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Non-bank lenders thrive in the shadows

When the dotcom bubble burst, Chuck Doyle smelt an opportunity — arranging loans for companies shunned by big banks and too small to tap the bond market. It proved very fertile ground.

His company, San Francisco-based Business Capital, says it has since helped hundreds of smaller companies raise money to keep afloat, finance their inventory or expand. But Mr Doyle, an avuncular former fibre-optic salesman, says conditions in the non-bank, non-bond “private debt” market have never been more frenzied.

“We’ve been through a few cycles, but this one is crazy,” he says. “We’ve seen unbelievably explosive growth. We’ve seen deals that banks wouldn’t have done even before the financial crisis.”

The post-crisis explosion of the US corporate bond market, and more recently the leveraged loans industry, have hogged the attention of analysts, investors and regulators. But it is arguably the underbelly of the American debt market that has seen most change in recent years.

“It’s a wild west space, where everyone competes for every deal,” says Oleg Melentyev, head of high-yield credit strategy at Bank of America Merrill Lynch. “The whole thing has exploded in size, and everyone is getting into it.”

There is no clear definition for so-called private debt, which is often also called direct lending or mid-market lending. It broadly consists of bespoke loans made by specialised lenders such as fund managers, insurers and tax-advantaged vehicles known as “business development companies.”

Borrowers can range from sizeable international groups to small companies seeking money for a new store — or just a shot of cash to keep trading for another quarter. Unlike leveraged loans, private debt is typically not widely traded, and unlike bonds, the market is largely unregulated and opaque.

The US market has swelled from about $300bn in 2010 to about $700bn by the end of last year, according to Bank of America, as pension funds, insurers and even sovereign wealth funds have sprayed money at the asset class. Last year fundraising topped $100bn for the fourth consecutive year, according to Preqin.

Demand has two main drivers: the falling returns on offer from more mainstream parts of the debt market, and the desire to diversify into new asset classes that are — in theory, at least — less correlated to the undulations of stocks and bonds. Institutional investors in private debt are in practice trading liquidity — the ability to move in and out of positions — for the prospect of juicier returns.

The Debt Machine

Lenders outside conventional banking are helping companies get further into debt. What will the consequences be as the economy tilts towards recession? This series will look at the following issues

Part One 
Leveraged loans: undermining financial stability?

Part Two 
Mapping the ecosystem

Part Three 
How investors are losing out

Part Four 
CLOs: the debt machine’s engine

Part Five
Leading small businesses into temptation 

Part Six 
The private debt flood

Part Seven 
The legal labyrinth of leveraged loans in Europe 

Private debt “can be a powerful diversifier,” says Maddi Dessner, a managing director at JPMorgan Asset Management. “We still think there are opportunities, with the right partner.”

However, the scale of the inflows is stirring concerns. Economic growth is slowing, and while the Federal Reserve may be sounding a more cautious note after December’s market ructions, most economists still reckon the central bank will raise interest rates further in 2019. The combination of a weaker economy and higher rates will test the corporate debt market, and some suspect that cracks will show first in private debt.

“Direct lending has been the strategy du jour — when we see stresses we’ll probably see it there first,” says Jim Smigiel, head of portfolio strategies group at SEI Investments, near Philadelphia. He doubts the market is extensive enough to cause systemic problems, but “a lot of people will lose a lot of money”, he predicts.

Private debt investors admit that the flood of money has dramatically eroded both standards and returns. KKR estimates that the average private debt yield has now fallen to about 6-8 per cent, down from the low teens a few years ago. That is only slightly higher than in the mainstream junk bond market, which is actively traded and far more transparent. 

“It puzzles me,” says the head of one credit hedge fund that has shunned private debt. “They’re lending to complete shit at a spread of 100-150 basis points above high yield.”

Even inside the industry there are concerns. Some say falling rates have spurred investors to borrow some of the money they deposit with private debt funds, in an attempt the juice the returns. One private debt fund executive, speaking on condition of anonymity, even sees similarities with the pre-crisis subprime mortgage market. 

While private debt does not typically have the low “teaser” rates and brutal re-setting that proved so damaging, many borrowers might never be able to repay lenders at the end of a loan. That means the market is dependent on a constant influx of fresh money to allow borrowers to refinance, he says.

Tuesday, 22 January, 2019

“There are a lot of parallels with the subprime crisis,” he concedes. “As long as [companies] can keep refinancing things are fine. But if there are redemptions then it means some people won’t get a seat on the musical chair. Someone will be crying.”

Mr Doyle says that lending standards have improved a little, after the market ructions of December and rising concerns that private debt has become too frothy. But he is also confident that the recent boom will at some point end in tears — especially in the shadiest “merchant cash advance” part of the market, where companies get a quick shot of money by selling their receivables at a discount. 

“MCAs are the crack cocaine of the credit market,” he says. “It’s going to get interesting, for sure.”

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