The prolonged bull market shows worrisome signs of reversal, and many economists fear a looming recession amid a fragile global economic system beset by trade wars, currency imbalances, and negative interest rates. Meanwhile, the U.S. Treasury is projected to borrow a record $1.4 trillion in 2019.
Amid the unstable environment, some observers also raise concerns over alternative lenders, or what they may refer to as “shadow banking” — debt-based financings led by unregulated investors to help fund buyouts, mergers, and other transactions.
Alternative lenders, along with private equity firms, are turning into an issue on the campaign trail, with “progressive” presidential candidates targeting them as predatory figures dangerous to the American economy.
In fact, alternative lenders could prove to be a lifeline in the event of another recession. They’re holding substantial “dry power” — cash reserves that could provide a soft landing for distressed companies and borrowers when conventional equity and debt markets tank. They may even save some companies from liquidation, thereby saving jobs if unemployment starts to take a turn upward.
According to a 2018 fundraising report by Private Debt Investor, U.S. private debt investors raised more than $134 billion last year. Funds focused on Europe reached more than $15 billion. One report predicts that the private credit industry will hold $1 trillion of assets under management by 2020.
The recent surge of private credit stems directly from the extreme limitations placed on commercial lenders by Congress and Dodd-Frank reforms coming out of the financial crisis of 2008. When banks pulled back from business lending, a new class of lenders stepped in that included hedge funds, alternative asset managers, private equity firms, and business development companies.
The build-up of private debt has financed everything from management-led buyouts and take-private transactions to mega-mergers and acquisitions of storied companies. When Warren Buffett purchases billions of dollars in preferred shares from Wells Fargo and Occidental Petroleum, he is likewise using fixed debt instruments that can transfer to equity down the road.
But private credit also has a creative side and can benefit all kinds of stakeholders, even musical artists.
Consider a recent deal by a Blackstone-owned company called Sesac, which raised $560 million by issuing bonds backed by royalty payments owed to pop icons Bob Dylan, Neil Diamond, and Adele, along with some 35,000 other entertainers. The so-called “whole business securitization” helped Sesac receive a more favorable credit rating and lower borrowing costs than it would have by issuing unsecured bonds or even doing an IPO.
It’s not a stretch to say that if private equity firms and other credit investors ceased leveraged finance transactions, the United States would experience more defaults and lost jobs as the economy starts to cool off. Moreover, the underlying source of funding for many of these credit deals are bedrock investors — endowments, sovereign wealth funds, family offices, and even public pension plans in the U.S. and Europe.
Private bespoke financings in the middle and large markets can provide a larger buffer than more conventional bank deals, despite the extra capital cushion banks have added in recent years following Federal Reserve-mandated stress tests.
Consider the mechanics of a typical private credit transaction. The lender of so-called unitranche debt may have backing from a sophisticated private equity sponsor, which provides an equity investment that accounts for 40% of the total purchase price for the acquisition of the target.
Compare that with deals done during the heyday of subprime lending, when certain investors may have posted de minimus equity contributions.
Credit is central to sustaining certainty and confidence in the capital markets. It’s very absence helped fuel panic in the days surrounding the collapse of Bear Stearns, Lehman Brothers, and other old-line market makers.
Private funds deliver credit that is not tied to the traditional banking structure. They usually don’t have balance sheet restrictions and are subject to fewer regulatory limits, so they can more easily raise capital.
The cash reserves backing private credit transactions help lubricate financial markets in good times and can be a key back-stop in bad times. As a result, when the economy turns and banks stop lending, more stability may be maintained.
Ironically, the Volcker Rule, which banned proprietary trading by financial institutions after the crisis, helped make private debt a more plausible alternative to other forms of credit. The Volcker restrictions also turned banks away from trading in bond markets, creating less liquidity.
“Progressive” politicians should keep that in mind as they campaign on the idea of even further intrusion of our capital markets.
Of course, regulators are wise to watch for bad actors and keep a close watch on the solvency of lenders. Proposed changes to the bankruptcy code could also subject alternative lenders and private equity firms to more oversight.
But cutting off or interfering with this abundant supply of funding because it operates outside historical rules governing commercial banks would set off a cascade of problems. It could result in more defaults, greater loss of jobs, and gutted businesses.
The Office of Financial Research has been monitoring the private credit markets and studying its effect on financial stability. The OFR looked at whether alternative asset managers should be included among Systemically Important Financial Institutions specified in Dodd-Frank.
Overseas, the Financial Stability Board has been keeping an eye on the “shadow banking” world, creating a model for assessing this banking sector and defining its role in systemic risk.
But they would be wise to be cautious. Like a parachute, pre-bankruptcy direct lending or rescue loans can save some companies from filing for Chapter 11. The amount of capital being held can be used to prop up companies that are in the red as a result of a flawed acquisition, a misguided purchase of equipment, or an economic downturn.
Private credit deals also allow healthy companies with bad balance sheets to survive when traditional credit conditions sour.
Those who try to cast alternative lenders as shadowy figures in the dark corner of the schoolyard would do well to consider the lessons of the past dozen years. We’ve seen what the world can look like when the capital markets grind to a halt: The government has to step in and bail businesses out with taxpayer funds, and economic growth is choked by regulation.
The sizable base of private capital raised by alternative lenders in recent years creates economic options and solutions that did not exist following the last crisis. It could be the ozone layer we all need to prevent the next meltdown.
William Brady is a partner with law firm Paul Hastings, head of the firm’s alternative lender and private credit group, and a member of its special situations group.