Private credit revisited: what the scrutiny is about

A UK lender's collapse and a $40 million hit at HSBC have turned the assumption that banks are insulated from private credit on its head.

What happened

• The Financial Stability Board has warned that although banks' direct lending to private credit funds is 'relatively small', at less than 0.5% of their total assets, 'a web of interlinkages may create challenges for banks in effectively managing their direct and indirect risk'.
• The warning follows HSBC's $40 million hit from lending to a private credit fund, Apollo's Atlas SP, which in turn lent to Market Financial Solutions.
• In February this year Market Financial Solutions, a UK specialist mortgage lender, went into administration — less than six months after the back-to-back failures of First Brands Group and Tricolor Holdings in the US.
• Those failures created fears about underwriting standards in the fast-growing asset-backed lending market, which is increasingly funded by private credit providers operating under lighter regulation than banks. Asset-backed lending is where the primary source of repayment is a specific asset rather than the general creditworthiness of the borrower.
• HSBC had lent to Atlas SP rather than to the mortgage provider directly, which is why it did not initially appear among the large global lenders to MFS alongside Barclays, Santander and Jefferies.
• The conventional wisdom had been that lending to private credit through back-leverage — a bank lending to a fund, secured against the loans that fund has made — was relatively safe, because the direct lender absorbs the losses first. HSBC's announcement turned that assumption on its head.
• Andrew Bailey, governor of the Bank of England and chair of the FSB, drew attention to the 'significant interlinkages' between private credit and banks, asset managers, insurers and private equity, and said these layers of leverage required 'deep scrutiny'.
• The older concerns have not gone away either: opacity, and a 40 to 50% concentration of exposure in a single sector, software.

How to use this in applications and interviews

• Every bank and every private credit fund with a warehouse facility is now reviewing its documentation. A warehouse facility is a loan from a larger lender — a bank or a credit fund — to a non-bank speciality lender such as MFS, which the speciality lender then uses to make loans to its own customers.
• That review is the work. Expect tighter eligibility criteria for what can go into the borrowing base, expanded events of default, and anti-double-pledging mechanics so the same asset cannot secure two facilities.
• Following the HSBC announcement, major banks are running portfolio reviews specifically on back-leverage exposure. Lawyers advise on the disclosure question — at what point does that exposure become material enough to require an announcement to the market — and, where there is a problem, run the internal investigation into how the original underwriting cleared it.
• The forward-looking half is regulatory. Funds have to think about restoring trust and preparing for rule changes, and their lawyers earn their fees by anticipating those changes: reading FSB papers, Bank of England Financial Policy Committee reports, FCA consultations, regulator speeches and select committee reports, then turning them into client alerts that say what they actually mean.
• If you want a single sentence for an interview: private credit's problem is not the size of bank exposure, it is that nobody can see clearly where the exposure ends up.

Key terms

• Private credit is lending by non-bank funds rather than banks, usually with lighter regulation, less disclosure and higher rates.
• Back-leverage is a bank lending to a credit fund against the loans that fund has already made, adding a second layer of borrowing to the same underlying assets.
• Warehouse facility is a revolving loan that lets a speciality lender originate loans before they are sold on or securitised.
• Asset-backed lending is lending repaid primarily from a specific asset or pool of receivables rather than from the borrower's general cash flow.