Why Private Credit Concerns May Be Overblown

Private credit has exploded over the last two decades and now measures nearly a $2 trillion asset class by some estimates. Regulators worry that these 'shadow lenders' could trigger the next financial crisis. The recent collapse of automotive supplier First Brands has amplified concerns that non-bank lenders could trigger systemic defaults.

But according to David Robinson, the James and Gail Vander Weide Professor of Finance at Duke University’s Fuqua School of Business,  concerns about private credit “might be overblown,” as they are based on the misconception that these players are simply lenders willing to take risks banks will not. 

“Private credit companies don’t just lend money to un-bankable firms,” Robinson said. “That's a major gap in our understanding of how private credit works.” 

In their new paper, “Why is Private Lending So Popular,” Robinson and his Fuqua colleague Melanie Wallskog studied Business Development Companies (BDCs)— a major part of the private credit landscape—and found that BDCs invest in ways that banks cannot. Instead of just making loans, they hold a complex array of securities that constitute both debt and equity—more akin to what private equity companies do.

Their paper also found that retail investors are fueling the private credit surge—rather than institutional investors like insurance companies, pension funds, and endowments. This shift, the authors argue, is transferring risk from the banking system to individual portfolios, now exposed to a higher-yield-higher risk class of assets.

The rise of private credit

Conventional wisdom assumes private lenders are merely filling a gap left by traditional banks, which scaled back lending after the 2008 financial crisis. Robinson thinks this is not the whole story.

“Most people have understood the rise of private credit through the retreat of banks from lending to small and medium sized businesses, but I think it is better to see private credit as part of the explosive growth in private equity over the last twenty years,” he said.

Private lenders don’t just write loans, he explained. They invest through customized combinations of loans, preferred stock, and warrants, offering small firms capital structures that look more like growth equity or traditional private equity than bank financing.

For example, a growing tech company that can't qualify for a bank loan might turn to a BDC, which might instead provide both $5 million in debt with interest allowed to accrue unpaid, as well as a 2% equity stake—betting on the company's upside while earning interest.

BDCs act like private equity, not banks

Created by Congress in 1980 to support small business growth, BDCs have become a key part of the private lending market.

The researchers analyzed the filings of 53 publicly traded BDCs—representing about one-third of all BDC capital—to understand how these firms invest. They found that between 2001 to 2023 roughly half of all BDC investments differed from bank-like lending in that they combined debt with equity stakes or deferred interest. Some loans, for example, allow interest to accrue rather than being paid immediately, a feature known as paid-in-kind (PIK) interest, which increases the eventual payout but helps cash-strapped companies survive.

“BDCs operate in a much broader security space than banks,” Robinson noted. “They can take upside risk through equity, defer cash payments through preferred stock, and charge higher fees because they fund companies that traditional banks might avoid.”

BDCs’ rewards and risks

The researchers found that loans involving complex security packages—like those that include equity or PIK interest—command higher interest rates, sometimes 1.2 and 1.8 percentage points higher than standard loans. These higher spreads compensate for greater risk but also allow BDCs to share in the upside when portfolio companies succeed.

At the same time, the hybrid character of BDCs’ investments also changes who holds the risk. As banks face tighter regulations, BDCs have attracted a different kind of investor: individuals. Institutional ownership of BDCs has fallen from about 40% before the financial crisis to around 25% today, even as bank and private equity stocks remain largely institutionally held.

“The typical BDC shareholder isn’t a pension fund or sovereign wealth fund—it’s a retail investor,” Robinson said. “That shifts where the financial exposure resides.”

What it means for regulators

Private credit’s boom raised alarms among regulators worried about “shadow banking”—the idea that non-bank lenders could amplify systemic risk.

In addition, policymakers and commentators are concerned because many private credit organizations rely on borrowing from banks, explained Robinson. “They worry that they borrow from banks and then recycle those loans—with a markup—to firms that banks might judge too risky.”

But as this research suggests, because BDCs now hold both debt and equity in the same company, they may be better equipped to renegotiate in times of distress.

“They're transforming bank capital into a new security that wouldn’t have any ripple effect back into the banking system. Also, these organizations are typically much better capitalized than banks. They have much larger equity cushions than a bank has.”

A shift of risk to households?

After the financial crisis, ownership of these non-bank lenders significantly changed, with institutional investors like pension funds reducing their BDC holdings from 40% to 25% and retail investors—drawn by higher yields—replacing them. 

This shift away from institutional investors and from banks transfers risk from the banking system to individual portfolios, Robinson argues.

For policymakers, the researchers noted that the hybrid nature of BDCs and the expansion of their ownership base suggest, first, that applying bank-style rules to BDCs could misfire. And second, that any regulatory concern should be better framed in terms of “consumer financial protection,” rather than systemic risk to the banking system.

“The question is ‘who's holding the equity?’” Robinson said. “Because if there is a default, it’s the equity holders who will be holding the bag.

“If we’re worried about instability, we have to recognize that private credit’s risks are increasingly sitting on household balance sheets, not on those of banks.”