The concept of private debt, also referred to as private credit, has gained significant attention, though many remain unfamiliar with its workings. This financial mechanism has arisen as a response to the shifting landscape of corporate financing, especially following the 2007-2009 financial crisis.
Private debt financing is provided by specialized funds that operate similarly to banks. However, unlike traditional banks, these funds do not use deposits from individuals or companies but rely on long-term capital entrusted by institutional investors.
Although private debt has existed in some capacity since the 19th century, its exponential growth has occurred primarily in the wake of the global financial crisis. The collapse of Lehman Brothers in 2008 highlighted the limitations of banks in managing liquidity and performing their traditional role in the capital flow cycle.
Banks, which rely on short-term deposits to fund long-term loans, face significant challenges during financial crises. While regulations and central bank oversight provide a stabilizing effect, they did not prevent the failures of Lehman Brothers or other banks.
Life insurance companies and pension funds, characterized by long-term liabilities, are now better suited for financing obligations. Their capital constitutes the backbone of the private debt market. However, these institutions often lack expertise in credit risk assessment, a field traditionally dominated by banks.
The emergence of private debt can be seen as the financial market’s response to this mismatch in liquidity. Funds in this sector are typically managed by former bankers using capital from life insurance companies and pension funds, thus combining long-term liabilities with credit expertise. The first private debt funds appeared in the United States, serving as alternative financing sources for corporate clients, particularly medium-sized firms with limited access to bond markets.
Exponential Growth
The growth of the private debt sector has been remarkable, correlating with decreasing interest from U.S. banks in long-term financing. Currently, it is estimated that 60-70% of financing for medium-sized companies in the United States comes from private debt funds, while banks provide the remaining 30-40%. In Western Europe, growth has been slower due to continued interest from European banks in financing medium-sized firms, yet private debt funds now account for 20-30% of this market.
In Central Europe, the development of the private debt market is progressing at a slower pace due to ongoing interest from banks in corporate financing. However, it is expected that the factors driving the rapid growth of private debt in the U.S. and Western Europe will eventually extend to this region. Until then, the private debt sector will complement rather than replace traditional banking.
Credit Risk Assessment
Assessing credit risk in banks is influenced by the Basel II agreement, which allows for significant reductions in regulatory capital based on internal rating models approved by banking supervisors. These models, applied to specific credit portfolios such as medium-sized firms, must guide all credit decisions within those portfolios.
Expert judgment in decision-making is severely limited. Based on past experiences, it is estimated that around 5-7% of negative credit decisions made by banks regarding medium-sized companies could potentially be regarded as acceptable risks if assessed through expert analysis, similar to practices before Basel II. Banks consider these losses a cost of maintaining attractive capital management efficiencies resulting from internal models. This segment represents an opportunity for firms like ACP Credit, which operates on an expert basis without the binding influence of rating models.
Seven-Year Term
Private debt typically functions through closed-end funds established for a specified duration—usually seven years—with the possibility of extension if the loans provided are not fully repaid by that time. This seven-year period can be divided into an investment phase followed by a repayment phase.
As the investment period concludes, efforts to raise another fund begin. Over the past four years, ACP Credit has fully invested the capital from its first fund—ACP Credit I—and has now launched ACP Credit II, which is expected to be more than twice the size of its predecessor.
In recent years, there has been a trend of “packaging” private debt into open-end funds, primarily to offer attractive investments to individual investors. However, this approach introduces significant liquidity risks. While investors in closed-end funds are (or should be) aware that their capital will be tied up for seven years, open-end fund investors rely on the ability to withdraw their investments during that period. If withdrawals exceed expectations, the fund could face liquidity issues similar to those experienced by illiquid banks—an irony, as private debt was designed to mitigate such risks.
Fortunately, most funds raised in Central Europe operate as closed-end funds, thereby minimizing liquidity loss risks. Both ACP Credit I and ACP Credit II are structured this way, with investments coming solely from institutional investors, including international and domestic financial institutions as well as family offices outside Poland.
Funds in this region differ from those in the United States and Western Europe in several respects. Smaller operational scales and significantly less competition allow Central European funds to extend loans selectively and under more conservative terms—utilizing lower financial leverage, stricter covenants, and better collateral. Moreover, U.S. private debt funds often exhibit high exposure to certain sectors; for example, their exposure to the IT sector is 25-30%, while in Western Europe, it is 10-15%. This high concentration could pose risks during economic downturns.
These differences are likely to diminish over time. As banks in this region begin to reduce financing and significant players from the U.S. and Western Europe enter the Central European market, competition will intensify, making selective investment more challenging for private debt funds. Until then, these funds will continue to be high-quality partners for regional medium-sized firms and attractive investment assets for institutional investors from both the region and beyond.
Mariusz Grendowicz is an economist and banker, a former executive of several Polish banks, and the founder and manager of the ACP-Credit debt fund.
