Private debt strengthening hold in mid-tier segment as banks shy away

The global financial crisis in 2008 prompted the introduction of stricter regulations on banks to mitigate a potential risk to the financial system, leading to implementation of the Basel III standards.

The new norms, however, weakened the competitiveness and inclination of banks to provide loans to middle-market companies. This led to a significant shift in the market, with alternative financing options gaining popularity.

Private debt asset managers emerged to fill this void, creating a new asset class that has grown rapidly. Institutional investors have shown interest in this asset class due to its potential to generate high cash returns and its resilience during periods of market stress.

On their part, borrowers find private debt attractive because of attributes such as certainty of deal execution, flexible funding structure, and shorter timelines of deals to closure. In fact, they are willing to pay a premium for these benefits.

Private debt attributes borrowers find appealing

Thus, with favorable supply-and-demand dynamics, private debt has become the fastest-growing asset class over the past 12 years, with assets under management (AUM) clocking a compound annual growth rate of 14% between 2010 and 2022 to almost $1.5 trillion.

We believe private debt as an asset class is poised for further growth, driven by both structural and technical factors.

We take a close look at two such factors in this article.

Tightening regulations for regional banks

The recent failure of Silicon Valley Bank (SVB), a mid-sized bank in the US, has highlighted the issue of inadequate regulation of mid-sized (total assets of $100-250 billion) and small banks (total assets of <$100 billion), which are classified as Category III and IV banks, respectively, by the Federal Reserve based on their total assets.

The primary reason for SVB's failure was an asset-liability mismatch, with short-term assets (cash and equivalents) at ~$40 billion and deposits due within a year at ~$175 billion as of end-2022. The mismatch resulted from poor risk management and led to terminal issues for the bank when market sentiment deteriorated, and clients withdrew deposits.

For a large bank with similar interest rate risk exposure, a supervisory intervention would have been triggered. However, such rules do not apply to mid-sized and small banks, exposing them to greater risk.

In response to the collapse of SVB and another cryptocurrency lender, Signature Bank, the Federal Reserve is now considering increasing capital and liquidity requirements for Category III banks, which may include Category IV banks in future, to prevent similar incidents. The Federal Reserve has also announced that it will review its annual stress tests, which assess the lenders' ability to withstand unfavorable economic and financial conditions, among other regulations.

This, in our view, could further restrict the US regional banks' ability to support middle-market companies, which were already facing significant challenges due to the depletion of deposits in the aftermath of SVB's collapse and shareholder pressure to strengthen their balance sheets. The ultimate consequence of SVB's collapse is that it has served as a catalyst for a hastened shift of credit away from regional banks and towards private debt asset managers, which are not constrained by the shifts in regulatory regimes, flight in deposits, and ever-increasing pressure from shareholders. Interestingly, Category III and IV banks reported a combined commercial and industrial loan book of ~$2.0 trillion as of end-2022, and we estimate that middle-market companies currently account for the majority of these loans.

This potentially presents a strong opportunity for private debt firms to gain market share from regional banks and establish themselves as an alternative and reliable source of finance for middle-market companies.

The LBO opportunity

The past year has seen a significant rise in interest rates, leading to disruptions across equity and fixed income markets, with one of the hardest-hit areas being the liquid primary leveraged-loans market.

Historically, large banks have underwritten most of the debt for large leveraged buyout (LBO) transactions, but banks have been retrenching from this market since late-2022, when broad market weakness left banks with several high-profile hung syndications’ worth ~$75 billion, including the debt financing for the takeover of Citrix, Twitter, and Nielsen. This ultimately forced banks to take losses to unload this debt at a steep discount.

We anticipate that it will take time for banks to regain the willingness and the ability to actively participate in LBO transactions.

As a result of limited financing options, the terms for leveraged loans have become much more favorable for those who can provide capital, with average coupons at 650-700 basis points (bps) above floating rates for senior secured debt, compared with 550-600 bps a year ago, and loan-to-value (LTV) for large LBO loans falling from 60-70% to less than 50% today.

On the other hand, we feel that private equity sponsors continue to actively look at deploying their dry powder (~$2.0 trillion), as the current environment presents high-quality companies at reasonable valuations. Private equity sponsors would be in need of debt financing to lever their investments. Given that the most preferred source of debt financing for leveraged transactions remains almost shut, we feel private equity sponsors would increasingly look at private debt firms to fund these transactions.

Also, we think that private debt firms should be able to capitalise on this opportunity by filling this void and demanding generous interest, low leverage ratios and better covenants in exchange for supplying scarce capital. This trend, in our view, particularly benefits large and established private debt firms, given their ability and flexibility to underwrite large private equity sponsored LBO transactions.

Private debt growth drivers

Conclusion

Stricter banking regulations and the quest of institutional investors for high cash returns have made private debt a fast-growing asset class.

The recent failure of mid-sized banks has exposed their inadequate regulation and risk management, leading to a shift of credit away from regional banks and towards private debt asset managers.

Private debt firms are also poised to capitalise on the limited financing options for LBO transactions, with private equity sponsors increasingly looking towards private debt firms for debt financing.

Established private debt firms are expected to benefit from these trends by underwriting large private equity sponsored LBO transactions.