of private debt funds in managing risk and creating value that would otherwise not exist[5]. If private debt funds are not efficient at managing risk, they could create systemic risk that could have broader implications for the financial system.
In summary, lowering lending standards can lead to increased risk and potential losses for private debt funds. Fund managers must balance the pressure to close deals and generate income with the need to maintain prudent lending standards and manage risk effectively.
Citations:
[1] https://www.bloomberg.com/opinion/articles/2023-08-01/private-credit-investors-should-beware-of-riskier-newbies
[2] https://www.washingtonpost.com/business/2023/08/01/private-credit-investors-should-beware-of-riskier-newbies/fc0fb594-30b1-11ee-85dd-5c3c97d6acda_story.html
[3] https://www.spglobal.com/en/research-insights/featured/special-editorial/look-forward/private-lending-time-to-adjust-the-sails
[4] https://www.pimco.com/gbl/en/insights/opportunistic-credit-weakening-credit-and-tightening-lending-conditions-drive-compelling-value
[5] https://bfi.uchicago.edu/insight/research-summary/a-survey-of-private-debt-funds/
[6] https://pe-insights.com/news/2021/09/28/seven-questions-future-of-private-debt-agnes-mazurek/