The last time we checked in on the private debt market was October 15 – so, just when things were starting go awry for risk assets of all stripes.
At the time, BofAML had just released a pretty comprehensive note documenting the explosion of the market which had ballooned to somewhere between $400 and $700 billion. The high end of the range encompasses private, direct and middle market loans.
That is disconcertingly large if you think about it in the context of the high yield and leveraged loan markets (~$1.3 trillion and $1.2 trillion, respectively).
Growth in private debt has of course been driven by the hunt for yield and, relatedly, by investors leaning into the liquidity premium (the ubiquitous “anything without a Cusip” story). As demand grew, so too did competition and that naturally raised concerns about looser underwriting standards. Meanwhile, some worry that the post-crisis regulatory regime has indirectly made this space more dangerous. Here’s what BofAML wrote back in October, for instance:
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. 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.
These concerns were amplified late last year by generalized jitters about risky corners of the credit market, with an emphasis on IG’s “BBB problem” and, of course, leveraged loans.
Fears have abated in the new year as the risk-on mood catalyzed by the Fed’s dovish pivot sparked a rally in BBBs (which have now tightened for 12 consecutive sessions) and catalyzed a bounce in the leveraged loan benchmark which was in free fall for much of Q4.
With all of that as the context, Goldman is out with a pretty interesting piece (dated Thursday) on direct lending. Here’s the bank setting the stage by reiterating the points made above and explaining direct lending’s role in the private debt market:
Within the $8.8 trillion alternative asset universe lies the $700 billion private debt market, which includes a variety of investing strategies such as direct lending, distressed debt, mezzanine and ‘special situations’. This market’s strong growth since the financial crisis has established it as an important new asset class, attracting participation from a wide array of investors. At the same time, the market’s opaque nature and signs of heightened competition have fueled concerns about deteriorating credit quality. This is particularly true in the direct lending space, which currently holds the largest amount of capital available for deployment (across all private debt strategies).
The bank goes on to emphasize that growth in the market is driven by “search for yield motives” (on the supply side) and access to capital on the demand side. Competition, Goldman writes, “has become a key risk given the potential negative influence on underwriting standards and returns.”
In terms of AUM earmarked for investment in the private debt market, Goldman puts the figure at $110 billion for 2018, the fourth straight year of >$100 billion fund raising.
Out of that $110 billion, some $45 billion was set aside for deployment in direct lending, defined as “financing that is directly negotiated between a lender (typically an alternative asset manager) and a borrower (typically a small-to-mid sized company, with high-yield or no debt ratings).”
This is generally floating rate, secured debt and, as noted in the linked post above from October, is distinct from “normal” leveraged loan issuance in that it’s held by the lenders themselves (i.e., not by multiple investors).
One thing worth mentioning is that some of what makes this market sound dangerous might actually insulate it from problems. For instance, concentrated ownership likely means that whoever the investor is can be pretty demanding when it comes to covenants and protections. According to admittedly “anecdotal” evidence, BofAML said covenants are a bit stronger compared to the leveraged loan market.
Goldman goes on to note that AUM in direct lending has doubled over the past half decade to more than $250 billion through summer of last year. Brisk growth and late-cycle worries are a recipe for investor concerns, which accounts for heightened scrutiny of the market.
Getting back to investors leaning into the liquidity premium, regular readers might recall that we kicked off our October post on the private debt market by reminding you that on November 16, 2017, when 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 eschewed levered exposure to compressed risk premia in favor of “leaning harder into liquidity premium”. Well, in their Thursday note, Goldman explicitly ties that dynamic to private debt. To wit:
In the years following the financial crisis, investors allocated significant amounts of capital to direct lending funds, driven by strong ‘search for yield’ motives. The outstanding amount of leveraged fixed income structures such as CDOs and CLOs declined 43% from 2007 ($1.06 trillion) to 2013 ($599 billion). This was in stark contrast to the 88% and 102% growth in the size of the IG and HY corporate bond markets, respectively, over that same timeframe. This dynamic resulted in fewer higher-yielding opportunities for investors, which created a pathway for direct lending to grow. Simply put, the illiquidity of direct lending products became the new substitute for the leveraged structures which were popular, prior to the crisis.
Ok, so in terms of that liquidity premium, Goldman drives the point home by showing that the yield on the Cliffwater Direct Lending Index has averaged nearly 12% from early 2010 through September of last year, versus just 7.1% for HY and 5.4% for leveraged loans.
To the point about investor protections mentioned above, Goldman writes that investors aren’t sacrificing to get higher yields. “The percentage of direct loans in senior secured form has grown in recent years, as alternative asset managers have become more active in the space”, the bank says, adding that “for context, 63% of loans in the CDLI are now senior secured, compared to 38% at the end of 2009.” Obviously, higher yields and better protections create still more demand.
So, what are the risks? Well, again, competition is heating up. Goldman uses syndicated middle market leveraged loans to proxy for direct lending (as an asset class) and the spread between middle market loans and large corporate loans has tightened inside of 135bps, from as wide as 210bps in May of 2014. Given that there’s a ton of dry powder (see exhibit 2 above), you can expect competition to increase, driving spreads tighter still. Further, it’s entirely possible that the deregulation push brings in the big boys. To wit, from Goldman:
Additionally, we also see potential for heightened competition from banks, fueled by the prospect of some deregulation and banks’ appetite for new areas of growth, which will likely push banks to increase their middle-market lending capabilities. Some regional and global banks referenced expansion plans in middle market lending throughout 2017 and 2018. That said, banks’ participation in this area will likely increase gradually (over the next few years), given the time required to rebuild infrastructure and human expertise.
The other big risk is obviously opacity. Amusingly, Goldman notes that these deals are only marked-to-market “once per quarter” which might as well be “never” (I mean, a lot can happen in a quarter, just ask Q4 2018). The bank also flags deteriorating middle market leverage metrics (debt multiples), both in aggregate and relative to large corporates.
Ultimately (and this is a long note with a ton of nuance not captured in this post), Goldman doesn’t see scope for direct lending to be “the next subprime” (as the bank claims some commentators have suggested).
Simply put, the amplification channels that could transform the private debt market into a systemic issue simply aren’t present. “These include maturity mismatches in the funding structures and the ability to deploy significant financial leverage, both of which were key drivers of the 2008 credit crunch”, Goldman writes, before (again) noting that ownership concentration generally means stricter covenants.
Of course readers won’t be satisfied if this post ends with a benign assessment of the balance of risks, so in the interest of giving you what we know you want to hear, we’ll close with the following passage from Goldman which finds the bank admitting that because there’s no precedent, it’s hard to say for sure what would happen if the market were to collapse.
Given that the bulk of the growth in direct lending has taken place post-crisis, there is no precedent to gauge the magnitude and persistence of defaults and losses in a full-blown recession. Assumptions on long-term defaults and potential returns remain largely untested, while data on recovery values are too sparse to provide any reliable guidance on the forward distribution of losses. This lack of analytical tools, combined with the rapid growth and the relative opacity of direct loans, has fueled concerns over potential risks to financial stability and credit availability. Some commentators even go as far as making the parallel with the subprime residential mortgage debacle that sparked the global financial crisis in 2008.