Shadow banking is drawing some investors to corners others dare not go.
Suni Harford, head of investments at UBS Asset Management, said during a June lunch in New York that her industry peers had recently expressed concern over collateralized loan obligations. She said they “would not touch CLOs.”
CLOs, the biggest buyers of risky corporate loans, are one part of the expanding market of nonbank lenders drawing a growing chorus of concern. U.S. Senator and Democratic candidate for president Elizabeth Warren voiced her concern about leveraged loans and CLOs in a letter last year to regulators including the Federal Reserve and the Securities and Exchange Commission. In April, JPMorgan Chase & Co. chief executive officer Jamie Dimon wrote in his annual letter to shareholders that shadow banking — including fund managers engaged in direct lending to companies — was accelerating and needed careful monitoring.
While CLOs buy portions of leveraged loans arranged by Wall Street banks and broadly sold to investors, direct lending funds increasingly have taken on a traditional banking role by originating and holding them. The market for private debt funds has swelled on the back of bank regulation developed after the 2008 financial crisis. These lenders compete in the middle market, catering typically to the booming private equity industry.
“The question that investors need to answer is, ‘Am I getting paid for the illiquidity I have in this portfolio?’” says Rodrigo Trelles, co-head of capital solutions at multistrategy hedge fund manager UBS O’Connor, in an interview this month at the bank’s New York office. “Our view of the world is no, you’re not getting paid for that.”
Institutional investors have been pouring money into private credit, with direct lending funds now dominating the scene, according to Preqin, a provider of alternative-assets data. They’re betting on an area of the nonbank lending market whose rapid expansion since the crisis has not been tested in a downturn. And they’re locking up capital with funds that hold loans that don’t trade.
With their money tied up in portfolios of risky debt backing midmarket buyouts, investors are hoping to reap bigger gains than from more liquid bets. Direct lending funds lost 1.1 percent in the year through September 2018, and posted annualized internal rates of return of 4.5 percent in the three years through September and 4 percent over a five-year period, according to Preqin.
After that performance, investors are ready to keep chasing the so-called illiquidity premium — and Preqin sees plenty of opportunity to do so.
At the start of July, direct lending funds were aiming to raise $98 billion globally, more than half the total sought by other private credit pools, including mezzanine, distressed debt, special situations, and venture debt funds. They’re adding to record dry powder exceeding $100 billion, a pile of uninvested capital that has soared from $23 billion for direct lending in 2012, Preqin data show.
Yet dangers lurk amid the strong demand.
Direct lending has morphed into a world of higher leverage, loose loan covenants making it easier for private equity owners to collect dividends from companies, and creative accounting that inflates their earnings so they may borrow more, according to Baxter Wasson, the other co-head of capital solutions at UBS O’Connor. Plus, he says, debt financing is cheaper than in 2012, when the market was in the earlier stages of its post-crisis growth. And the loans are getting larger.
“You look at that and say, ‘What is happening here?’” says Wasson. “The most logical explanation is just a massive expansion in the number of lenders, the amount of capital they’re looking to put to work, all to some degree undergirded by the fact it’s been a very constructive and long, positive credit cycle.”
Now cracks may be starting to appear ahead of a downturn.
For the first time in his career as an attorney, William Brady, head of the alternative lender and private credit group at Paul Hastings, is busy working on both “front-end” deals and restructurings. Historically, Brady says, he has spent more time on one side of the business or the other, depending on the stage of the market cycle.
There’s “very, very little margin for error for companies because of the leverage,” says New York-based Brady. “A couple hiccups, or a couple mistakes by management, and you can find yourself in a default scenario.”
“The risks are continuing to accumulate in this space,” says Anton Pil, managing partner of J.P. Morgan Asset Management’s global alternatives group. “I’ve tried to avoid this space entirely.” In addition, central bank policy shifts toward “easier money” may delay a potential squeeze in private credit, according to Pil. He says the easing of global monetary policies will prompt investors, who are facing negative yields in government and corporate debt outside the U.S., to hunt for yield in riskier loans.
They “will probably continue to funnel excess assets into private credit markets where you can still have positive yields,” says Pil. “The bubble that’s forming can stay a bubble longer before it gets unwound.”
Debt levels in the middle market have risen at the same time concern has grown that borrowers are using “add-backs” to earnings before interest, taxes, depreciation, and amortization to appear more creditworthy on paper, according to Brady. Adjusting EBITDA for items such as expected cost savings inflates the earnings measure, allowing companies to increase leverage, he explains.
When hammering out lending agreements, Brady says, he seeks to limit total add-backs to around 25 percent of EBITDA. In many cases, companies that turn to direct lending funds for financing are able to borrow at six times EBITDA, he says.
Amid the risks, some asset managers point to the benefits of locking up capital in illiquid private credit funds. In a tumbling market, investors — unable to withdraw their capital — remain positioned to ride the assets back to recovery, instead of exiting at a low point in the cycle.
“Now that does presuppose that the asset is going to rally back,” says Wasson. “It might just crash.” In taking a closer look at the deterioration of lender protections and the vulnerabilities of smaller companies, Wasson says that “what’s going on in the middle-market loan space right now becomes doubly concerning.”
While infrequent valuations may keep investors from worrying about daily price swings, borrowers aren’t shielded from the tumult of an economic downturn. In a recession, smaller companies likely are more volatile for a variety of factors, according to Wasson, citing possible concentrations in customers or geography.
But the current concerns over debt don’t stop with direct lending.
In late November, Jonathan Insull, a managing director at alternative credit manager Crescent Capital Group, listened to Federal Reserve chair Jerome Powell tell members of the Economic Club of New York that a rise in corporate debt levels and deteriorated lending standards were on the Fed’s radar.
The question, Powell said, was whether “elevated business bankruptcies” and “outsized” investor losses might undermine the stability of the financial system. In the Fed chair’s view, such losses were “unlikely to pose a threat to the safety and soundness of the institutions at the core of the system.” Instead, he said, they were “likely to fall on investors in vehicles like collateralized loan obligations with stable funding that present little threat of damaging fire sales.”
“Oh, thanks,” thought Insull, who is also a member of Crescent Capital’s structured product team, as he watched the speech on television. While he says it was “refreshing” to hear Powell speak to the stability that CLOs bring to loan prices, he found it tough to hear him suggest that they’re good for markets because they act as shock absorbers for losses that otherwise would have been realized inside the banking system.
“I sort of feel like it’s a backhanded compliment that he’s paying,” says Insull, who has worked in the CLO industry for about two decades. The leveraged loan market has evolved over that period, from one where banks originated and held the debt to one where they underwrite the financing and sell it to investors. Insull believes the drumbeat of concern surrounding CLOs is overdone, saying their complex structures have proved resilient in past downturns, including through the Great Recession.
Yet some CLO investors are better protected than others, with risks increasing the further down the layers of the debt structure they venture.
Wells Fargo & Co., JPMorgan, and Citigroup are among the big U.S. banks that invest in CLOs, according to Insull. Japanese banks have also been investors, he says, along with insurance companies, pension funds, and asset managers.
Banks tend to own the safest and largest portion of CLOs, the so-called AAA-rated tranche, says Insull. “It’s really hard to get hurt,” he says. “The amount of loss you’d have to realize before that play would be impaired is tremendous.”
At least one asset manager, Schroders, isn’t taking any chances investing in the riskier portions of CLOs.
“We are only investing in AAA-rated classes,” says Anthony Breaks, a New York-based fund manager in the firm’s securitized credit group. “We are being very selective about our CLO investments because we continue to be concerned about the quality of the loan market.”
A CLO, backed by a portfolio of leveraged loans, issues a series of bonds of varying risk and return. The so-called equity tranche is the riskiest because it’s at the bottom of the stack, where investors are first to take a hit should problems arise with the underlying assets.
As the record-long U.S. economic expansion presses on this year, the $1.2 trillion market for broadly syndicated risky corporate loans hasn’t suffered many high-profile defaults or outsize investor losses. But “the conditions for that to happen, when the credit cycle changes for corporates, are absolutely in place,” Breaks says.
While recent Citigroup research shows that pensions are absent from CLO equity, they may be seeking exposure through asset managers.
For example, the Canada Pension Plan Investment Board announced in September that its credit investment arm would be broadening its portfolio by purchasing CLO equity alongside experienced credit managers. Sound Point Capital Management, a New York-based asset manager, would be its first partner, the pension said, with CPPIB Credit Investments committing $285 million to a fund that will buy equity in Sound Point’s CLOs over the next several years.
“CLO investments help to diversify CPPIB’s portfolio in pursuit of better risk-adjusted returns when compared to traditional fixed income and equities,” the Canadian pension said at the time.
Citigroup, which pegs the U.S. CLO market at about $640 billion, estimates that banks represent 46.5 percent of investors in the AAA-rated portion of the structured loan pools. Asset managers and insurers are the next biggest buyers of that safest and largest tranche, the bank’s research shows.
The majority of CLO mezzanine, meanwhile, is held by asset managers and insurers, with pension funds being the third biggest group. The equity piece is mainly held by asset managers.
At this stage of the credit cycle, buying into riskier classes of CLO tranches doesn’t seem like a great strategy for fund managers evaluated on risk-adjusted returns, according to Breaks.
“You can absolutely get into a situation where the losses in the underlying loans are so great that you won’t be able to ever get any cash flow in that mezzanine position,” says Breaks. “Once you’re the bottom pancake, losses wipe out your principal awful fast.”
Although CLOs were resilient during the financial crisis, Breaks would rather avoid riding out a downturn in volatile portions of the loan pools.
Sure, “the hold-to-maturity result for CLOs was quite good in the financial crisis,” he says. But “in the thick of the crisis,” mezzanine CLO bonds traded down to around 20 to 30 cents on the dollar. Many changed hands at distressed prices because clients decided “they had all the fun they cared to have in structured credit.”
Instead, investors could be sitting in a safer tranche and have cash ready to swoop in later at a deep discount. “Why would you buy a bond like that at par if you think you’re going to go into a distressed environment?” he says.
U.S. Senator Warren’s concerns about leveraged loans and CLOs were addressed by bank regulators earlier this year.
Fed chair Powell, Office of the Comptroller of the Currency head Joseph Otting, and Federal Deposit Insurance Corp. chair Jelena McWilliams told the senator in a February letter that they were closely monitoring leveraged lending, including the fewer and less stringent covenants they’d observed.
“Although the supervised banks originate a majority of leveraged loans, a large percentage of leveraged loans are sold to investors outside the banking system,” Powell, Otting, and McWilliams said in the letter. “While these loan sales allow risks to be shared more broadly, we continue to evaluate whether some of that diversification is being diluted by banks increasing their exposure to collateralized loan obligations and other holding vehicles to which those loans are sold.”
Their written reply to Warren followed a January letter from SEC chair Jay Clayton, who acknowledged her concerns about leveraged lending separately. He said the SEC had been monitoring the market, including CLOs, “with increased attention” since mid-2018. SEC staff was aware of rising debt at companies relative to their earnings, he said, and had seen a decrease in the “average rating of the subordinated tranches of CLOs in each of the past two years.”
While investing in credit outside the purview of bank supervisors is commonly known as shadow banking, the term is not always appreciated.
“We’re not that shadowy,” says Insull. “We wear suits and we’re readily visible during the daytime.”
In the world of shadow banking, private equity firms are everywhere — and are fueling its boom.
They’ve been on a tear raising buyout funds that purchase companies small and large, relying on nonbank lenders to finance their deals. They turn to direct lending funds for acquisitions in the midmarket, and for larger deals, ask CLOs and other investors for deal financing.
They also sit on the other side of the table, creating CLOs and powering the private credit boom with their own direct lending funds. For example, Carlyle Group announced this month that it closed a $2.4 billion fund that will provide direct loans to upper-midmarket borrowers, including companies that are not backed by private equity firms. With leverage, Carlyle Credit Opportunities Fund can invest as much as $3.1 billion, the firm said.
Many of the same concerns about loose lending standards in the broadly syndicated leveraged loan market — where Wall Street banks arrange and sell the debt to investors — have shown up in the smaller, but expanding, universe of direct lending funds in the midmarket, often backing private equity deals. Lenders are vigilant but can’t escape the forces of supply and demand that may lead to terms favoring borrowers, according to David Lyon, co-head of private credit at Neuberger Berman.
That may mean lower interest rates as well as weaker lender protections. Lyon is paying close attention to covenants that govern how much flexibility a private equity firm may have to take cash out of a company, a borrower’s ability to incur additional debt, and the ability to remove collateral from deals. “Those are bright lines,” he says.
Yet for all the worries about shadow banking, the expansion of private debt funds may actually help provide a cushion in a downturn, according to Brady of Paul Hastings.
As capital becomes harder for borrowers to access because banks are pulling back from lending in volatile markets, managers of private debt funds may show up. “I think the biggest difference between whenever the next recession hits and the last recession is all that dry powder sitting on the sidelines,” he says. It may be “a softer landing.”
But some funds are avoiding midmarket buyout loans on purpose.
In a crowded market of direct lending funds focused on private equity firms, J.P. Morgan Asset Management and UBS O’Connor, to name two, are searching elsewhere for opportunities.
J.P. Morgan’s Pil prefers lending against real assets, while UBS’s Wasson and Trelles say they’re using their broad, flexible mandate to focus on asset-based finance involving loans with hard and financial assets as collateral. Within that area, the O’Connor Capital Solutions co-heads are finding another way to keep out of trouble: They’re providing short-term loans.
“We are late in the credit cycle and we manage the risk accordingly,” says Trelles. “We don’t know when this is going to turn, so we want to make sure our loans get repaid soon enough.”