The Real Reason Why Private Credit Is Problematic

'Covenant-light' Loans Reduce Fund Control Over Borrowers
Funds Increase Liquidity by Borrowing Against Loan Assets
Lack of Regulatory Oversight on Fund Leverage is the Core Issue

Warnings about private credit are emerging, particularly in the United States. The private credit market is estimated to be worth around $1.7 trillion (approximately 2,490 trillion won). As recent defaults have increased, concerns are growing that a crisis similar to the 2008 global financial meltdown, triggered by subprime mortgages, could be repeated.

What makes private credit problematic? In short, the relaxation of loan terms means that lenders (mainly private equity funds) cannot control risks early on. They also use loan assets as collateral to secure additional liquidity, but regulators have no oversight over these activities. The fundamental issue is that, like subprime mortgages, private credit operates outside the boundaries of regulatory supervision.

The Spread of Cov-lite (Covenant-light) Loans

Major private equity fund managers are increasingly competing to win deals, which is leading to ever-looser loan agreements. These relaxed loans are called "cov-lite" (covenant-light) loans. In the past, such loans typically appeared in the broadly syndicated loan (BSL) market during periods of large leveraged buyouts (LBOs), but now they are rapidly spreading in the private credit market as well.

Large private equity firms such as Ares, KKR, Blackstone, and Apollo are accepting similarly loose terms as in the public markets, focusing on speed and scale. As a result, the line between public and private markets is blurring, and both are experiencing "liquidity-driven credit expansion" in much the same way.

For borrowing companies, cov-lite loans are convenient. They are less likely to violate financial covenants, and fund managers intervene less frequently. The problem with cov-lite loans is that lenders cannot control risks early on. If a company's performance deteriorates, warning signs appear late, and by the time they are detected, fund managers have little time to respond.

This means that risks that should have been managed at the company level are transferred to the fund level. Funds end up covering liquidity shortages or refinancing on behalf of companies, and fund managers themselves increase borrowing. In other words, a "multi-layered leverage" structure emerges, where corporate debt is transferred onto the funds' balance sheets.

The Problem of Multi-layered Leverage in Private Equity Funds

The key instrument fueling the spread of hidden leverage and invisible risks is the NAV loan (Net Asset Value loan), where funds borrow money using the net asset value of their investment portfolios as collateral. Fund managers use their loan assets as collateral to borrow more from banks and institutional investors, which is then used for new investments or to repay existing loans. On the surface, this appears to be a way to secure liquidity, but in reality, the fund is assuming the debt of the portfolio companies. If a company faces a crisis, risks are transmitted in a chain from "company → fund → lender group."

The problem is that most of this fund-level borrowing is not disclosed. As a result, regulators cannot accurately assess the leverage of each fund, and outsiders have no way of knowing how much risk is accumulating. This is why global credit rating agencies refer to it as "hidden (back) leverage."

Lee Youngjoo, an analyst at Hana Securities, stated, "The current growth of private credit and the spread of cov-lite loans signal not just an expansion of alternative finance, but a structural shift in which credit is rapidly increasing outside regulatory oversight." He added, "The boundaries between public and private markets are blurring, and no segment-large or small-can be considered a 'safe zone' in terms of risk." He continued, "In the short term, growth may continue thanks to liquidity and momentum, but once invisible risks reach a certain level, credit sentiment could tighten rapidly. Ultimately, credit sentiment and liquidity flows will hinge on the extent of exposure to this hidden leverage."

In the end, the problem with private credit is not simply the relaxation of loan terms. The real issue is that corporate risks are being quietly transferred to funds, and fund risks are being passed on to the broader market. While the surface appears calm, the tectonic plates of credit are subtly shifting beneath.

This content was produced with the assistance of AI translation services.