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Today's Bullets:
What is Private Credit?
Why has it grown so much?
What is the danger?
Inspirational Tweet:
Often referred to as 'Shadow Banking", we're starting to hear rumblings about the world of Private Debt and how this is a growing bubble that is bound to burst at some point.
Especially with a recession coming.
But what exactly is Private Debt, are funds that offer it predatory, and has it really ballooned to bubble levels? I.e., should we be concerned about them imploding the general markets soon?
Good questions, and ones you will likely hear being asked more often soon.
But if it all sounds confusing, don't worry, we are going to break it down nice and easy for you, as always, today.
So, grab that cup of coffee and settle in for a peek into the so-called Shadow Banking world with The Informationist.
🧐 What is Private Debt?
Shadow-banking.
Yes, yes, Elizabeth Warren. We hear you back there.
But we will refer to it as private debt (or private lending) for our purposes today.
Traditionally dominated and created by non-bank private funds, much like private equity or hedge funds, these pools of private capital offer direct lending to borrowers.
Explain please.
OK, if you are a small or mid-sized company, you may be in need of financing for something. Like equipment or a building lease, or maybe raw materials, or even just to pay for invoices because your customers are late on their payments to you.
Back in the day, if you couldn't get a loan from a bank or someone you knew, tough luck.
You went out of business.
In today's market, you have a choice. If you cannot get a loan from a bank or syndicate (group) of banks, you can borrow money from a direct lender, like a private debt fund.
You may be asking, what's the difference, and given the choice, why would you use a private lender rather than a real bank?
Let's bullet-point it out:
Relationships:
Traditional Lenders (banks) often have a slightly 🙄 impersonal and structured approach to lending, and borrowers typically deal with loan officers rather than individual investors
Direct Lending often establish a more direct and personal relationship with borrowers, working directly with individual investors
Approval Process:
Traditional Lenders follow rigid underwriting processes that often involve stricter credit checks, regulatory requirements, and a much longer approval process
Direct Lending can be much more flexible and quicker, as decisions may be based on alternative criteria, including creditworthiness, collateral, and business plans
Loan Options:
Traditional Lenders offer traditional loan products, like mortgages, business loans, and credit lines, which follow conventional lending standards and practices
Direct Lending offers a wide range of loan types, including small business loans, real estate loans, etc., and these loans can have varying terms, interest rates, and structures.
Interest Rates and Terms:
Traditional Lenders offer loans at prevailing interest rates with standardized terms and conditions
Direct Lending rates and terms in direct lending can vary widely depending on the lender and the specific loan product.
Regulatory Oversight:
Traditional banks are subject to extensive regulatory oversight and must comply with banking laws and regulations (read: onerous, costly, and often unnecessary paperwork and red tape)
Direct Lending involves fewer regulatory constraints, period, making the process faster, cheaper and far less unpleasant for the borrower
OK, so much more flexibility, personal relationship driven, less regs, got it.
But what are the loans themselves like? How are they structured?
Because of the flexibility of private debt, there are a whole bunch of different types of loans that companies use in order to finance something that traditional banks are either not set up to finance or would be unable to offer because of the borrower's credit profile.
Things like:
Small Business Loans for working capital, equipment purchase, business line expansion, or debt consolidation
Corporate Loans for various purposes, like mergers and acquisitions, or refinancing existing debt
Commercial Real Estate Loans for the purchase or development of commercial properties, like office buildings or retail storefronts
Cash Flow Financing to provide businesses with advances on their outstanding invoices (this helps businesses access cash flow while waiting for customers to pay their invoices) or cash advances to businesses for anticipated credit card sales
Equipment Financing for the purchase of equipment or machinery (the equipment itself then serves as collateral for the loan, much like a car loan)
Bridge Loans used to bridge a gap in financing, often during real estate transactions, which are repaid when permanent financing becomes available
Mezzanine Financing, or subordinated debt, which combines both debt and equity (often used in leveraged buyouts)
Structured Credit Products, such as collateralized loan obligations (CLOs), which pool together various loans to create investment opportunities for institutional investors
So, to recap. Private lending offers more personal, more flexible, and more types of loans.
No wonder companies have been turning to private credit vs. traditional bank (syndicated) loans lately.
But how big has this market gotten, and how much has private lending grown versus traditional (syndicated bank) lending?
Let's look at that next.
🤯 Why has it grown so much?
Blackstone just raised $8 billion in the first close of a new direct lending fund, and Oaktree Capital is looking to raise more than $18 billion for the world's largest private credit fund.
But that's just a drop in the bucket.
Because, would you believe that over $1.5T is now available or being used in private debt,globally?
For context, that's now larger than the global High Yield (Junk Bond) market.
Whoa.
And you can see in the charts that private debt assets have grown, right when high yield debt seemed to be contracting.
But why?
Conventional thinking would argue that rising interest rates would harm private credit, not encourage it.
Well it may have to do with this.
What you are looking at here is the lending standards of traditional banks. The blue line is bank lending standards to small firms, and the arrange is larger or middle-market firms. The higher the percentage, the tighter the lending, the harder for companies (especially smaller ones) to get loans.
And while the standards have clearly begun to ease this past few months, we can see that as lending tightened at commercial banks, private lending just marched higher.
As banks became more and more risk averse (along with rising rates), they avoided loaning to customers (companies) who needed it most.
Then, as companies scrambled to find financing, private lenders swooped in and filled the void left by banks, deploying over $333B of cash in 2022, an increase of 60% from 2021.
The private lenders have helped the companies and small businesses survive and keep growing.
Low and behold, guess who now wants in on the action and is scrambling to join the private debt game?
You got it.
Big banks.
Citigroup, JP Morgan, Blackrock, Blackstone, and even Fidelity are all setting up shops, partnerships and funds to enter private credit.
Today's white-hot sector of finance.
Don't get all teary-eyed, they aren't entering the sector to help small businesses. They see fees.
Loads and loads of fees.
Smart move, as continued high interest rates will make traditional financing more difficult for companies rated under investment-grade. This, plus the coming regulations under Basel III could allow for more holdings of this type of debt.
As of now, private credit is widely expected to surpass $2T in assets by 2027.
And that has many politicians and some regulators nervous.
But how nervous should they be? Is this really a bubble set to burst someday soon?
✍️ What is the danger?
First, let's get a few things straight.
Most direct lending funds make senior secured loans. This means they are first in line to get paid back in the event of a default or bankruptcy. Because they are secured, the assets themselves are pledged by the company to the lender for the loan (yes, like a mortgage and a house).
Also, because they are lending directly to the companies, they can negotiate strong covenants or protections.
And perhaps most importantly, when a company runs into problems, direct lenders can help figure out a solution, such as a higher interest rate or more protections for the lender.
Remember, private debt capital at the funds loaning the money comes from long-term investors such as high net worth individuals and pension funds. This makes the assets more sticky and easier to manage the risks around lending for years, not just months.
A couple of advantages for the lenders that are harder on the borrowers:
1) Most direct lending is done with floating interest rates, which works out to be SOFR + 5 to 7% spread.
SOFR is basically an overnight rate that is tied to Fed Funds. (as you can see in this chart). So, today, these loans are at floating rates that are about 10 to 13% annualized.
You can see that this has protected the lenders from rising rates (unlike banks who are sitting on impaired, fixed-rate USTs).
But on the flip side, it has made the cost of borrowing higher for the companies.
Also, the ability of lenders to negotiate covenants (more protections) could allow them to be predatory and demand the types of protections that will all but ensure that the lender ends up owning more equity or gets higher fees from the borrowing company.
That said, with all the new capital pouring into the space and competing for the business, we have actually seen covenants loosen over the past two years.
Admittedly, this is a small data set, but interesting nonetheless.
But let's face it. We are headed into tightening economic conditions. And with a lack of transparency and regulatory oversight in the private lending markets, it is difficult to say just how many companies are headed for trouble.
We can see look at how small companies with public debt are faring, though.
As you can see, the bankruptcies have begun to spike. Still not levels that compete with the GFC, but a clear directional signal for certain.
We can extrapolate that small private companies with private loans are faring about the same.
It is no surprise as we have seen how high these loan rates have jumped, and that they are not yet coming down, causing extended financial challenges for many small companies.
In fact, S&P's credit analysts estimate that just 46% of private companies would generate positive cash flow from their business operations under S&P's mildest stress scenario, in which earnings fell by 10% and the Fed's benchmark rates increased by another 0.5 percentage point.
And analysts at Bank of America said recently that they expect the rate of private debt defaults to reach 5% next year if interest rates remain high.
The biggest danger, in my opinion?
A number of large lenders going bankrupt due to related entities failing, and causing a spiderweb of defaults.
Contagion.
I believe this is unlikely however.
Most private deals are well capitalized with 2x debt to equity (making deals much less risky than the media would have you believe), and with large interest rates, there is plenty of room for lenders to weather any storm and continue to operate.
These funds and lenders also have over $500B of dry powder (unused capital) to deploy in the space. Plenty of room for additional lending and covenant adjustments.
They have the benefit of diversification, flexibility, deep pockets.
Still. Do I believe it is possible for one big fund to get over their ski-tips and have a massive leveraged implosion?
Of course I do.
I lived through the Long Term Capital Management debacle. Anything and everything is possible.
Do I think it is likely right now in the private lending market?
Put simply, no.
But I do still believe that a credit event is growing more and more likely every day that the Fed keeps rates up at this level. So, I am watching everything.
Treasury Auctions. Commercial Real Estate. Junk Bond Debt. Repos. Reverse Repos. And yes, the Private Debt Markets.
All of it.
And I am keeping myself diversified to weather any storm that comes, just like private lenders.
Because with or without a credit event, I believe an economic storm is head our way, and I am well prepared.
I strongly suggest you look at your own portfolios and do the very same.
That’s it. I hope you feel a little bit smarter knowing about private lending and how the so-called shadow banking world works.
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Talk soon,
James✌️