Back on November 16, 2017, Goldman outlined their “top ten themes” for the coming year.
Number 10 on that list was “Illiquidity Is the New Leverage”. The bank’s point was simple: Having learned a lesson from the crisis, market participants have eschewed levered exposure to compressed risk premia in favor of “leaning harder into liquidity premium”. There is, Goldman warned, voracious demand for “anything without a Cusip”.
Smart people can argue about whether investors have indeed avoided employing leverage in order to squeeze out yield in a world where there is no conceptual difference between trades. It’s all one trade, and each option is distinguished only by the amount of carry on offer. What isn’t debatable, though, is that the QE-inspired global hunt for yield has forced investors into less liquid assets.
When you dump trillions in liquidity at the top of the quality ladder, it forces everyone down that ladder and out the risk curve. Eventually, everything becomes priced to perfection. Invariably, the chase leads folks into less liquid assets.
This isn’t confined to the “smart” money. Retail investors have been similarly herded into corners of the market where they might not otherwise have ventured thanks to, for instance, high yield and emerging market debt ETFs. Those vehicles mask an underlying liquidity mismatch. Proponents will tell you the “miracle” of the creation/destruction process and the AP middleman mitigates that mismatch, but the inescapable reality is that those vehicles offer intraday liquidity against a pool of inherently illiquid underlying assets. It is not a matter of whether that could snap (it can), rather, it’s a matter of whether a fire sale acute enough to break the model will materialize.
Before I get off on a tangent, let me steer this discussion back onto the highway and off the ETF debate rumble strips. In the same note cited above, Goldman wrote the following about the type of assets that have benefited from investors chasing illiquid assets:
Examples include private equity, private debt, direct lending, and commercial real estate (CRE), among others. The compensation for owning illiquid assets has consequently compressed.
With that in mind, consider the following chart from a BofAML note dated October 12:
As you can see, that’s an estimate of the private lending market and growth in the post-crisis era is, well, extraordinary.
What exactly does that encompass?, you might fairly ask. BofAML is happy to tell you.
“We define this market as the segment of total US non-financial debt space that is neither in a form of bonds, or bank-held-loans, or broadly syndicated leveraged loans”, the bank writes, adding that their estimate is derived using the Fed’s Flow of Funds which allows for the estimation of the market by essentially taking all US non-financial business credit and netting out bank loans, HY and IG bonds, commercial paper, and broadly syndicated loans.
If you’re wondering whether growth in the private debt market is the product of the hunt for yield and also indicative of banks being reluctant to engage for fear of running afoul of the post crisis regulatory regime, the answer is “yes.”
“This sector has experienced significant growth in recent years, driven by several factors, including changing regulatory environment for banks and broker-dealers, monetary policies leading to shortage of yield opportunities, and the savings glut driven by changes in global economic balance and demographics”, BofAML says, on the way to pseudo-lamenting the fact that “capital markets have responded in a predictable way, by creating a new class of investors/vehicles, less constrained by regulatory hurdles and designed to take advantage of banks’ retreat.”
There you go. This means that anyone who wants to speculate (because that’s what this is, speculation) by throwing money at this market is doing so away from the Street’s balance sheet.
So who, exactly, are the lenders here? They are, basically, institutional funds and “separate account managers”. Here’s a fun table and I guess what I would note is that the private debt space is now disconcertingly large compared to high yield and leveraged loans:
Given that this is a “hot” market (as BofAML puts it), it goes without saying that not everyone involved is what one might call a “name brand.” Here’s BofAML:
A new industry of alternative investment managers has emerged to participate in direct lending. Prequin estimates the number at 322 funds, roughly a quarter of which debuted in the last five years. While early entrants in this space are represented by veteran institutions such as Ares, Golub, Oaktree, Apollo, Blackstone and others, the number of new participants raises questions around their experience, ability to attract capital and build necessary analytical infrastructure.
Why, yes – yes, that does “raise questions”, doesn’t it?
BofAML goes on to note that private debt has experienced more rapid growth than other segments of the U.S. corporate credit market, no trivial feat in a world where corporate management teams have taken advantage of low rates to lever up.
Of course Wall Street isn’t just content to sit idly by while a handful of PEs and a hodgepodge of nobodies eats their lunch in a red hot market.
“Banks, feeling the pressure from a new competitor on their historical turf are also getting more aggressive in defending their lending business, offering competitive lending solutions to issuers who would otherwise borrow from direct lenders”, BofAML goes on to say, before noting the obvious which is that “these competitive pressures lead to more aggressive deal structures and pricing.”
One thing worth mentioning is that some of what makes this market sound dangerous might actually insulate it from problems. For instance, these are obviously smaller deals, which means ownership is concentrated. When one investor owns the whole shebang, that investor is free to be pretty demanding when it comes to covenants and protections. According to admittedly “anecdotal” evidence, BofAML says covenants are a bit stronger compared to the leveraged loan market.
But all “mitigating” factors aside, the bottom line from a liquidity perspective is that in a pinch, there won’t be any – liquidity that is. Here is the best line from BofAML’s lengthy analysis:
Secondary trading liquidity of private and middle-market debt is meaningfully more constrained given their private nature and small size even under normal volatility circumstances. For all practical purposes, such liquidity should be expected to evaporate entirely in a stressed market environment, unless price discounts get deep enough to capture the attention of distressed community.
That’s intuitive and again, the irony is that because lenders know there will be no buyers for these deals in a fire sale environment, they (the lenders) are likely to be more careful in terms of demanding high quality standards. Then again, the hotter the market, the lower those standards, because you can’t very well compete for business when you’re being stringent and everybody else is giving away free money.
In any event, this is what Goldman meant nearly a year ago when they suggested that “liquidity is the new leverage”.
You can take all of the above for what it’s worth, but I would encourage you to consider it in conjunction with what we know about the proliferation of cov-lite deals in the leveraged loan market.