At the Future of Finance conference last month in New York City, an annual summit meeting of leading finance industry executives sponsored by “Fortune” magazine, Joshua Easterly, co-CIO of the global investment firm Sixth Street, recalled the moment in 2009 when he saw the future of finance.

“I was inside a business that ultimately survived in Goldman Sachs,” he said, referring to the company’s fallout after the global financial crisis in 2009. Easterly was running a team at Goldman Sachs that specialized in public and private market transactions in distressed debt, and his boss posed a question.

“He asked me, ‘Do you think the Fed is going to want Goldman in your business?’” Easterly recalled. “This was in 2009, and I thought. ‘I need to find another job.’”

Easterly started Sixth Street, a private credit firm he co-founded with other Goldman Sachs veterans that went on to lend the money to fund companies like Airbnb, Spotify, and the San Antonio Spurs, among other investments.

Since then, many other finance execs have also defected to the world of private credit, which involves non-bank institutions, like hedge funds, providing loans directly to companies. It’s a booming segment; analysts are predicting that the private credit market could grow to between $15 to $25 trillion in the next decade. Pretty big, considering that all publicly traded stocks in the U.S. are currently worth about $51 trillion.

“This was the intended consequence, not the unintended consequence, of the regulation that came out of the global financial crisis,” Easterly said of the boom. Policymakers wanted to diffuse risk away from the Federal Disposit Insurance Corporation (FDIC), he explained, and reducing credit would have only crushed the economy. “So the private credit industry grew.”

Today, private credit has emerged as the dominant force in contemporary finance, offering an alternative to traditional bank lending. Chris Lamoureux, a professor of finance at the University of Arizona with nearly 40 years of experience in the field, notes that private credit fills crucial gaps left by traditional banks, especially for more risky borrowers.

“They’re not going to banks; they’re going to the financial sector writ large, like hedge funds and other types of investors,” he said. “Those investors are finding attractive yield spreads on borrowing from sub-investment grade companies.”

“Private credit is basically just kind of a replacement for a traditional bank lending package,” explained Ryan Shumway, a Tucson-born financial whiz who graduated from the University of Arizona’s finance school and worked directly in private credit for over a year before taking a job as an investment banking associate for Jefferies Financial Group on Wall Street.

The appeal of private credit lies in its flexibility and fewer regulatory constraints compared to traditional banking, Shumway said. “Private lenders aren’t regulated in the way that banks are, so they’re willing and able to provide capital at lower rates or higher leverage levels,” he continued. This flexibility allows for higher leverage levels and lower borrowing costs, making private credit an attractive option for borrowers.

“They can also be a little bit more flexible with the terms of the loans,” he added. “So they don’t have to be as stringent as a bank.”

Mark Papoccia, chief member experience officer at Vantage West, Tucson’s largest credit union, admits that the boom in private credit has had an impact on traditional financial institutions.

“Financial institutions have undoubtedly faced increased competition for deals,” he said. “We’ve lost several high-profile opportunities as private equity firms can offer more favorable terms and, in some cases, fund quicker. Additionally, some financial institutions have tightened their credit appetite, leading businesses seeking growth capital or undergoing significant transitions to prefer private equity investment over traditional bank loans. Private equity firms are typically willing to take on more risk since they benefit from the upside of their investment and are less regulated.”

Papoccia says much of the growth in the private credit sector occurred following 2020.

“A significant amount of unused capital accumulated during the COVID-19 pandemic is now being deployed, leading to a surge in private equity activity,” he said. “Additionally, historically low borrowing rates have made financing large acquisitions more attractive, further fueling the boom. Another major driver is the increased focus on sectors that demonstrated resilience and growth potential during the pandemic, such as healthcare and technology. In addition, sustainable and Environmental, Social and Governance (ESG) investing continues to surge.”

However, the rapid growth of private credit is not without risks. Lamoureux warns that the sector’s ability to circumvent traditional regulatory safeguards can lead to financial instability. He says that many past financial crises have been exacerbated by new financial institutions bypassing established regulations.

“There’s less regulatory oversight, there’s less constraints and less costs, in a sense, of such institutions doing business,” he said. “This is, of course, how a lot of problems start, right? It’s how many of our problems, in both the savings and loans crisis and then the global financial crisis, started. When we see new institutions arising either as a result of changing regulations or changing technology coming about and circumventing the regulations that are in place on the banking system, trouble often follows.”

Lamoureux has a sense of déjà vu watching the gold rush to private credit.

“It’s always been interesting to me that the global financial crisis really had very little to do with the banks in 2007, 2008,” he said. “The traditional banks were largely unaffected. Now, of course, part of that is thanks to the Fed and the Treasury stepping in. But the problems were in the so-called shadow banks and in wholesale finance. And again, that was a situation that arose as a way to circumvent the costs that regulators impose on the institutions that they regulate. 

“One of the consequences of the global financial crisis in light of all this, of course, was that there is heightened regulation and oversight on hedge funds. So we’re not completely in the Wild West as it might have been pre-2007. But there are certainly less regulations and restrictions on their activities than there are on banks.”

Shumway acknowledges these risks but points out that failures in private credit would primarily impact direct lending companies and their investors, rather than the broader financial system. “If a bunch of loans go bad, the only people that would be affected are those direct lending companies and their investors,” he explained, suggesting that the risk is somewhat contained.

Additionally, the economic impact of private credit extends beyond traditional sectors, reaching into infrastructure, energy and other areas requiring significant capital. 

“You’re financing the real economy — you’re not waiting for M&A (mergers and acquisitions) transactions to happen,” said Michael Zawadzki, Blackstone Credit and Insurance’s global chief investment officer in a recent interview with Bloomberg Television. “You’re financing consumers, you’re financing data centers, you’re financing energy transition. Huge growth capital expenditures, that’s what’s really driving the growth.”

In the current high-interest-rate environment, with borrowing costs elevated, there is reduced lending activity, yet the influx of capital into private credit funds continues.

“With cost of borrowing so high, there’s just less activity happening,” Shumway said. “But there’s still the growth of capital flowing into these private lenders.” This creates a dynamic where lenders and borrowers must navigate competing interests, balancing the need for capital with borrowing costs.

“On one hand, there are borrowers that are finding themselves in a tough spot because they need to get this money and it’s very expensive. And then there are the lenders that have so much capital but they can’t deploy it at a super-low interest rate, because they need to be above the Fed rates and make money for their investors. So it’s kind of these competing interests that will be driving this dynamic between the lenders and the borrowers in the market for the next five or 10 years.”

Papoccia put a local perspective on these trends, observing that while some large financial institutions are loosening their lending standards, others have tightened their credit appetites, driving businesses towards private equity. 

“As many large financial institutions become more comfortable with their commercial real estate portfolios, we’ve observed some financial institutions loosening their lending standards in response,” he said. “At Vantage West, while we have maintained our credit appetite, we have had to sharpen our pencils to win deals.”