Watchdogs are concerned about the “substantial” risk to investors in the private-credit market after it emerged that almost 40% of funds don’t have skin in the game.

The decision by so many managers to avoid putting their own capital into the vehicles creates an “incentive misalignment”, the Bank of International Settlements (BIS) said last week. The risk is that industry players could prioritise their profit over investors’ returns.

Private credit has grown rapidly into a US$2.1 trillion industry, according to BIS estimates, after banks pulled back from certain types of lending following the financial crisis.

Now, supervisors are growing concerned about the effects the sector could have on traditional lenders because many of the managers haven’t been through a credit cycle. And that, in turn, means risks behind manager selection may not be clear.

There are also increasing worries about valuations, with only 40% of private-credit funds reporting data to the US Securities and Exchange Commission using third-party marks.

Watchdogs including the Bank of England have spent months examining how private markets interact amid wider concerns about the risks that shadow banking, which encompasses everything from insurers to money market funds, pose to the financial system.

Private equity’s being scrutinised after a jump in the cost of the floating-rate that debt managers typically used to secure deals made repayments more difficult.

About 78% of private-credit deal volume in the United States goes to private equity-owned firms, according to the BIS report.

In Europe, regulators now plan to seek more transparency around how shadow banks interact with one another.

“The part we don’t know is what goes on” when “non-banks are interacting with other non-bank financial institutions or ultimately with the borrowers”, Jose Manuel Campa, the head of the European Banking Authority (EBA), said. “That’s the bit we have to understand better, and have better discovery.”

The EBA is concerned that off-balance sheet exposures could become a problem for banks if large non-banks need to access credit lines simultaneously.

In addition, traditional lenders can cut their average capital demands by extending short-term loans to shadow banks, which typically attract a more favourable regulatory treatment than the consumer and real estate lending that make up the majority of their loan books.

The danger is that shadow banks could then buy up their lenders’ bonds and use them as collateral in the repo market, creating a “circle of exposures” and leading to “both on and off-balance sheet links between the two types of lenders”, the EBA said.

“Such two-way links in bank-issued debt securities would give rise to a funding liquidity risk for both parties.”