Direct Lending: Exacerbating the Next Financial Crisis

Alternative Asset Managers Smell Opportunity

In the wake of the financial crisis, banks became more tightly regulated by external authorities. Regulators put controls in place to reduce the prospect of banks growing too big to fail and to help avoid another taxpayer funded bailout. Moreover, banks changed their own lending standards in an effort to reduce the financial risks they exposed themselves to. This risk aversion made it more difficult for a small or medium business to receive financing from banks.

Sensing opportunity, alternative asset managers like private equity firms and hedge funds filled this void. Companies with under $50-100 million in EBITDA now have loans directly underwritten by alternative asset managers. This direct lending strategy employed by alternative asset managers has become a booming market. While it’s difficult to assess the size of the market, fund managers raised $107 billion last year to invest in “private debt.” Unfortunately, there is more capital invested in the strategy than there are deals to deploy the investments to. This market dynamic is leading to fierce competition and relaxed underwriting standards.

Why Do Investors Like Direct Lending?

We’re finding ourselves nearing the end of the credit cycle. Interest rates are increasing at a steady pace, which pushes investors to search for “defensive” positions. The direct lending strategy is palatable because these loans have floating interest rates. As rates rise, investors get a more sizable return, assuming, of course, the borrower can continue to service its debt. The amount of debt small and medium businesses are burdened with, though, is incredibly concerning. These direct lending investments are illiquid for the term of the loan. In a private market, it’s difficult to assess the true fair value of a company, but easy to inflate it. These estimates are therefore incredibly subjective. High leverage ratios can be more easily justified, which enables alternative asset managers to magnify returns. This development is similar to the improperly rated mortgage securities that led to the previous financial crisis.

Business Development Companies: A Source of More Leverage

Private equity firms and hedge funds have been either partnering with or purchasing business development companies as a means of implementing their direct lending strategies. Business development companies, or BDCs, are publicly traded entities that invest in small, risky companies that cannot issue bonds or get financing from banks. BDCs themselves are highly leveraged (sometimes 2:1), which exposes all investors to great risk. The average returns of 13% have been quite handsome, but a house of cards has been erected. Unfortunately, the lesson in debt reduction we hoped both borrowers and lenders would learn as a result of the last financial crisis didn’t sink in.

A Race to the Bottom

Due to the high returns the direct lending strategy has gotten, alternative asset managers are having a difficult time deploying their capital. Direct lending deals are getting crowded, so, in order to win, many of the protections (covenants) investors expect as part of a deal are removed. “Cov-lite” deals allow borrowers to sell their assets in the event of a contraction, defer their scheduled interest payments, and other such activities. These cov-lite loans can prevent investors from recovering a large percentage of their investments.

What Will the Impact Be?

Direct lending will not be the cause of the next financial crisis, but the dynamic is indicative of our global economy’s obsession with debt. Highly leveraged borrowers will go bankrupt and employees will lose their jobs. Retail investors who have invested in BDCs will lose their money. The institutions investing in the direct lending strategy (pension funds, university endowments, retirement plans, sovereign wealth funds, etc.) will see their capital commitments disappear. The scale of corporate debt will reverberate throughout the market and further exacerbate the larger issue of government debt. I suggest you find means of preparing yourself for the inevitable crash we will see within the next 1-3 years. Reduce your exposure to the market and find safe haven investments, like gold.

Do you have thoughts on the direct lending market, or the next financial crisis? Contact me or leave a comment below.

 

 
Direct Lending Financial Crisis

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