The size of the leveraged loan market doubles in ten years, private credit explodes

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

It was December 2010, in the aftermath of the financial crisis, when the US government was forced to approve a $700 billion bailout designed to stave off the collapse of the country’s financial system. The 2008 crisis may have been the first time many American households heard of leveraged loans for businesses that take on large amounts of debt. And households did so amid the chaos and worry of a long, deep recession that many believed the obscure and little-known loan product was partly responsible for.

The loan market, which provides financing to US businesses and pays investors an interest rate tied to the London Interbank Offered Rate for the privilege of borrowing, was just $497.5 billion in December 2010. 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 has more than doubled to $1.2 billion. Loans rose, 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 significant phenomenon,” said Jonathan Insull, managing director of Crescent Capital Group, which oversees more than $26 billion in assets.

A decade of low interest rates that injected the financial system with much-needed post-crisis liquidity has allowed corporate America to binge on cheap loans. Loan exchanges have become faster and the secondary market, where bankers and investors exchange loans like stocks or bonds, has deepened. Transaction sizes have increased as lending has evolved into a mature asset class.

Leveraged 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, lured by the leverage on offer, tapped into the loan market to fund buyouts – and cash out soon after. Idiosyncratic terms like covenant-lite have become standard in the institutional market, along with sponsors massaging debt to earnings before interest, tax, depreciation, and amortization (Ebitda) levels, through add-ons, which reduce leverage through expected synergies or future cost savings. And companies such as 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 has led to heightened scrutiny as regulators, fearing another downturn, have tried to clamp 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 Collateralized Loan Obligation (CLO) managers to retain 5% of their funds, or having “skin in the game”.

The Volcker Rule, best known for its ban on prop trading, prohibited banks from investing in CLOs holding bonds, leading funds to buy only loans or lose significant investors. Leveraged lending guidelines from the Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corp, which were updated in 2013, limited leverage limits in buyouts and encouraged rapid debt repayments.

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

BIGGEST LOAN BUYERS

The explosion of leveraged loans that took place this decade would not have been possible without the appetite of CLOs, the biggest buyer of leveraged loans.

After being compared to Collateralized Debt Obligations (CDOs), which gained significant notoriety – a bad reputation – due to the defaulting mortgages they held, which led to the financial crisis, the issuance of CLOs is stopped.

As the narrative changed and the public became better educated on the differences between the two markets, CLO shows skyrocketed. The asset class rose 144% from the start of 2013 to the end of November, according to data from LPC Collateral.

Issuance of US CLOs continued at a healthy pace in 2019 after a record year in 2018. According to the data, more than US$114 billion of US CLOs were arranged this year, up to December 18.

“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 issuance that drove 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 was a decline in lending by some of the largest banks, which pushed the most aggressive funding to non-guideline institutions, and the private debt lending system was created.

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

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

This move was made possible by a wave of institutional capital flowing into alternative investments in a global hunt for yield.

“Negative interest rates have created an environment where investors have had to go deeper into the spectrum of risk,” said Elaine Stokes, portfolio manager at Loomis Sayles. “All over the world, this is challenging investors when looking for (investment) returns.”

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 have taken advantage of this and raised record capital, giving them the firepower to compete with traditional banks one-on-one for deals.

“Shadow banks, or unregulated financiers, can be more creative and take on more risk (than banks),” said Todd Koretzky, partner at law firm Allen & Overy. “It’s a lower risk proposition for a borrower because it locks in a relationship through a club.”

Driven by interest from private equity funds and by emphasizing the middle market, which was largely ignored by financial institutions, private credit flourished.

“The mid-market space has been flooded with a number of new lenders and new direct lenders as well as regular asset managers who have been active for a number of years,” said Art de Pena, head of loan syndications. and distribution at MUFG. “As they grew 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 for them, they say, “Let’s go straight to it.” Direct loans have therefore become really fashionable.

FULL CIRCLE

This year has seen a wave of unitranche units over US$1 billion taken up by the biggest players in the private credit industry, a milestone first achieved in 2016 when Ares led a US$1 billion financing. US dollars for the takeover of Qlik Technologies by private equity firm Thoma Bravo.

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

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 are backed by large financial institutions and pension funds.

Private credit funds come from a range of constituencies. Some were born in 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 built on credit.

Antares Capital, a unit of GE Capital that dominated the non-bank lending market during 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 of the middle market, are owned by investment firms Nuveen and Angelo Gordon.

Most private credit funds also manage public and private business development companies to provide funds for loans and to raise funds from retail investors.

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

As private credit continues to dominate the discussion, the biggest investment banks have benefited from President Trump’s pro-business policies, pushing them back to the top of the rankings and coming full circle in the lending market over the past decade.

Priscilla C. Carnegie