Challenges for private credit funds in a volatile market: opacity, illiquidity and litigation risks

The private credit market has grown exponentially over the past decade. The latest estimate from the Alternative Credit Council is that it is a $3 trillion industry, the majority of which is based in the US but increasingly in Europe and Asia. Throughout last year, concerns about potential systemic risks posed by the industry drew significant media attention. 

Policymakers, regulators and industry analysts highlighted how various challenges could exacerbate vulnerabilities in the private credit market during periods of global volatility. The US Federal Reserve highlighted the challenges posed by the opaque and lightly regulated nature of private credit, warning of potential liquidity mismatches and overleveraged portfolios during economic downturns. The Bank of England followed suit, underlining the increasing reliance of private credit funds on bank financing, raising questions about spillover risks in times of market turbulence.

Industry experts have voiced concern over the flood of money into assets such as securitised products and private debts,[1] with some even drawing parallels between private credit’s rapid growth and the subprime mortgage crisis which contributed to the 2008 financial crisis.[2]  Further, a recent decision in National Association of Private Fund Managers v. SEC, No. 23-60471 (5th Cir. 2024), overturning a rule requiring oversight by the US Securities and Exchange Commission (SEC) in certain cases, highlights a potential gap in market governance. While such systemic risks have, rightly, commanded media attention, this piece focuses on a less-explored but important dimension: litigation risks. Given the opacity of private credit funds and their illiquid characteristics (in their investor base and their assets), coupled with growing complexity and the interconnectedness of private credit with broader financial markets, disputes are likely to proliferate.

Challenges for private credit funds

Facilitating lending outside traditional bank channels, private credit funds have become a vital funding source for a wide array of sectors, even including farming, car finance and housing.  Most of the activity is in direct corporate lending but there is increased activity in asset-backed, real estate and infrastructure debt.  Those involved include direct players, such as private credit funds, and indirect participants, like pension funds, insurance companies and banks, which either invest in or lend to these funds.

The combination of these credit funds’ lending practices being private (and therefore not public or transparent), the growing prevalence of payment-in-kind (PIK) arrangements, their illiquid characteristics, and challenges in valuation and mark-to-market accounting underscores the vulnerabilities in the private credit market.  Adding to the complexity, private credit instruments are increasingly packaged into securitised products and traded in (as yet fledgling but developing) secondary markets, amplifying their reach – and their vulnerability – particularly in turbulent markets.

Lack of transparency

Unlike public markets, where detailed information about issuers and terms is readily available, the private credit market operates in near opacity.[3] There is little to no public information about who the borrowers are, the terms of the loans, whether amendments or extensions have been made, or even the overall health of individual loans.  This lack of visibility not only hampers the ability of investors to assess risk but also complicates regulatory oversight.

Recent efforts to enhance transparency have faced significant setbacks. For instance, the SEC proposed rules to increase disclosure requirements in the private credit space.  However, these efforts were thwarted when, last year, the Fifth US Circuit Court of Appeals overturned the SEC's proposed rules, citing overreach.  This legal challenge highlights the tension between the growing demand for regulatory oversight and the industry's preference for maintaining its opaque structure.

Valuation and marking

The lack of transparency extends to the price of the loans themselves, creating a risk of inconsistent or overly optimistic valuations.

Private credit funds typically charge management fees based on the net asset value (NAV).  As a result, fund managers may be tempted to maintain or inflate NAV figures, even when underlying loans may be deteriorating.  Divergent valuation methods can exacerbate these issues.  For example, last year, lenders valued the same (eventually defaulted) loans to technology company Pluralsight drastically differently, with one lender marking the debt down to 83 cents on the US dollar and the other valuing the loan as high as 97 cents on the dollar.

It is uncontroversial to state that adequate management of bad loans involves creditors identifying such loans at an early stage and writing down the value of them equal to the expected credit losses.  When funds fail to adjust marks to reflect early warning signs, the true risk profile of the loans may remain hidden until it is too late.  Setting aside that investors may not learn about issues until defaults occur, inadequate marking may leave little opportunity for corrective action.  Defaulted loans in private credit (which are anywhere between 2% and 5%), as with any loan, are more difficult to recover than loans which may be in trouble, but which have not yet reached the default stage.  While there may be some credit losses, early recognition of trouble can significantly improve recovery outcomes. However, the opaque nature of the market may delay this process.

Compounding these issues is the lack of a robust secondary market for private credit.  If a fund must sell troubled loans, it will often do so at steep discounts to NAV, eroding investor returns.  For locked-in investors, this timing issue may seem less relevant since their ability to withdraw funds is already restricted.  However, the broader implications of late recognition of risk (such as delayed strategic adjustments or the inability to shore up liquidity) can have cascading effects on the portfolio's overall performance.

Payments-in-kind

In a high interest rate environment, PIK arrangements have become more prevalent in private credit markets as borrowers and lenders seek flexibility amid rising costs.  PIK arrangements allow borrowers to defer interest payments by adding the owed amount to the loan balance or offering equity instead of paying in cash.  This provides liquidity relief for companies facing tighter cash flows, enabling them to conserve capital for operations or growth.  For lenders, PIK arrangements offer the potential for higher returns as they typically come with increased interest rates to compensate for the added risk.

However, this structure introduces significant risks to the private credit market.  By deferring payments (and imposing higher interest rates), PIK arrangements increase a borrower’s debt burden over time, increasing the risk of default, particularly for companies already struggling with solvency.  While most funds will restrict redemptions so that liquidity concerns are less immediate on a day-to-day basis, the overall health of the portfolio and the returns to investors can still be impacted.

Illiquidity

Most investors in private credit funds are, like their private equity counterparts, locked in for a specified period.[4] They are also generally invested in private loans for which, as explained previously, there are only fledgling secondary markets.  As stated above, the funds will tend not to have to deal with liquidity mismatches between their lending and redemption to investors.  Some players, however, will allow for redemptions and we know from the global financial crisis in 2008 that, in volatile markets, investors are more likely to seek to redeem their investments, leading to liquidity mismatches and other issues.  In some cases, funds may completely collapse, which is what happened more recently, for example, to the Woodford Equity Income Fund which became increasingly concentrated in illiquid and high-risk assets, such as unlisted and small-cap stocks.  When performance began to lag, nervous investors started pulling their money.  This exposed the fund's structural vulnerability, as the illiquid assets could not be sold quickly to meet redemptions without significant losses. In 2019, the fund was eventually wound up, with investors incurring heavy losses.

Litigation risks

When funds face liquidity challenges or fail to meet investor expectations, legal claims often follow.  So, with high interest rates, illiquid characteristics and PIK arrangements, the private credit sector may well see increased disputes looking forward. 

Investors have limited visibility of key aspects of their investments, such as loan terms (and amendments) and borrower health, leaving them reliant on fund managers’ disclosures.  When issues such as inconsistent valuations or undisclosed risks emerge, litigation becomes a tool for recourse.  For instance, management fees linked to inflated NAVs or failures to adjust valuations to reflect financial trouble, can trigger claims of mismanagement or breaches of duty.  Poor, biased or misleading valuations (or inadequate monitoring systems) may also give rise to negligence claims.  Even if investors are locked into illiquid positions and unable to withdraw their money, they may argue that these deficiencies prevented critical mitigation steps, such as restructuring loans, selling troubled assets, or auditors identifying risks in time.

PIK arrangements present additional challenges, as they defer interest payments but increase long-term repayment obligations.  These arrangements can create liquidity pressures for funds and amplify risks at the end of a fund’s lifecycle, potentially leading to disputes with investors if defaults occur or returns are diminished.

Types of claim

Investors may pursue claims based on contractual breaches (e.g. breach of mandate), misrepresentation or, in some cases, statutory violations.  Contractual claims will focus on clauses related to valuation methods or disclosure obligations, while tortious claims may allege the misrepresentation of risk or breaches of duties of care.

The success of these claims often hinges on proving harm which can be complicated in illiquid markets.  With investors locked into their positions, timing plays a less significant role, shifting the focus to whether fund managers misrepresented risks, breached contractual obligations or were negligent – and such claims will need to rely on hypothetical counterfactuals. Additionally, third-party valuation agents, auditors, borrowers and even institutional investors may face legal exposure for their roles in the ecosystem.

Fund managers

Managers involved in private credit investments could perhaps face greater risks of liability compared to those managing traditional equity or bond investments.  Traditional asset managers hold shares and bonds without influencing company decisions and any claim in negligence, for example, would be difficult to prove absent exceptional circumstances (including scandals alleging fraud, such as in the case against Arch Financial Products LLP in SPL Private Finance (PF1) IC Ltd & Ors v Arch Financial Products LLP & Ors [2014] EWHC 4268 (Comm)).  Private equity managers tend to be more concerned with their liability for acts of portfolio companies and their exposure as directors of those companies than for any liability attaching to original investment phases (fund raising and investing).  That is in part because it is likely to be difficult for a court to decide that it knows better than equity investors and managers which companies to invest in.

However, the situation is likely to be a little different when it comes to lending decisions.  Lending decisions can be scrutinised more readily, compared against what other (reasonable) market participants might have done, with a more readily accessible set of standards of practice and policies against which to judge. A court might be more ready to characterise a lending decision as botched from the start than an equity investment. Further, decisions around continuing to finance failing borrowers, delaying restructurings or mishandling the enforcement of security can all lead to accusations of negligence. Poorly structured loan agreements, inadequate collateral and weak monitoring systems can compound these risks, as they expose investors to greater losses and hinder recovery efforts. It therefore seems possible that private credit fund managers could face higher risks of scrutiny and liability for their investment decisions than their private equity counterparts.

Fund managers are commonly indemnified by the fund to protect them from liabilities incurred in the course of their duties, provided they have acted in good faith, generally excluding gross negligence and fraud.  However, a private credit fund (like a private equity fund) will wish to invest as much of the funds raised as possible throughout the fund's life. This evidently reduces the amount of capital retained within the fund and, therefore, could reduce the amount available for indemnification, depending on whether insurance has been obtained and whether reserves or other relevant arrangements have been put in place.[5]

Fund administrators

Fund administrators are generally responsible for NAV calculations, processing redemptions and managing investor communications.  Errors in these areas can lead to legal claims.  For instance, mispricing a portfolio heavy with PIK arrangements could artificially inflate NAV, misleading investors about the fund’s true value.  Similarly, delays in processing redemptions or inaccuracies in investor reporting could expose administrators to accusations of professional negligence.

Auditors and actuaries

Auditors (and potentially actuaries) play a crucial role in ensuring the accuracy of financial statements and NAV calculations.  However, when funds collapse, their role often comes under scrutiny.

In the Woodford collapse, for example, auditors were criticised for failing to identify and flag liquidity risks, though no direct claims were made against them.  In private credit markets, where valuation challenges may be even more pronounced, auditors face increased exposure.  For example, PIK arrangements complicate revenue recognition and a fund’s over-reliance on deferred payments could mask underlying financial instability.

Comment

The private credit market’s rapid growth and structural intricacies make it a double-edged sword: offering lucrative opportunities but also exposing investors to market shocks.  At the end of the day, the private credit product is mainly made up of loans, although many players are branching out. While the majority of debt finance transactions may run smoothly, it remains the case that loans have been defaulted on since time immemorial and litigation has most often followed.  As the private credit market continues to grow, we should expect an expansion in defaults and it may be that the litigation risk profile, in particular that of fund managers, is increased in this investment category when compared with others.

Footnotes

[1] FT article dated 16 October 2023, JC Flowers warns of systemic risk as insurers binge on private credit investments: https://www.ft.com/content/e63357a9-d0fd-4747-8901-d640092b5658?segmentId=2c1df321-36a4-1206-2c08-112c059dd69d.
[2] Wall Street Journal article dated 13 November 2024, Private-Credit Boom Has Echoes of Subprime, Warns Senior Central Banker: https://www.wsj.com/livecoverage/cpi-report-today-inflation-dow-sp500-nasdaq-live-11-13-2024/card/private-credit-boom-has-echoes-of-subprime-warns-senior-central-banker-glGnbSH73p8mYbEHOrfS.
[3] Save for Business Development Corporations in the US, who are required to make public filings.
[4] Private credit funds are either open or closed-ended (or hybrid), although usually they are closed-ended, offering investors access to high-return, illiquid investments.  There are hybrid funds, for example so-called “interval funds”, which are closed-ended with no secondary market but allowing for limited redemptions in the form of regular repurchase periods.
[5] To mitigate this risk, private credit fund documents sometimes include provisions for maintaining reserves to cover potential liabilities or delaying distributions until potential claims are resolved, or clawback provisions that allow the fund to recover previously distributed amounts from investors if needed.  Additionally, fund managers may purchase liability insurance, such as directors and officers (D&O) insurance, to provide further protection.