Rick Blumen outlines factors underlying the rise in alternative lenders in debt markets.
How have the debt capital markets performed in 2016? Do the forces of supply and demand currently favor lenders or borrowers?
The early part of 2016 was a period of turmoil and deterioration for most of the U.S. capital markets, including the loan market. At the end of the first quarter of 2016, investor sentiment began to shift away from concerns about slowing economic growth and monetary policy, and investor demand started to grow. Loan prices were rising, and investors were hunting for yield in a loan market that, at times, lacked adequate supply to meet investor demand. With the supply and demand pendulum swinging in the other direction, borrowers began to have the upper hand. As a result, borrower repricings became more frequent and other borrower-favorable terms were augmented in the leveraged loan market.
Suffice it to say, the current environment for leveraged lending is a fairly competitive one. Between traditional and nontraditional lenders, the current sources of debt capital for properly structured transactions are plentiful. Providers of debt capital are competing rather fiercely for loan assets.
What led to the increase in alternative or direct lenders?
In 2013, certain federal regulatory agencies promulgated what is known as the “Leveraged Lending Guidelines” to address (and curtail) leveraged lending practices of banks. The guidelines target underwriting standards for below-investment-grade loans (called leveraged loans) to prevent banks from taking on excessive risk. Among other criteria, the guidelines look at total leverage levels to determine which loans are leveraged loans. If leverage for an acquisition transaction, for example, results in a total leverage ratio greater than 6:1 (total debt to EBITDA), a red flag goes up in terms of the regulatory scrutiny. While a 6x total leverage ratio is not necessarily a bright-line test, it has had the effect of limiting leverage levels that banks will underwrite.
Non-bank financial institutions, business development corporations and loan funds are not subject to the guidelines. Because they are not constrained by the guidelines, these unregulated lenders have become a new source of debt capital, particularly in middle market lending, for the more risky loans. Capital continues to flow into these vehicles given the attractive yields they can garner. Because the alternative lenders can provide the leverage levels that many private equity firms desire and price the risk to generate healthy returns, alternative lenders have prospered. That’s why the percentage of loans originated in the leveraged lending space by non-bank competitors continues to grow.
What effect has the increase in alternative lenders had on the market?
Direct lending has benefited both investors searching for higher yields in the current low-interest-rate environment and private equity firms seeking to juice their returns by maximizing leverage levels. Highly leveraged acquisitions and dividend recaps have not disappeared. Instead, the sources of capital used to finance these transactions have shifted to unregulated lenders who are not constrained by the guidelines. While banks are losing market share to direct lenders in the middle market, the corresponding default risk for the more leveraged transactions has shifted away from bank depositors to investors in these alternative lending sources.