September 20, 2023 - On September 14, the Board of the International Organization of Securities Commissions (IOSCO), which includes the SEC, published two reports. First, a thematic analysis of “Emerging Risks in Private Finance,” which comes in light of the rapid growth of the private credit and private equity asset classes globally since the Global Financial Crisis. The second is a consultation report on “Leveraged Loans and CLOs – Good Practices for Consideration.” Today, we analyze the Private Finance report, which seeks to identify the threats that private markets pose to investors, the financial system and IOSCO objectives. Later this week, we will review the Leveraged Loans and CLOs consultation.
As IOSCO’s Private Finance analysis is final, there is no opportunity for the public to provide comments. However, given our initial reaction that the report’s claims are not well-founded, we believe the report provides impetus to dispel misinformation on private credit, as it pertains to the interests of our members that are active in the space.
In the report, IOSCO focuses on four risk areas in private finance: opacity, leverage, market integrity and risk transmission to public markets. IOSCO notes that these risks are offset by lower volatility and compliance costs than in the public markets.
Among the vulnerabilities it highlights, IOSCO points to valuations, arguing that they can be stale – evidenced by a two- or three-quarter lag in prices in public and private markets – and subjective, potentially leading to overvaluation and inaccurate portfolio weightings for investors. The report calls out several conflicts of interest stemming from the opaque nature of the private markets, including excessive risk-taking by fund managers to meet carried interest targets, preferential treatment, and financial sponsors holding both debt and equity in portfolio companies.
IOSCO suggests that private credit funds may finance portfolio companies that take on levels of leverage that exceed the risk appetite of banks. It argues that this additional debt, alongside leverage incurred at the fund level, could have a cumulative negative impact on the financial system.
With respect to market integrity, the report spends time on the hazards of asymmetric information in private markets that can add to the liquidity constraints imposed by closed-end funds. IOSCO asserts that uneven information flow at the portfolio company and fund level can pressure prices of secondary market transactions and will disadvantage the retail investors that fund managers tap to support growth of the private markets. Retail could become a critical segment of the investor base as limited partners rebalance their portfolios more frequently (e.g., to address denominator effects, new investment policies, or to meet liabilities). The increase in rebalancing activity may reduce institutional demand for private assets.
The report also flags the interconnectedness of the public and private markets, and the risk of potential spillover when either of them encounters stress. IOSCO offers examples including defaults at the portfolio company level in a private credit fund that cause the fund to default on its own debt, forcing fire sales that result in losses to investors and, in turn, forcing investors to sell other assets to meet redemptions.
We will continue to analyze the release as we set out to address IOSCO’s misconceptions of private credit.