Hal Weitzman: One of the fastest growing parts of the financial system in the past 15 years has been private credit, that is lending not my banks, but by other financial institutions or funds that don't take deposits. The sector expanded tenfold between 2009 and 2023 to reach a value of about $2 trillion according to McKinsey. And McKinsey thinks it has room to continue growing to become a $30 trillion industry. What does this mean for companies and for the broader US economy?
Welcome to the 黑料传送门 Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way. I'm Hal Weitzman, and today I'm talking with 黑料传送门 Booth's Amir Sufi about the rise of private capital. Is it better or worse for borrowers? Should we be worried about systemic risk and why aren't banks lending as they used to? Amir Sufi, welcome back to the 黑料传送门 Booth Review Podcast.
Amir Sufi: Thanks for having me.
Hal Weitzman: Last time, we had such fun talking with you about your new line of research about customer capital, but this time we're going to switch gears a little bit, talk about a different kind of capital, private capital, the rise of private lending. Just tell us what do we mean by private capital?
Amir Sufi: So private capital refers to an institutional organization in lending to businesses. That's very different. I think maybe it's worthwhile to start with what it's not. It's not a bank. So we all know what a bank does. A bank takes deposits from people and just like it's a wonderful life kind of George Bailey, they go out and they make loans with those deposits. And that's the traditional way we thought intermediation worked for a long time. Private credit is this pretty interesting organizational form where instead of taking deposits, you take investment directly from pension funds, from insurance companies, from endowments. You put it not as deposits, but it's actually structured as a closed-end fund, more like a private equity fund or a venture capital fund, and then you go out and make loans to businesses. So we as financial economists find it really fascinating because the way in which these private capital financiers are themselves financed is very different. They're not relying on deposits, they're instead relying on institutional investors.
Hal Weitzman: And those institutional investors, I was going to say, they're big funds, they're big themselves have collect masses of deposits. So what's the role? Are the banks being disintermediated, if that's the right word, by private capital?
Amir Sufi: Yeah, I mean, what's interesting is the rise of these institutions really took off after the great financial crisis. And a lot of people say it wasn't in fact these private credit funds displacing banks. It was the banks pulling back from lending to these middle market firms. And there was this gap that private credit funds then went into. And so, the story usually is it's something about regulation or some reason banks pulled back and there was a need from the firms, they needed to borrow in order to grow. And that's where these private credit funds stepped in.
Hal Weitzman: I see. So just to dig into that, the reason that the banks pulled back was partly because they were under more scrutiny, they had to hold more capital and that kind of thing?
Amir Sufi: Absolutely.
Hal Weitzman: They were more cautious because they lent money to people who couldn't repay it in the past?
Amir Sufi: Absolutely. So that's the story you hear on the street, but I think one of the things we hope to do in the research is to nail down that story if it exactly is correct or if there were some other factors that are underappreciated on why the rise of private credit happened in the aftermath of the great financial crisis.
Hal Weitzman: So there's a reason which we'll find out from future research maybe it sounds like, but there was a hole there that they weren't lending. Now banks weren't lending, they were obviously still lending mortgages, although there's been a lot of new mortgage providers as well, but who was not able to get credit in that system?
Amir Sufi: That's one of the things I find so exciting. As you know, I've done a lot of research on mortgage markets and on banks, sometimes very bad mortgages they made during, especially the period before the great Recession. I like financial institutions making loans to middle market companies. This is generally defined as companies that have between say 10 million to 100 million of revenue. So they're not tiny, the corner dry cleaner, but they're also not big publicly traded firms. And these firms oftentimes are the engine of productivity growth of getting larger. And so, we really would like these companies to be getting more financing. So I think that's one of the reasons I'm so excited about this area is it's the good finance view that this is exactly what finance should be doing is financing these productive businesses. And I think they have stepped in and proven they're willing to do that.
Hal Weitzman: So you said that the people who are most likely to borrow it sounds like from private capital, private lenders are medium-sized, small and medium-sized firms. And that makes me think that another complementary trend is the rise of private equity and private ownership of companies, and that's an increasing part of the US economy. Is that related to private capital?
Amir Sufi: Very, very closely. So in fact, private credit in some ways is an outgrowth of private equity and venture capital in that this funding structure is what's called a closed-end fund, a private fund. And so, the funding structure is actually almost identical to private equity funds and venture capital funds, except the big difference is of course, they make loans. The private credit funds make loans, they don't make equity investments. But oftentimes, they are an outgrowth in that of the companies, the estimates are between 70 and 80% of the companies that the private credit funds lend to are owned by private equity firms. And in fact, the largest private equity firms that your viewers will know the names of, KKR, Carlyle, they actually have set up both private equity funds and private credit funds underneath the same overall company. And so, these are very complimentary funding techniques.
Hal Weitzman: I see. So one being to lend to the companies, the other being to take them over.
Amir Sufi: Exactly. Exactly. And oftentimes, it happens at the same time. So a private equity fund who gets to buy a company.
Hal Weitzman: Who gets to-
Amir Sufi: And they will use a private credit fund to get the borrowing to take over the company.
Hal Weitzman: And so, just to be clear, the thing that's drawing the borrowers to these private lenders is just that they can't access credit anywhere else. Is that right?
Amir Sufi: Or at least on the same terms. Yeah, I mean, I think they get much better terms. They get much better monitoring, they get much better covenant structures, so they just find it overall a better product oftentimes than going to the banks.
Hal Weitzman: I remember in the past when we talked about shadow banking in the wake of the Great Recession when we first came to 黑料传送门 Booth, and there was concern about the systemic significance of private ownership and the involvement of more lightly regulated or unregulated companies in the market. What is the regulation about private lending and what concerns should we have about it, about its growth?
Amir Sufi: So I think the consensus, I think pretty much everyone would agree that the most dangerous financial institutions from the perspective of financial stability are institutions that borrow via, say, deposits or extremely short-term financing. This is of course the reason my colleague Doug Diamond won the Nobel Prize is pointing out that this is inherently an unstable activity. One of the advantages of the private credit funds is they do not borrow short-term with demand deposits. In fact, they're structured as what we call closed-end funds. So all of the investment into these funds is equity investment by these institutional investors. And they're closed-end so you can't yank your money out if you get nervous.
Now that being said, the private funds, the private credit funds do themselves also borrow in order to help finance some of those loans. But all of the evidence we have right now is that they borrow very little relative to, for example, how much banks borrow. So there is some regulatory structure right now. I can go into that a little bit more. It's the SEC actually that looks over and regulates these private credit funds. And there is a form called Form PF, which stands for private funds. It's highly confidential data, but they do provide summary statistics. And we can see from those regulatory filings how much the private credit funds are borrowing. And at least as of now, they're not borrowing very much. And so, I think from a regulatory standpoint, they're actually quite a bit safer than banks because they're not borrowing short-term and they're borrowing in a closed-end structure.
Hal Weitzman: So these institutional investors are putting their money into these closed-end funds. That money is then being lent to small and medium-sized businesses. And what happens if those businesses fail?
Amir Sufi: So finance is all about taking risks. So of course, I'm not saying these insurance companies and pension funds may lose money, they may lose money, but you're not going to get the kind of runs and instability that we have seen in the financial system based on very short-term overnight type financing. So I think if there is a risk that's arising from this, it is the traditional risk that people take when they invest, which is the private credit funds could end up making loans that go sour and then the pension funds and the insurance companies will lose money. I mean, that's of course always a risk, but that's of course pension funds and insurance companies are always taking risks, not just in private credit funds. So I'm just trying to emphasize that there's nothing really special in terms of the liability side.
Hal Weitzman: You're doing it riskier for your retirement fund manager to be putting its money into private credit or presumably it's very carefully managed. They're not putting the majority of their cash in, but they're nevertheless making significant investments. This is a growing part of the economy. I'm just wondering what happens if there's a big recession and a lot of those, because what you described is a section of the economy that is maybe riskier than a very large company.
Amir Sufi: Yeah, I agree with that. I mean, it's in general exposing to fundamental credit risk. And I think the insurance companies and pension companies, I think they understand that that's why they're getting the better return. And so, they are taking more risk. The same is true, of course, of mutual funds or any other type of, mutual funds oftentimes are investing in more middle market type firms, smaller cap firms, and those do tend to be riskier. And I think we know they have higher returns because they are riskier. So from that perspective, of course, there is always risk being taken, but at least you don't have this leverage short-term run risk as much.
Hal Weitzman: Right. It's not equivalent of a bank run, I guess. So you referred there, and I was going to ask you earlier about the rates at which companies are borrowing. So I mean these are presumably not competitive with the traditional rates that larger companies can borrow.
Amir Sufi: Of course not. Of course not. They borrow and the rates are pretty steep. I mean, they can be 10, 11, 12%. And one of the interesting findings from the literature that we know so far is that the returns that the private credit funds are earning do seem pretty high for the risk they're taking. Because remember, they're taking first lien secured loan positions in these companies. They're not taking the equity position in these companies. And so, a lot of people have asked why. Why are they able to earn these returns even though they're taking what look like pretty safe positions?
Hal Weitzman: In other words, they're going to get paid back first, whatever happens.
Amir Sufi: Exactly. They're going to get paid back first whatever happens, and if default, they can potentially take over the company because they're the first lean position. And I think there's been two explanations about why they're being able to earn these returns. One is that the positions really are riskier than we may think, and that's what we talked about before. Even though they're first lean, this is a segment of the economy that could be potentially very cyclical and could really be hurt in a downturn.
The other explanation is there's a scarcity problem, which is there's these good companies, they have very good investment opportunities, the banks have pulled back, and so these companies are willing to pay a higher interest rate they otherwise can't take on these very valuable projects. I think we don't really know which of the two is true right now. What is true is that the market is growing so fast. And that's one of the reasons so interesting. It's growing so fast that we probably should see those yields, those interest rates come down if it's just a scarcity story. And the most recent evidence does suggest that the interest rates are starting to come down in that market.
Hal Weitzman: So there's just more and more private lenders coming in.
Amir Sufi: Yeah, of course. And that's the way the economy should work. If there's something that's profitable because there's not enough resources in it, we should see more resources move toward it. And that seems to be what's happening in the private credit sphere.
Hal Weitzman: But it does make me wonder if those high rates are hampering the growth of those companies, like you say, that's fast-growing, those should be fast-growing companies and they should be companies that in aggregate add a lot to the US economy. Are they adding less because of the interest rates?
Amir Sufi: Absolutely. But the problem is the counterfactual is not getting any loans at all. And so, if you don't get any loans at all, you can't grow. And so, the hope is if the private credit industry continues to grow, another knock-on effect is the banks seem to get more interested now. So it does seem like the banks want to get back into the business because they're realizing, "Oh my gosh, there's all these good investment opportunities." So hopefully, the interest rates and the cost of capital come down so that this important segment of the economy can continue to grow.
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So Amma, we talked in the first half about the banks removing themselves for whatever reason. We don't quite know why from lending to certain sectors of the economy, particularly smaller and medium-sized businesses, and into that void stepped private capital, private lenders. And now we're coming back talking about how the bank's suddenly saying, "Hang on, this is pretty good business actually." They're charging higher interest rates. It makes me wonder if in an ideal world if we could compel banks to lend to this sector, would that be a better system because they would lend at lower rates? After all, banks have all these protections built into the US economy that private lenders presumably don't have.
Amir Sufi: Yeah, I think it is a great question. It does seem like what banks, when we think about why banks pulled back. One obvious thing is, oh, there's more regulation and the regulators cramped down on them more. But I think there's something deeper than that. It does seem like banks, and there's a lot of research to back this. It does seem like banks are primarily about trying to maximize the value of what we call their deposit franchise. Really it is, they're able to get your money at really low interest rates. And so, what are they going to do with that money? They could go out and try to make really information sensitive productive loans. They seem to be less wanting to do that. It might be very costly to hire loan officers that do the really fundamental work of looking at companies and instead they seem to just invest more in treasury securities. They invest more in agency mortgage-backed securities. And so, it does seem like they're becoming more just disintermediated in the sense that they don't seem to want to do the really hard work of doing the commercial and industrial lending.
Now of course, I'm speaking in hyperbole. There's a lot of banks out there that do a lot of that lending still. But that's the open question is what will banks continue to do? Ironically enough, in a very interesting aspect of this is the banks themselves are starting to lend to the private credit funds. And so, it's just an intermediate level of intermediation where the private credit funds are now acting as the intermediary between the banks and the ultimate companies. And so, that's another interesting-
Hal Weitzman: This is fascinating because this is a really big change in banking behavior. Like you say, it's not uniform, but it is a trend that they are taking deposits and no longer packaging them up and lending them out to people in the same rate that they used to, but putting them into basically safe deposits that arbitraging the system. And that's really why I find this area so fascinating because as a financial economist, I always try to think hopefully that finance can be true economic value added. And I think in this area, the way in which finance can actually add true economic value is by having excellent loan officers and excellent underwriting that goes out and actually finds the good businesses that are starved of capital that are willing to pay a good return because they have such good projects. And I think banks did pull back from doing that, and I want somebody to do that. And so, private credit funds are really interesting because maybe they're a solution to that problem.
Hal Weitzman: But it's fascinating that rather than getting back into that business, as you say, banks are now getting back into it by lending money to these private lenders.
Amir Sufi: Yeah, because I think at the end of the day, if you think about if I'm a bank and I think where I'm getting most of my value is being able to pay Hal just a 1% interest rate on his deposit, and I can then just take that and put it in a 4% treasury security, why not just do that and go home? I earn a 3% spread. And so, it does seem like they're not as incentivized to go out and pay loan officers and underwriters to do the hard work, which can be expensive work in order to get that higher interest rate of 10, 11% that maybe you get on a middle market loan.
Hal Weitzman: And what you're describing sounds more like just a money management firm than a, I mean the social function of a bank was supposed to be, you referred to. It's a wonderful life, I think because British, I think more of Mary Poppins, the social function of a bank is to take in deposits, tuppence at the bank, and then they turn it into loans that do amazing things.
Amir Sufi: Absolutely.
Hal Weitzman: But are we moving to an era when that may not be the case anymore?
Amir Sufi: And again, I don't want to speak in too broad a strokes. I think if you look at the very large bank, let me just say this. If you look at the portfolio composition of the asset side of banks over the last 40 years, it's unambiguous that they've pulled back very strongly from traditional commercial and industrial loans they have. And that's just a fact. They've gone way more into securities, treasuries and agency mortgage backed securities in particular. I'm trying to give you some sense of the economics of why that might be happening. And I think it is closely related to this idea that it's really the deposit business that they care about. That's really where they make the money. And on the asset side, they're just trying to make sure they get their return. But it is something that leads to the question, well, somebody needs to be doing those activities. And so, maybe private equity, maybe venture capital, private credit, all of these intermediaries are stepping in to do the work of actually finding good businesses and financing them.
Hal Weitzman: But it's still remaining institutional. It's not as if I should expect that I'll still put my money in the bank, but any loan, my car loan will come from some private lender that I've never heard of.
Amir Sufi: It could be. I mean, they are starting to say, I mean, that's kind of the future of private credit. When you look at, for example, McKinsey just put out a big report about what the future of private credit is, and they talked about maybe private credit funds will try to start making jumbo mortgages. Maybe they'll try to do more asset-based lending in, say, auto loans. I will say that everything I've said here, if they start doing jumbo mortgages, I would put to the side, then I would start getting quite worried. If private credit funds start doing mortgages, real estate lending, we know that's a sector of the economy that can be very dangerous. So maybe that's the future. Maybe they will start to make consumer loans, try to make credit card loans, but that's all remains to be seen. That's not happening right now.
Hal Weitzman: Right. One thing that's fascinating to me about this is how it relates to your former body of work about debt, because in your book House of Debt, you talk about the possibility of creating a mortgage product that would share the burden, the risk between the lender and the borrower so that if the price of a house went down, the person had to sell, then the lender would bear some of that risk. And here, you've almost got the same kind of system, but it's actually happening where private capital is lending and these closed-end funds, as you say, people can't withdraw. And presumably there is a possibility some of those loans won't work out and they'll take a bit of a loss, but on balance, they reckon they're going to make money, but they will share in the burden with the borrower.
Amir Sufi: I'm very happy that you connected the dots in that. That is a definite connection. And one of the reasons I got interesting because it is kind of fascinating. As I mentioned at the beginning, it does turn on its head our notions that the kinds of institution that make loans should be the kinds of institutions that take deposits. This does suggest that the act of making loans doesn't mean you need to finance yourself with very short-term debt like debt liabilities. You can be more equity financed. A lot of these are purely equity financed instruments. There's no debt at all. They're not borrowing at all, and they're going out and making loans. And so, that really does kind of raise very fundamental questions about why is deposit taking and lending taking place under the same roof? And I think this industry is challenging that question. I think there'll be more research on it as a result.
Hal Weitzman: Fascinating. So one other thing that occurs to me, as you said, the banks, or at least there is an increasing trend, let's say, of banks taking deposits, paying depositors basically nothing, and then getting slightly more and arbitraging it by putting them in safe investments that pay more. We've been living through a very high interest rate environment, but we are on the, well, I don't make too much of a prediction, but it appears that we may be on a heading down in terms of interest rates and we have been a little bit. How do you think that could affect behavior banks and lending behavior in general?
Amir Sufi: Yeah, so I think the classic research on this question does suggest that when the spread between the federal funds rate or market interest rates and the deposit rate starts to narrow, which maybe that will happen going forward, then banks are willing to expand the number of loans they make. And so, maybe the high interest rates are really why they're playing this game of just trying to take the low interest rate deposit and get the high interest rate market security. So it'll be a very interesting question whether they make a strong comeback into commercial lending if interest rates come down. But I think still the long-term trend has been in this direction, so I'm doubtful that somehow interest rates coming down is going to reverse the long-term trend that has been leading them more and more towards investing in securities rather than loans.
Hal Weitzman: Okay. So it sounds like private capital, you think state's going to grow.
Amir Sufi: Yeah. I mean, we've been looking in this research, it's not yet complete, but if you look at the micro data, you realize that primarily private credit funds are still only lending to private equity sponsored companies. That's still a pretty small segment of the economy. The open question really is whether they're willing to expand into lending to middle market firms that are not private equity sponsored. That is a huge market. And so, a lot of people say, "Oh, it's a private credit bubble. It's grown too fast." I think it's only a bubble and it's only grown too fast if you think that they're only going to limit themselves to private equity sponsored firms. If you think about all of the middle market firms in the US economy, they're still a tiny fraction of the overall lending that's being done.
Hal Weitzman: But then those are riskier, aren't they? If you start expand.
Amir Sufi: Could they could very well be. And then, the question is, who do we want making those risky loans? Do we want banks? Do we want private credit funds? And that's going to be an interesting question for research going forward.
Hal Weitzman: Amir Sufi, this has been another great discussion. Thank you very much for coming on talking to us about private capital.
Amir Sufi: Thank you.
Hal Weitzman: That's it for this episode of the 黑料传送门 Booth Review Podcast, part of the University of 黑料传送门 Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.
This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.
