Leverage loan market size doubles in ten years, private credit explodes

NEW YORK, December 23 (LPC) – What a difference 10 years makes.

It was in December 2010, in the aftermath of the financial crisis, when the US government was forced to approve a $ 700 billion bailout designed to prevent the collapse of the country’s financial system. The 2008 crisis may have been the first time many American households learned of the existence of leveraged loans for companies that are taking on significant debt. And households did so amid the chaos and worry of a long, deep recession for which many believed the obscure and little-known loan product was in part to blame.

The loan market, which provides finance to US businesses and pays investors an interest rate tied to the London Interbank Offered Rate for the Privilege of Borrowing, was only $ 497.5 billion in December 2010. The Bids Lending averages rebounded from a low of 62.8 during the financial crisis but were still sitting at 96.61.

Fast forward to December 2019 and the size of the leveraged loan market more than doubled to $ 1.2 billion. Lending rallied, pushing prices to an average of 98.95 cents on the dollar, the highest level since October 2018.

“The growth of the loan market has been a big phenomenon,” said Jonathan Insull, managing director of Crescent Capital Group, which oversees more than $ 26 billion in assets.

Ten years of low interest rates that injected the financial system with much-needed liquidity after the crisis have allowed US businesses to gorge themselves on cheap loans. Loan exchanges have gotten faster and the secondary market, where bankers and investors trade pieces of loans like stocks or bonds, has deepened. The size of transactions has grown as lending has become a mature asset class.

Leverage loans have returned 7% this year, according to data from Refinitiv LPC. High yield bonds, meanwhile, returned less than 14%, according to the ICE BofAML US High Yield Index.

Lender protections eroded as private equity sponsors, attracted by the leverage offered, exploited the loan market to fund buybacks – and cash out soon after. Idiosyncratic terms like covenant-lite have become the norm in the institutional market, as have sponsors massaging the debt to earnings ratio before interest, taxes, depreciation and amortization levels (EBITDA), through additions, which reduce the leverage effect through expected synergies or cost savings in the future. And companies like Neiman Marcus and PetSmart have created unrestricted subsidiaries in an effort to protect their most valuable assets from creditors.

The explosive growth and notoriety of the market prompted increased scrutiny as regulators, fearing a further downturn, tried to crack down on the excesses.

“The benefits have been greater liquidity and a larger asset class,” Insull said. Over the past 10 years, loans have become more common. It also attracted more attention.

The 2010 Dodd-Frank Bill, which was signed by President Barack Obama, prohibited banks from speculating with their own money and required guaranteed loan bond (CLO) managers to keep 5% of their funds, or to have the “skin in the game”.

The Volcker Rule, best known for its ban on prop trading, banned banks from investing in CLOs that hold bonds, which resulted in funds buying only loans or losing large investors. Leveraged lending guidelines from the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp, which were updated in 2013, limited debt limits in redemptions and encouraged redemptions. rapid debt repayments.

But even a stricter regulatory environment could not slow the growth of leveraged loans.

LARGEST LOAN BUYERS

The explosion of leveraged loans that has taken place this decade would not be possible without the appetite of CLOs, the biggest buyer of leveraged loans.

After being compared to Collateralized Debt Obligations (CDOs), which gained notoriety – a bad reputation – because of the defaulted mortgages they held, which led to the financial crisis, the issuance of CLO s ‘is stopped.

As the rhetoric changed and the public became more informed about the differences between the two markets, CLO’s show skyrocketed. The asset class grew 144% from early 2013 through late November, according to data from LPC Collateral.

U.S. CLO issuance continued at a steady pace in 2019 after a record year in 2018. There were more than US $ 114 billion of CLOs arranged this year, up to Dec. 18, according to the data.

“The obvious change is really the growth of the market for both CLOs and loans as they are interconnected, and in particular, the growth of the CLO market given its performance during the crisis and the resurgence of emissions that resulted which stimulated the market. “said Steven Oh, global head of credit and fixed income at PineBridge Investments, which oversees more than $ 96 billion in assets.

REGULATORY EFFECT

The result of the post-crisis regulatory crackdown has been a decline in lending from some of the largest banks, which has pushed the most aggressive funding to non-directive institutions, and the private debt lending system has collapsed. was created.

“The theme for 2019 was private debt,” Grant Moyer, head of leveraged capital markets, told reporters at a MUFG event on Tuesday. “The emergence or take-off – this was a slow build after the 2008 financial crisis… and really started to increase in 2014 and 2015, creating an opportunity for private debt markets to be more aggressive in facilitating debt. transmitters. “

Originally known as shadow banking, the private lending market is perhaps the most significant effect of new lending market regulations over the past 10 years.

This movement was fostered by a wave of institutional capital flowing into alternative investments in a global hunt for yield.

“Negative interest rates created an environment in which investors had to dig deeper into the risk spectrum,” said Elaine Stokes, portfolio manager at Loomis Sayles. “All over the world, this puts investors in difficulty when they are looking for returns (on investment).”

As a result, insurance companies and pension funds have turned to riskier investment strategies to earn higher returns and fill growing deficits. Private credit funds took advantage of this and raised record capital, allowing them to compete with traditional banks for transactions.

“Shadow banking, or unregulated finance, can be more creative and take more risk (than banks),” said Todd Koretzky, partner at the law firm Allen & Overy. “It is a lower risk proposition for a borrower, because he engages in a relationship through a club. “

Driven by interest from private equity funds and focused on the middle market, largely ignored by financial institutions, private credit flourished.

“The middle market space has been inundated with a number of new lenders and new direct lenders as well as regular asset managers who have been active for several years,” said Art de Pena, head of loan syndications. and distribution at MUFG. “As they increased their assets under management, they said, ‘Hey, how can I see more trades? And instead of waiting for Credit Suisse or RBS to come up with deals, they say, “Let’s go straight.” Direct loans have therefore become very fashionable.

FULL CIRCLE

This year has seen a surge of more than $ 1 billion in units underwritten by the biggest players in the private lending space, a milestone first taken in 2016 when Ares led a $ 1 billion financing. dollars for the takeover of Qlik Technologies by private equity firm Thoma Bravo.

Direct lenders “call the sponsors directly and they call the companies directly and they say we can take the distribution risk out by giving you immediate capital and we can hold that capital for the long term, so it’s a lot more attractive than take the risk of distributing in the market, ”said de Pena.

Over the past five years, private credit has become a mainstream asset class. Banks manage private credit funds through asset management services. Private equity firms operate credit shops and other companies have the backing of large financial institutions and pension funds.

Private credit funds come from a variety of constituencies. Some were born into the world of private equity by companies seeking to diversify their offer by managing private credit funds. These include KKR & Co, Carlyle Group, Bain Capital and Apollo Global Management. Some of the biggest players in the market, such as Ares Management Corp, Golub Capital, and Owl Rock Capital Group, were designed into credit.

Antares Capital, a unit of GE Capital that dominated the non-bank lending market in the first half of the decade, was sold to the Canada Pension Plan Investment Board in 2015. Twin Brook Capital Partners and Churchill Capital, two of the most active managers in the core mid-market, are owned by investment firms Nuveen and Angelo Gordon.

Most private credit funds also operate public and private enterprise development companies to provide finance for loans and to secure finance from retail investors.

While the institutional capital deployed in funds has fueled a structural realignment in the leveraged finance market, many market participants are tired that the private lending asset class has not been tested during a downturn. , which could, at best, lead to market consolidation.

As private credit continues to dominate the discussion, the largest investment banks have benefited from President Trump’s business-friendly policies, pushing them back to the top of the rankings and closing the loop in the loan market over the past decade. .

Priscilla C. Carnegie