By Sebastien Canderle, a consultant, a university lecturer in private equity, and the author of Private Equity’s Public Distress
As regulators have sought to curb bank instability, in many cases, the result hasn’t been risk reduction, but merely the transfer of the same risks to different players. Increasingly, the new risk takers are investors. One place this has occurred on a large scale, yet gotten very little notice, is how private equity funds, whose business model depends on high levels of borrowing, have gone into the shadow banking business to supplant banks as their debt suppliers.
A combination of regulatory intervention and residual memory of the 2007-2008 buyout frenzy has restrained some of the worst behavior. The Volcker Rule forced the banks that were active in private equity to shed most of these assets. Globally, annual buyout fundraising amounts remain a quarter below their peaks of 2007 and 2008. In Europe the total value of buyout transactions in 2015, although up a quarter on prior year according to the Centre for Management Buyout Research, was still half that recorded in 2007. Extreme behaviours such as quick flips and repeat dividend recaps have been partly curtailed by the European Union’s Alternative Investment Fund Managers Directive. US bank regulators have guidelines for banks to limit leverage assigned to LBOs to 6 times EBITDA. And the worst performing fund managers have been shunned by LPs – natural selection has operated as intended by preventing incompetent managers from gorging themselves on fees for another ten-year vintage. No doubt it will take a little while for these zombie funds to disappear, but if LPs remain disciplined and strong-willed, disappear they shall.
Yet a new source of risk, that of PE groups “diversifying” their fee-earning activities by building private debt businesses, is now almost entirely outside regulatory reach. Whilst several of these investors had arguably been very active on the credit side for years and can claim real expertise, others piled on opportunistically as their levered portfolio companies were in dire need of balance-sheet restructuring. And frankly the initial nibbling quickly turned into a feast, so discounted were some of these companies’ LBO loans. In 2009 and 2010, a vast array of mega-buyout debt tranches were trading well below par, with high-profile transactions like Caesars and TXU seeing their unsecured loans hit 20 cents on the dollar or less. It was too tempting an occasion for some PE groups to resist.
While Regulators Put PE Lending’s Jack-in-the-Box Back Inside, Private Credit Funds Popped Out
The cruel irony for traditional lenders, in particular commercial banks, is that while they were being subjected to a long list of restrictions, a new breed of investors invaded their market. Because of the light-touch regulation that most alternative investment groups enjoy, private debt managers were quick to fill the gap left by conventional banks. The latter incurred $235 billion in regulatory fines between 2008 and mid-2015.
By contrast, undeterred by a few slap-on-the-wrist fines related to fee-overcharging and alleged collusion, the largest PE groups have continued to expand at a very fast pace. Between 2008 and 2015 Blackstone grew assets under management more than sixfold to $330 billion. Carlyle, KKR and Apollo have not been left far behind with annual growth rates of 11%, 12% and 20% respectively over the same period. When one digs a bit deeper, a few facts jump up immediately.
The share of the big private equity groups’ assets under management represented by lending activity has gone up dramatically. At Apollo, credit products went from 25% of assets under management (”AUM”) in 2007 to 68% in 2014. At Blackstone, they went from 12% to 25%, and at KKR from 17% to 26%.
So whereas private equity activity has experienced, at best, low single-digit growth (in some instances LBO funds have in fact shrunk in size), these fund managers have morphed into lenders, expanding their credit businesses at a pace of 20% to 40% per annum between 2007 and 2014. Other top tier firms like Bain Capital and TPG in the US or CVC, 3i and Permira in Europe have tagged along for the ride.
Indeed, it looks like credit fund managers are behind the recent surge in EBITDA multiples, which now exceed the peak of the last cycle. Buyout lenders have started to be more generous and to exceed the bank regulators’ leverage guidelines. Anecdotal evidence suggests that on some US buyouts, up to 90% of debt holders are credit and collateralized loan obligation fund managers. In Europe, they account for 40% to 60% of lender groups depending on the deal size. In other words, conventional leveraged lenders are being squeezed out of LBOs.
Not only have are credit fund not subject to the EBITDA multiple guidelines that constrain banks, but they also seem to have provoked the return of one of the main controversial products released during the last bubble. Covenant-lite debt products are indeed back with a vengeance eight years after creating havoc. Many banks, including the Royal Bank of Scotland, the world’s largest bank by total assets in 2008, are still dealing with their bloated, uncovenanted LBO loan portfolio dating from the mid-noughties. As for investee companies, several like the aforementioned Caesars and TXU are yet to emerge from bankruptcy or to shake off the debt straightjacket embraced pre-credit crunch. Presumably credit fund managers believe that they can do a better job when the next financial crisis hits.
Yet many of these private equity experts are new to the world of lending. They might feel that moving from one side of the capital structure to the other is a no brainer, but it raises a few issues.
Systemic Risk, Transparency, Conflicts of Interest and Collusion
Most industry insiders consider that it is a good thing that the LBO loan markets are not so dependent on a handful of ‘too-big-to-fail’ banks. It should in principle reduce the risk of systemic contagion. But it is worth being cautious.
Replacing a few giant banks with a small group of large fund managers does not reduce the overall risk – it simply moves it further away from the public eye. Although credit fund managers used to account for a small part of LBO loan issues and of the segment’s total capital base, their share is growing quickly. According to research firm Preqin, total dry powder of these debt managers has risen by 85 per cent between 2007 and mid-2015 while total assets under management of private credit funds have practically doubled to $500 billion over that period. During that time banks have been asked to buff up their equity base, and one way to do that was to stop lending, so their LBO loan portfolios have shrunk.
But the gain in market share by fund managers is even greater than the Preqin numbers let out. The credit-related AUMs of the seven largest listed alternative investment groups, namely Apollo ($110 billion in debt products), Ares ($75 billion), Blackstone ($80 billion-plus), Carlyle ($25 billion), Fortress ($17.5 billion), KKR ($20 billion) and Oaktree ($80 billion-plus) have an aggregated value of $400 billion.
Once unlisted providers like Bain Capital ($25 billion managed by Sankaty, Bain’s credit unit) and CVC Credit ($13.6 billion in 2015) are added to the mix, the amount of capital managed by traditional PE firms in LBO debt significantly exceeds $500 billion – presumably because Preqin only tallies loans to privately-held businesses whereas alternative investment groups also provide loans to publicly-quoted corporations. The size of the private equity lending segment is clearly a lot bigger if LBO loans held by hedge funds/credit specialists like Paulson, Highbridge, Golub, Centerbridge, etc. are included.
This difficulty of properly sizing this new private debt market is likely to lead to further loss of faith in our dear capitalist system, in no small part due to the lack of transparency of these shadow-lending activities. For such a fast-growing portion of risky credit assets to be left out of the realm of proper regulation is inviting potential trouble further down the line. Just like the real impact of the credit crunch was caused by the numerous CLOs and off-balance sheet special purpose vehicles established by banks during the bubble years, the current growth in this largely-off-the-radar lending activity is far from a safe development for the debt markets.
Even though the biggest managers of private equity credit funds are publicly listed, there is little information on the debt multiples their funds grant to portfolio companies. Without setting proper leverage restrictions, this new generation of lenders is likely to replicate the mistakes perpetrated by bankers only a decade ago. To reiterate the point, it does not feel like replacing banks with fund managers will lower risk.
In addition, we can expect increasing conflicts of interest. With private equity groups now also LBO lenders, what happens when one of them takes equity and debt positions in the same company? Suddenly the investment team of the debt fund might wish the business to default in order to take ownership of it while the investment team on the equity side will be rooting for the opposite result. Whose interests will the fund manager choose to serve? The interest of LPs invested in its PE fund or that of LPs committed to the PD fund?
The clearest conflict has already manifested itself and is of huge benefit to the PE groups that operate in-house debt funds: by using their private debt arms, buyout groups are able to exert pricing pressure on all potential lenders. Conventional loan providers, such as banks and mezzanine funds, have no choice but to align their pricing (that is the margin they apply to their loans) if they want to be competitive with credit fund managers. Financial sponsors do not even have to use their own credit facilities to reduce the cost of debt. Just the threat that they might do so is enough to compel independent lenders to offer cheaper terms.
Another problem with acting both on the equity and the debt sides is that it makes self-dealing easy, particularly since there is no prohibition on insider trading in the credit business. Both shareholders and lenders might wish the portfolio company to remain alive as a zombie company in order to keep charging fees to the LPs. Another type of collusion that could occur is if one financial sponsor is a debt holder in the portfolio company controlled by a second financial sponsor, while the latter is a lender to a company owned by the former. Both could find it beneficial to conspire in order to maximise their interests even if their agreement is not in the interest of their LPs, co-investors or fellow debt holders, or even in the interest of the underlying investee companies.
As an aside, it is worth pointing out that it is the first time in the history of capitalism that equity holders willingly aim to also become debt holders, or conversely that lenders wish to be shareholders. This kind of hybrid strategy is not accidental, it is in fact central to the approach adopted by several alternative fund managers – one sign of this strategy’s influence is the growing importance of ‘loan-to-own’ investors. It is a development that might well redefine the way companies are managed. In the past, free-enterprise advocates had claimed that business owners came first and that the sole goal of any corporate manager was to serve the interests of shareholders. But if the aim is to maximise shareholder value, what happens when a key investor also happens to be your lender, even if only temporarily until the loans are swapped for equity?
If private equity groups continue to gain market share in the credit markets, and there is no reason to believe that they won’t, we can predict that capitalism is likely to become schizophrenic. The demarcation between equity and debt, the two traditional components of capital, has become blurred. Increasingly LBO fund managers are playing on both sides of the capital base. It is bound to create problems down the line and is partly why the Volcker rule was introduced in the US. It was not just to reduce the ‘too big to fail’ risk by hiving off casino banking from traditional commercial lending. It was also to remove apparent conflicts of interest. Why should we feel reassured now that this activity has moved to the under-regulated end of the financial sector? PD fund managers are unlikely to behave more responsibly than bankers did ten years ago.
Of course, we could always wait to see what comes out of this sudden surge of shadow lending before ‘overreacting’ and regulating for the sake of it. Historically, the financial services industry has demonstrated that it is not capable of self-regulating. So if you are a government official, legislator, watchdog or central banker, you can choose to let the rise of private debt run its course, or you can start taking a closer look straight away, before it all gets out of hand.