Money lenders are pretty well-accustomed to getting a bad rap. In Dante’s The Divine Comedy, usurers are condemned to the Seventh Circle of Hell – further down than violent murderers – where they face gale-force winds that cover them alternately with burning sand or flames. Lenders who started their careers before 2008 may have some sympathy.
The latest iteration of this sentiment is the consternation amongst policymakers at the rapid growth of leveraged loans in general, and those lent by private debt funds in particular. The numbers are certainly striking. At an estimated $1.2 trillion, the total volume of leveraged loans is now twice what it was at its pre-crisis peak. The share held by “direct” (i.e. non-bank) lenders has also ballooned, from $300 billion in 2010 to $700 billion in 2018. And this looks set to grow further in 2019: private debt funds raised an additional $100 billion last year.
The impact on buyouts is also clear, especially in the mid-market. Pre-crisis, around 90% of mid-market deals were supported by bank debt; anecdotal evidence suggests that this is now more like 50%, with the remainder provided by direct lenders. Going by debt volume, as opposed to transaction number, it is likely that private lending now forms the majority.
Time to panic, then? Financial market authorities seem to think so, with the Bank of England, the US Federal Reserve, the Bank of International Settlements and the IMF all having issued warnings on leveraged loans in recent months. A commonly cited concern is the growth of loans lacking key covenants and investor protections, dubbed “cov-lite”. In the period following the financial crisis, a typical loan agreement would contain at least three to four covenants requiring the borrower to maintain specified financial ratios or face default. Today’s market has shifted substantially in favour of borrowers, with 88% of European leveraged loans issued in 2018 lacking most of these protections. A recent report by Moody’s, the credit rating agency, suggested that loans issued in 2018 contained the weakest investor protections on record. Yields have also moved down, with KKR estimating that the average private debt yield has fallen to [6-8]%, down from the low teens a few years ago.
So it is easy to see why regulators are worried: investors are accepting lower returns while simultaneously appearing to increase their risk by sacrificing key protections. Nor is this the only reason to be cautious. Private lending in the volumes we are seeing today is a post-crisis phenomenon, meaning that most debt funds are yet to be tested by a downturn. In particular, it is not clear that those which allow early redemptions would have the liquidity to meet these in the event of a sudden market dislocation. In a crisis, this could lead to fire sales of loans to small and medium-sized companies, leaving them in a vulnerable position at precisely the worst time. And where borrowers do go into default, there is the question of whether the private lenders who end up seizing the reins are best-placed to run a distressed business.
Such concerns are valid, but overblown. In the first place, there is scant evidence that strict financial covenants actually improve lenders’ recovery rates in the event of a default. A report by S&P Global Market Intelligence found that the average recovery rate on defaulting loans with weak covenants issued before 2010 was 78%. Those with stronger protections allowing the lender to take control if key financial ratios were breached fared little better. In other words the argument that lenders may not be the best people to turn a business around cuts both ways. Meanwhile, the growth of the private debt market might be striking, but in relative terms its $700 billion size is tiny. The corporate bond market in the US alone has a size of around $7.5 trillion, of which $5 trillion is categorised as “high risk” by credit rating agencies.
Then there is the more fundamental issue. However worried they are today, central bankers and regulators need to look to their own role in this. Private debt funds did not appear out of the ether – their growth was incentivised by the increased capital requirements placed on banks after the crisis. The resulting loss of profitability on the bank side could virtually have been designed to push lending into more lightly regulated institutions. At the same time, central banks took deliberate action to encourage borrowing by cutting short term rates, and to push investors up the risk spectrum by depressing long term rates through QE. If they are now concerned, it is because their actions appear to have been too successful.
Don’t expect the scorn poured on private lenders to die down any time soon. Its pedigree is far too long for that. But the policymakers who are now sounding the alarm should read Dante as well. Usurers may end up in the Seventh Circle of Hell, but barrators – public officials who fail to uphold the interests of those they serve – get landed in the Eighth.
For more information, please contact Joshua Roberts, Associate Director at JCRA, at firstname.lastname@example.org.