Minnesota and other pension funds invest in private credit. What are the high risk, high reward loans?

When the economy is good, predictions for the next downturn abound: when it will start, what will cause it and who stands to lose.

This time around, Wall Street-watchers are warning about private credit, a high-risk, high-reward debt market that shuttles billions of dollars beyond the constraints of traditional banking.

Defaults on these risky loans could send the U.S. economy into freefall, critics say, similar to how the subprime mortgage crisis spurred the Great Recession in 2008.

“I see this as a degree of risk comparable to the global financial crisis,” said Rod Dubitsky, an independent financial analyst who previously worked on Wall Street.

While traditional lending relies on underwriting from banks — which the federal government regulates — private credit brings more risk. It is a direct transaction between lenders and borrowers. Private businesses might turn to private credit when they can’t find financing elsewhere, so they are willing to pay high interest rates in exchange for fast cash.

The lenders — usually private credit funds or business development companies (BDCs) such as Apollo Global Management, Blue Owl Capital and KKR & Co. — raise money from investors, including pension funds, endowments and insurance companies that can afford to make a risky bet in hopes of a big return.

The Minnesota State Board of Investment — responsible for the investments of three pension funds covering about 800,000 retirees, survivors and current employees — has invested in private credit for decades “and has experienced a full range of credit and economic cycles,” said Executive Director Jill Schurtz in an email.

Investors have flocked to private credit in recent years, flooding the market with cash. According to a January report from Moody’s, the private credit market is closing in on $2 trillion in assets under management and could approach $4 trillion by 2030.

But beneath the bullish exterior, weak spots are beginning to appear.

Blue Owl has been at the forefront of the private credit boom and last year financed a headline-making $30 billion deal with Meta to build a Louisiana data center. In August, the Trump administration opened the door to including alternative assets in 401(k)s. Blue Owl in July had announced a partnership with retirement plan provider Voya Financial.

But Feb. 18, Blue Owl said it will limit withdrawals from its retail debt fund — aimed at individual, nonprofessional investors the private credit market is increasingly trying to attract. The move tanked shares in Blue Owl and its competitors and prompted fresh warnings of an impending downturn.

This was on top of a pair of auto industry bankruptcies last fall that raised alarms about the risks of private lending. And in January, BlackRock, the world’s largest asset manager, had disclosed a 19% drop in value of a BDC it manages, rattling investors.

Like private equity, real estate and cryptocurrency, private credit is usually considered too risky for typical investors. At Ameriprise, Saglimbene said, private credit investments are “very limited” and only available to clients after extensive due diligence.

“There’s a real opaqueness to this that there isn’t in a lot of other vehicles,” said John Canavan, lead analyst at Oxford Economics. Unlike a more traditional corporate or treasury bond, for example, private debt doesn’t trade on the open market, making it illiquid and obscuring its value.

But BlackRock and other firms in the private credit arena are jockeying for access to the everyday investor, and some have already succeeded.

As private credit continues to grow, so does the risk.

In early 2024, a Federal Reserve paper warned the amount of money flowing to private credit could prompt fund managers to pursue riskier deals. Already, the authors wrote, “it is likely that a significant share of borrowers would not be able to obtain adequate financing in the absence of private credit.”

A few months earlier, JPMorgan Chase CEO Jamie Dimon, a vocal private credit skeptic, told a U.S. Senate committee as “lending activity moves away from regulated markets, the likelihood increases that risks go unseen.”

“These are not threats,” he said. “These are economic facts.”

Still, JPMorgan Chase last year announced it would allocate $50 billion to private credit. The idea, the Wall Street Journal reported, is to position the bank to profit in the event of a collapse.

It’s not clear when, or if, the bottom will give. For now, Canavan said, the private credit market is likely to keep plowing ahead, despite the warning signs.