Ask these same people if they think commercial banks provide a necessary service to a modern economy, however, and you can expect a nod of agreement. It is well established among academics, policy makers and practitioners that the allocation of credit from savers to borrowers is an essential financial “plumbing”, directing capital to its best uses, and that regulated lenders (as well as functional capitals) exist to provide this service.
Since the 2008 financial crisis, a shift in the market architecture for credit allocation (particularly but not exclusively in the middle market) has occurred, with a considerable shift in market shares from traditional commercial banks to alternative lenders. This trend has further accelerated in the era of COVID-19. Preqin reported in February that fundraising for direct lending vehicles increased by 62% compared to January 2020; funds with direct lending investment mandates were targeting $150.3 billion in January, down from a January 2020 target of $93 billion.
Although these alternative lenders have increasingly supplanted banks as providers of direct credit to corporate borrowers, they differ from banks in several respects. While traditional commercial lenders must answer to various federal regulatory bodies, given the systemic risks their mismanagement can create, alternative lenders have virtually no such oversight. They also often contain incentive fee formulas that encourage reckless risk management and discourage investment in core business functions, including underwriting, portfolio management and restructuring (renegotiation of loan terms).
This nascent financial architecture remains largely untested in what has now been a decade-long credit bull market, one further extended by Federal Reserve interventions in the age of COVID. Given that credit is essential to a healthy market economy, how sustainable will this new architecture be?
Given the importance of efficient capital allocation in a market economy, it is imperative that the unrecognized risks associated with this emerging market structure be addressed before the next financial crisis. To do this, however, it is necessary to understand why direct lending stands out from other alternative asset classes and why a shift in credit supply from commercial banks to alternative lenders is important.
Private equity, real estate, and hedge fund managers have raised capital from limited partners on a lightly regulated basis with incentive fee structures for decades, and it’s hard to argue that these strategies have increased the degree systemic market risk. On the contrary, a more credible position is that the lighter regulation, more flexible mandates and financial alignment associated with these strategies have increased market efficiency and reduced market volatility. The reason these strategies have not contributed significantly to an increase in systemic market risk is that a failed investment thesis expressed by these vehicles internalizes losses and properly aligns manager incentive compensation with financial return. . In periods of excessive stock market exuberance and subsequent correction, government intervention in markets is usually more theorized than manifested, and there are few examples in the modern era of government socializing market losses. scholarship holders.
In contrast, direct lending only began its rapid rise in the 2000s, which accelerated after the 2008 financial crisis. Direct lending funds have similar compensation structures to private equity funds and hedge funds (despite lower gross returns on investments, returns at the fund level are magnified by leverage). The importation of these fund structures into direct lending is not surprising given that many of the sponsors of these funds are the same general partners who manage the equity strategies. The limited regulation, use of leverage, and functional underinvestment noted earlier allow generalists of these alternative lending funds to earn economic carryover interest comparable to that earned by private equity managers and hedge funds.
Despite similar fund structures, there is a significant difference between equity and debt investments related to systemic risk and the impact of a market failure on market participants and the taxpayer. While incentive fee structures can lead to imprudent equity investments, speculation only has an indirect impact on the real economy. The economic incentives of swing for the fences equity fund strategies do not involve moral hazard, as market losses are neither guaranteed nor socialized. Lending strategies, however, present a very real risk of such moral hazard. When the modus operandi of a private banking system deviates from its utility function, the risk of future socialization of losses in the credit market increases significantly. Interventions associated with the 2008 financial crisis are just one example of government actions taken to keep capital markets functioning.
Credit market failures can create (or contribute to) economic crises, the costs of which are borne by the taxpayer. Credit, by definition, has an asymmetric risk profile (declining total loss of principal, and “rising” modest interest rate and yield on principal); therefore, credit-related losses are difficult to recover organically in times of market recovery. This inability to self-repair, together with the essential nature of credit intermediation – particularly critical during periods of market instability, as seen during COVID-19 – necessitate public intervention when markets fail.
Unfortunately, current policy is not intended to mitigate the future cost of market failures. The relaxation of business development corporation (BDC) leverage limits, limited regulation, underinvestment in portfolio management, and favorable tax treatment of deferred interest compensation all remain inconsistent with the monitoring required to ensure the sustainability of alternative lenders throughout the credit cycle.
Additionally, while no Bernie Madoff-sized fraud has been uncovered in the area of direct lending, disclosure by public vehicles remains an issue, particularly with respect to the “branding” (valuation) of illiquid credits, misleading information about portfolio composition and investment structure, and obfuscation of what constitutes recurring items. The simplest solution would be to regulate alternative lenders like banks. To do so would be to recognize that a shadow banking system is still a banking system. Regulations have a purpose and should be applied consistently to institutions with a similar mandate.
That said, there are strong arguments in favor of alternative lenders operating under a separate regulatory regime from that of deposit-taking institutions. While credit intermediation is a utility function, depositor protection is a distinct policy priority and deserves greater regulatory attention. However, loan-specific regulation – leverage guidelines, asset categorization, reserve and infrastructure requirements, public disclosure, etc. – must be applied consistently. Within a coherent lending regulatory regime, there is still room to encourage innovation while avoiding incubating future systemic risks, such as with the regulation of systemically important financial institutions or “SIFIs” .
Market risks do not exist in a vacuum, but in a particular historical context. Fiercely anti-market voices have gained traction in developed market capitals around the world and in the culture at large. While alternative lending has a legitimate role to play in a healthy market economy – as pure lending vehicles, with reasonably transparent risk/return profiles and a degree of creativity not typically seen in commercial lenders – the utility function of lending poorly maps to “venture capital” vehicles due to the inevitability of loss socialization.
Fortunately, the alternative lending industry has yet to experience the Lehman Brothers moment, given its relative infancy compared to other financial platforms. Given its rapid growth, however, the industry faces a clear choice: prudential self-regulation now, or more invasive “reform” later.
Richard J. Shinder is the founder and managing partner of Theatine Partners, a financial advisory firm. He is based in Greenwich, Conn. This content represents the views of the author. It has been submitted and edited in accordance with Pensions & Investments guidelines but is not a product of the P&I editorial team.