To date, private credit has largely avoided the regulatory and reporting requirements traditional banks are beholden to. Some industry observers, including the Bank of England, say this lack of transparency heightens the risk of a systemic event by limiting regulators’ ability to understand and monitor links between private credit and other parts of the financial system.

The U.S. Financial Stability Oversight Council echoed these fears in its 2023 Annual Report, writing that “An unexpected rate of default [by private-credit borrowers] may have a cascading effect across broader financial markets.”

However, Zach Lewy, CEO, CIO, and Fund Principal at Arrow Global, told Transacted that these fears are overblown: a bad apple in the private credit market does not have the power to infect the barrel.

“I’m not convinced there’s a systemic risk,” Lewy said. “There’s so much capital in private credit and these non-banks, but are they run in such a fashion that there are black holes that cascade back into state guarantees and cause huge losses for taxpayers? I don’t see that.”

“Will you have an occasional bad company that blows up? Yes. Will that cause losses to the banking system? Yes. But, if you follow the history of the banking industry, that happens, but it’s not a systemic risk,” he said.

Lewy, who founded the Manchester, England-based firm in 2005, explained further:

“If you look at the limits on private credit — you have to go get the money from somewhere, usually insurance companies or pension funds, and you’re so limited based on how many there are, building up something that would amount to a systemic banking bubble that can cascade into a 2008-type thing I think is really unlikely.”

As for whether private credit is a temporary fad, Lewy classed market participants into two buckets: “residents,” or firms in it for the long haul, and “tourists,” those likely to flee when conditions change.

“That’s the case across the board, whether it’s venture debt, whether it’s private credit, you’ll have some residents which are businesses that exist to fund that space,” Lewy said. “Then you’ll have what I describe as ‘tourists,’ people that are multi-strat, have flexible mandates, which, if I was typecasting, I’d say are hedge funds but could also be investment banks. They have flexible mandates, so they live by the sword and die by the sword. Those with flexible mandates get involved in certain asset classes when they are interesting but also get out of it when they aren’t so interesting.”

For his own firm, Lewy sees some level of benefit from a ‘tourist’ market exit.

“When they leave, the pricing goes up, and the attractiveness goes up, but it really doesn’t affect the residents very directly. The residents keep their heads down and do what they do, but the weight of money coming from the tourists with multi-strat mandates can affect the overall liquidity environment of a given strategy. That is happening right now in every asset class.”

Lewy added that private credit has gained popularity because, in the short term, with the interest rates remaining high, the return on credit is higher and the return on equity is lower which has caused a “rebalancing shift in portfolios.”

For the long term, private credit is still a work in progress, he said.

“It’s a secular trend and a work in progress in terms of implementation. Everything from bridge lending to construction lending to agricultural and small business lending, specialty mortgages, backing private equity acquisition — 50 years ago that all would be done by banks. Private debt steps in where you need a real business partner with a operational commercial skill set.”

Going forward, Lewy said he envisions banks and private credit working together as they do in Northern Europe.

“Banks find a way to let private credit do the last mile of lending and then they can be the wholesale finance source to facilitate everyone being efficient.”