NEW YORK, Dec 23 (LPC) - What a difference 10 years make.
It was December 2010, in the aftermath of the financial crisis when the US government was forced to approve a US$700bn rescue package slated to avert the collapse of the country’s financial system. The 2008 crisis was perhaps the first time many American households learned about leveraged loans for companies that take on significant amounts of debt. And households did so amid the chaos and worry of a long and deep recession for which many thought the obscure and little-known loan product was partially to blame.
The loan market, which provides funding for US corporates, and pays investors an interest rate tied to the London Interbank Offered Rate for the privilege of borrowing, was just US$497.5bn in size in December 2010. Average loan bids bounced back from a low of 62.8 during the financial crisis but were still sitting at 96.61.
Fast forward to December 2019 and the size of the leveraged loan market has more than doubled to US$1.2trn. Loans have rallied, pushing prices to an average 98.95 cents on the dollar, the highest level since October 2018.
“The growth in the loan market has been a big phenomenon,” said Jonathan Insull, a managing director at Crescent Capital Group, which oversees more than US$26bn in assets.
Ten years of low interest rates that injected the financial system with much needed liquidity after the crisis allowed US companies to binge on cheap loans. Loan trades became quicker, and the secondary market, where bankers and investors exchange pieces of loans like stocks or bonds, deepened. The size of the transactions got larger as loans evolved into a mature asset class.
Leveraged loans returned 7% this year, per Refinitiv LPC data. High-yield bonds, meanwhile, returned less than 14%, according to the ICE BofAML US High Yield index.
Lender protections eroded as private equity sponsors, attracted by the leverage on offer, tapped the loan market to fund buyouts –and cash out soon after. Idiosyncratic terms like covenant-lite became the norm in the institutional market, as well as sponsors massaging debt-to-earnings before interest, tax, depreciation and amortization levels (Ebitda), through add-backs, which lower leverage through expected synergies or future cost savings. And companies including Neiman Marcus and PetSmart created unrestricted subsidiaries in a bid to shield their most valuable assets from creditors.
The market’s explosive growth and notoriety resulted in increased oversight as regulators, wary of another downturn, tried to crack down on excesses.
“The benefits have been greater liquidity and a larger asset class,” Insull said.” In the last 10 years loans have become more mainstream. It has also attracted more attention.”
The 2010 Dodd-Frank bill, which was signed by President Barack Obama, banned banks from speculating with their own money and forced Collateralized Loan Obligation (CLO) managers to retain 5% of their funds, or have ‘skin in the game.’
The Volcker Rule, better known for its ban on prop trading, prohibited banks from investing in CLOs that own bonds, which led the funds to purchase loans only or lose important investors. Leveraged lending guidance from the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp, which was updated in 2013, curbed debt limits in buyouts and encouraged quick debt repayments.
But even a tougher regulatory environment couldn’t slow the growth of leveraged loans.
LARGEST BUYERS OF LOANS
The leveraged loan explosion that took place this decade would not be possible without the appetite from CLOs, the largest buyer of leveraged loans.
After being compared to Collateralized Debt Obligations (CDOs), which earned significant notoriety – a bad reputation – due to the defaulted mortgages they held, leading to the financial crisis, CLO issuance ground to a halt.
As the narrative changed and the public became better educated on differences between the two markets, CLO issuance soared. The asset class has grown 144% since the start of 2013 through the end of November, according to LPC Collateral data.
US CLO issuance continued at a strong pace in 2019 after a record 2018. There has been more than US$114bn US CLOs arranged this year, through December 18, according to the data.
“The obvious change is really the growth of the marketplace both for CLOs and loans, since they are interconnected, and in particular, the growth of the CLO market given how well it performed through the crisis and the ensuing resurgent issuance that has driven the market,” said Steven Oh, global head of credit and fixed income at PineBridge Investments, which oversees more than US$96bn in assets.
The result of the post-crisis regulatory crackdown was a pullback in lending by some of the largest banks, which pushed the more aggressive financings to institutions not subject to the guidance, and the private debt lending system was created.
“The theme for 2019 was private debt,” Grant Moyer, head of leveraged capital markets, told journalists at an MUFG event on Tuesday. “The emergence or takeoff – it’s been a slow build after the financial crisis in 2008 … and really started ramping in 2014 and 2015, creating an opportunity for private debt markets to be more aggressive in facilitating for issuers.”
Initially known as shadow banking, the private lending market is perhaps the most significant effect of the new regulations in the loan market in the last 10 years.
Enabling this movement was a wave of institutional capital pouring into alternative investments in a global hunt for yield.
“Negative interest rates created an environment where investors have had to reach further down the risk spectrum,” said Elaine Stokes, a portfolio manager at Loomis Sayles. “Around the world, this leaves investors challenged when looking for returns (on investment).”
As a result, insurance companies and pension funds turned to riskier investment strategies to obtain higher returns and plug growing deficits. Private credit funds benefited and raised record amounts of capital allowing them the firepower to compete head-to-head with traditional banks for deals.
“Shadow banking, or unregulated financiers, can be more creative and take more risk (than banks),” said Todd Koretzky, a partner at law firm Allen & Overy. “It’s a lower-risk proposition for a borrower as they lock in a relationship through a club.”
Driven by interest from private equity funds and with a focus on the middle market, which was largely being ignored by financial institutions, private credit flourished.
“The middle market space has been inundated with a number of new lenders and new direct lenders as well as regular asset managers that have been active for a number of years,” said Art de Pena, head of loan syndications and distribution at MUFG. “As they’ve grown their assets under management, they said, ‘Hey, how do I see more transactions?’ And instead of waiting for Credit Suisse or RBS to bring deals to them, they are saying, ‘Let’s go direct.’ So direct lending has become really in vogue.”
This year saw a wave of US$1bn-plus unitranches underwritten by the larger players in the private credit space, a milestone first hit in 2016 when Ares led a US$1bn financing for a buyout of Qlik Technologies by private equity firm Thoma Bravo.
Direct lenders “call the sponsors directly and they call corporates directly and they say we can take distribution risk off the table by giving you immediate capital and we can hold that capital for long term, so therefore it’s a lot more attractive than taking market distribution risk,” de Pena said.
In the last five years, private credit has become a mainstream asset class. Banks run private credit funds through asset management arms. Private equity firms operate credit shops and other firms have the backing of large financial institutions and pension funds.
Private credit funds come from a range of constituency. Some were born in the world of private equity by firms seeking to diversify their offering by managing private credit funds. These include KKR &Co, Carlyle Group, Bain Capital and Apollo Global Management. Some of the largest players in the market, such as Ares Management Corp, Golub Capital, and Owl Rock Capital Group, were conceived in credit.
Antares Capital, a unit of GE Capital that dominated the non-bank lending market in the first half of the decade, was sold to the Canada Pension Plan Investment Board in 2015. Twin Brook Capital Partners and Churchill Capital, two of the most active managers in the core middle market, are owned by investment firms Nuveen and Angelo Gordon.
Most private credit funds also manage public and private Business Development Companies to provide funding for loans and source funding from retail investors.
While institutional capital deployed in funds has fueled a structural realignment in the leveraged finance market, many market participants are weary the private credit asset class has not been tested through a downturn, which could, in the best case, cause the market to consolidate.
While private credit continues to dominate the discussion, the biggest investment banks have benefited from President Trump’s business-friendly policies, pushing them back to the top of the league tables and bringing the loan market full circle over the last decade.