In 2025, the U.S. administration under President Trump is expected to implement deregulatory measures that may significantly impact the private credit sector.
The administration could reconsider existing financial regulations, potentially easing restrictions on private credit operations. The Managed Funds Association has advocated for a review of regulations that they consider detrimental to private funds, suggesting a shift towards a more lenient regulatory environment.
Moreover, maintaining or introducing tax policies that favor private investments could further stimulate growth in the private credit market. Pro-growth tax policies are likely to encourage increased capital allocation to private credit.
Deregulation is transforming private credit by expanding access, increasing liquidity options, and enabling new investment structures, such as ETFs and interval funds. While this growth benefits private credit firms, it also presents new risks related to liquidity, systemic stability, and protection for retail investors.
Expansion of Private Credit Access
Deregulation allows private credit markets to expand beyond traditional institutional investors, making these investments more accessible to retail investors and defined contribution (DC) plans, thereby broadening the investor base for private credit firms.
- Private ETFs: With regulatory relaxation, funds structured as interval or tender offer funds (semi-liquid private ETFs) can invest more in private credit, providing retail investors access to alternative investments.
- Private Marketplace Lending: Platforms can scale more effectively, as fewer regulatory constraints enable greater capital raising and participation from non-traditional investors.
- DC Plans (e.g., 401(k)s): Regulatory clarity, such as Department of Labor guidance on private credit investments in retirement plans, allows more plan sponsors to allocate towards private credit strategies.
Increased Liquidity in Private Credit
Deregulation has encouraged the creation of structures such as:
- Interval Funds: These funds provide periodic liquidity while allowing DC plans and retail investors to engage in private credit strategies.
- Private ETFs: Investment firms are exploring ways to package private credit into semi-liquid ETF structures, making these investments more accessible and tradable. With regulatory easing, we may witness an acceleration of these trends, leading to a decrease in the illiquidity premium in private credit markets.
Growth of Non-Bank Lending and Shadow Banking
Deregulation favors non-bank lenders, including private credit funds and private equity-backed lending platforms, over traditional banks, which continue to be subject to stricter capital and liquidity requirements. Some private credit firms have capitalized on these changes, expanding their direct lending operations to fill the gaps left by banks, particularly in the middle market and distressed credit sectors. The rise of private credit ETFs and marketplace lending facilitates capital flowing directly to borrowers, bypassing traditional banking intermediaries.
Risks and Structural Challenges of Private Credit ETFs
As private ETFs and private credit products gain popularity, they introduce structural vulnerabilities due to liquidity mismatches, valuation complexities, and regulatory gaps. Increased deregulation could magnify these risks.
Private ETFs aim to provide daily liquidity while investing in illiquid private assets such as private credit, real estate, or VC stakes. This approach presents significant liquidity risks, including:
- Forced Liquidation Risk: Illiquid assets take time to sell. If many investors redeem their shares at once, the fund may be compelled to sell assets at deep discounts, resulting in price distortions. Unlike publicly traded equities or bonds, private credit or private equity stakes may take months or longer to sell. For example, Blackstone’s BREIT had to limit redemptions in 2022 after facing a surge in outflows.
- NAV Discrepancy: Private ETFs often rely on model-based valuations (mark-to-model) rather than real market prices (mark-to-market). If redemption demands increase rapidly, NAVs may be mispriced, leading to unfair payouts and harming remaining investors.
- Discount or Premium Volatility: ETFs traded on an exchange can experience significant discounts to NAV if liquidity diminishes. This becomes especially concerning during economic downturns when investors may panic and rush to sell their private ETF shares. In a stressed market, private ETFs can collapse, potentially triggering systemic shocks, particularly in a deregulated environment.
If investors urgently seek to redeem their shares and the ETF lacks sufficient liquid assets, the consequences could be severe:
- The ETF might freeze withdrawals, trapping investors. While regulators may intervene, in a deregulated market, protective backstops could be weaker or nonexistent. The situation faced by Blackstone’s BREIT regarding redemption limits from 2022 to 2023 caused significant liquidity panic among investors.
- If private credit ETFs are forced to sell assets at fire-sale prices, valuations across private debt markets could plummet. This decline could negatively impact private equity-backed lending structures, creating spillover risks to broader financial markets.
- Some private ETFs employ leverage to enhance returns, which can amplify losses if asset values fall. A highly leveraged private credit ETF facing redemption requests could default on margin calls, triggering forced selling that disrupts the broader market. Ultimately, deregulation could lead to ETF bank runs, market panic, and severe liquidity shocks in private markets.
Private ETFs hold illiquid private assets but offer daily trading, which creates mismatches:
- Timing Mismatch**: Private credit loans often have multi-year maturities, while ETF shares trade daily. If there is a surge in outflows, the ETF may struggle to generate cash quickly enough to meet redemption requests.
- Valuation Lag: Since the values of private credit assets do not update daily, ETFs risk overpaying redeeming investors and underpricing shares for the remaining holders. For example, a private credit ETF might report an NAV of $100, but in reality, the assets could be worth only $85 in a stressed market.
- Weakness in Capital Buffer: Unlike banks, ETFs do not have capital reserve requirements, which means they lack a liquidity buffer to absorb financial shocks. In a deregulated market, private ETFs could be even more susceptible to liquidity issues. Thus, while ETFs promise daily liquidity on assets that do not trade daily, this arrangement can lead to fragility under stress.
Deregulation could weaken oversight on valuation rules, leading to potential conflicts of interest:
- Conflicts in NAV Calculation: Asset managers often set their own asset valuations using optimistic models to portray more stable returns. If regulations weaken, firms may inflate NAVs to attract investors, masking underlying risks. For instance, some private REITs and private credit funds employ smoothing techniques to minimize NAV volatility.
- Less Transparency in Model-Based Pricing: Private credit ETFs may utilize internal pricing models that allow them to overestimate the true market value of illiquid loans. In a deregulated environment, managers could exploit these models to delay the recognition of losses.
- Risks of Insider Trading and Front-Running: If valuation standards are weakened, asset managers might trade against uninformed investors by delaying NAV adjustments. For example, if a fund manager knows that private loan values have declined but continues to report a higher NAV to avoid redemptions, it creates a conflict of interest. Thus, deregulation may exacerbate valuation manipulation and further erode investor trust.
When private ETFs encounter liquidity stress, who bears the consequences?
In a fully deregulated market, the Federal Reserve is unlikely to bail out private credit ETFs. Unlike banks, ETFs and interval funds do not have access to Federal Reserve liquidity lines. While some large firms may provide temporary liquidity to prevent panic, they might refuse to backstop losses if the stress is severe, resulting in fund collapses. Asset managers could securitize private credit loans and sell them in the open market to raise emergency liquidity. However, during a crisis, these assets might trade at significant discounts, aggravating losses.
In a deregulated environment, investors bear most of the risk, while asset managers have limited obligations to provide liquidity. Pension funds and retirement investors in private ETFs could incur massive losses in a market crash.
In summary, although deregulation can foster growth, it also raises serious concerns. Interval funds and private ETFs promise periodic redemptions, but their underlying assets remain illiquid. Private credit firms could exploit regulatory gaps, leading to excessive leverage and financial instability. DC plans investing in private credit may expose retail investors to greater complexity and volatility, warranting enhanced fiduciary oversight. Regulatory bodies may continue to monitor the sector to ensure stability and protect investors.