The disintermediation of lending

With banks continuing to face pressure on capital, and increasing regulation, the provision of private debt – often to companies owned or sponsored by private equity – has been one of the fastest-growing parts of the capital markets for more than a decade. It now actively competes with more established funding routes such as syndicated loans and high-yield debt: all three are USD 1.5 trillion markets and private debt is forecast to reach at least USD 2 trillion by 2027, according to Moody’s Investors Service.

John Popp states that although that each of the three asset classes noted above will at times offer better value to borrowers, there is little sign that interest in private debt as a source of funding is waning. “We think all three markets will continue to co-exist and compete for capital. Sponsors have become increasingly sophisticated in comparing the relative attractiveness of these markets and will continue to work to optimize the borrowing costs of their portfolio companies,” he says. 

Baxter Wasson adds that borrowers can prefer dealing with a single lender, as is often the case with private debt deals, particularly if they are tapping the market with a highly structured transaction, the loan is tied to a merger or acquisition, or they are anticipating a potential future restructuring. As well as providing discretion, these bilateral private deals also reduce mark-to-market volatility, he says. “Lenders may also favor private debt because they tend to have more protections in those deals and in a volatile market those protections matter more,” he says.

Indeed, there are indications that the private debt market is set to grow even more rapidly, particularly in the wake of the regional banking crisis in the US. Popp notes there have been calls for banks to increase their capital ratios, or financial buffers, following the collapse of Silicon Valley Bank, the former darling of tech start-ups on the US West Coast. As has been the case since the global financial crisis, he says, the effect would be for banks to shift even more assets off balance sheet and to reinforce the option of private debt markets as an alternative.

As a further boost, Popp argues that regulators are likely to prefer institutional investors over banks as lenders. “From a policy perspective, I do think it is better to have risky assets owned by funds that are matched duration and with investors that have long-term hold outlooks such as pensions, sovereign wealth and insurance companies,” he says. “A bank by its nature is levered more than 10 times and weighted with short-term liabilities. We therefore believe the bias will be against lending to small and medium-sized businesses, by regional banks in particular.” A good structure for investors here may be pooled loans, or collateralized loan obligations.

Wasson says that there is a notable opportunity for growth in the larger private debt deals arranged by bigger funds and BDCs, or Business Development Companies, a form of closed-end investment fund. The size and stability of returns as well as the relative opacity and ability of both lender and borrower to negotiate attractive terms are key drivers, he says, adding that regulators have not yet intervened in the market and may be keen to divert more lending away from banks.

“The large-deal end of the market is arguably the most commoditized because it must compete with both broadly syndicated loans and with high yield bonds as potential alternative sources of capital for the borrower or sponsor,” Wasson says.

A reduction in lending among regional and mid-sized banks would create a significant void for private debt managers to fill, according to Wasson. However, he says the profile of the companies that regional and mid-cap lenders have targeted doesn’t match the direction of travel for the private debt market since the financial crisis. While private debt funds have favored the private-equity dominated areas of technology, software, services and healthcare – and loan deals that may exceed USD 200 million – the banks have tended to lend in smaller size to more diverse businesses, including in commercial real estate, and have mainly steered clear of private equity.

“Most private debt funds have spent the past more than 15 years effectively recreating the middle-market leveraged finance business that resided in investment banks in the early 2000s, and therefore are laser-focused by sourcing network, skill-set and team and will mandate on loans to increasingly large companies owned by medium to large private equity firms,” he says.

This divergence spurs innovation, according to Wasson, who reckons it might be one of the reasons that large private equity firms have been considering the possibility of investing in or buying regional and mid-cap banks.

But there are implications for the US regional banking crisis for specific sectors, such as commercial real estate, where lending is dominated by these players. Smaller banks account for around 70% of all outstanding US bank loans, according to figures from the Federal Reserve and MSCI Real Capital Analytics, and that equates to 40% of all lending to the commercial real estate sector. With roughly USD 900 billion of real estate loans due to mature by the end of 2024 – half of them backed by commercial mortgage-backed securities – there should be opportunities for private debt providers to step in with new facilities.

“As regional and mid-size banks reduce their commercial real estate lending, and perhaps even sell loans they own, it seems logical that private capital will seek to fill that void,” says Wasson. The newer players moving into the sector at the beginning of a cycle are likely to avoid the problems that beset the incumbents at the end of it by operating significant collateral coverage and securing attractive terms and pricing.

That is not to say there aren’t problems in the current property market, where increases in lease rates are not sufficient to cover rises in operating expenses and financing costs, raising the prospect of debt defaults.

Tiffany Gherlone says: “Covering financing costs is likely to be a struggle. Covenants get breached during downturns. In fact, just the specter of covenant violations one to two years out is prompting some borrower-lender negotiations now, though I have only seen that in the office sector.

“At least it means planning for work-outs and give-backs can begin well ahead of the distress. Some level of operating expense is reimbursable by tenants, a partial mitigator for buildings that retain their tenants.”

Gherlone believes that, while the retail, industrial and niche property sectors should weather the current storm, the offices market is likely to struggle for the next five to seven years. “Demand [among tenants] is low,” she says. “Even if a landlord signs a lease today, build-out of the space and free rent imply positive cashflow is unlikely for two and a half to three years.” She agrees that private lending to the commercial property sector is likely to grow.

More widely, the rapid growth of the private debt market has bought other potential challenges, which are likely to come into focus as the macroeconomic picture deteriorates. Some managers turned to more unorthodox underwriting techniques to assess loans to high-growth companies with little in the way of a track record on profits. At the same time, sponsors took advantage of high demand among private lenders and geared up their borrowing multiples or scrapped key protections such as covenants.

Popp points to the specific trend of private debt funds assessing companies based on their annualized recurring revenues because traditional credit metrics using, for example, EBITDA, did not apply. “For these deals that could be cashflow challenged, the question is: does the company have sufficient equity value beneath the debt such that the sponsor will put in more equity to bridge through this period of high borrowing costs or, if the lender gets the keys, is there sufficient recovery value there through the debt,” he says. Much depends on the idiosyncrasies of the borrower’s business model, but being senior in the capital structure is a real benefit, he says.

“Private credit managers who remained disciplined in their underwriting and did not buy business by stretching for leverage or engage in too many preferred and junior capital deals should be fine,” he says.

In the market for direct lending to mid-sized companies, Wasson says several characteristics have taken hold over the past several years that raise questions about how sponsors will react if their companies become cashflow-constrained, and in turn what it might mean for lenders.

These include heavily adjusting the definition of EBITDA and then substantially increasing the debt multiples of that adjusted measure. Leverage of six times is now commonplace, he says. As well as dropping covenants or loosening them to the point of irrelevance, borrowers have been able to sell off assets and reward themselves with handsome dividends with little or no payment to the lenders.

“So, as the cycle turns negative, will those large private equity sponsors that have already achieved fund-level returns ranging from acceptable to highly attractive put more equity capital into a company that cannot make interest or principal payments, about the only trigger for a default in a covenant-lite deal?” he asks. Should the sponsors choose not to support those companies, many of which are in asset-lite businesses such as tech, software, services and healthcare, then there are questions about how much of their outlay lenders might expect to recover, he says.

Standing back, both Popp and Wasson agree that the US is the most mature private debt market, although it is closely followed by Europe, and then in turn Asia.

Given its size, the depth and global nature of its capital markets and the sheer number of private equity players, the US is likely to remain the dominant market, they say. However, growth in Europe, which is overbanked, could outpace the US in future if there is an increase in cross-border banking consolidation. Asia and other emerging markets are less mature and there is a lack of consistency in legal documentation and bankruptcy processes between various countries.

Wasson adds that the European market is much more fragmented and many of its banks are domestically focused. “As those banks fill up on certain types of deals, it means that even high-credit quality borrowers may be open to higher pricing from private debt funds due to a lack of alternative sources of capital and the urgency of their borrowing needs,” he says.