Executive summary:
- In the aftermath of the banking crisis, many regional banks are likely to face tighter lending standards and a challenging environment in which to raise capital.
- Banks will likely present even less competition for non-bank lenders in the foreseeable future.
- We anticipate that this situation will result in more opportunities for private credit.
The terms private credit and private debt are often used interchangeably to describe direct origination credit strategies. But, the business is also known by another name: non-bank lending.
No doubt, you're probably aware that actual banks on both sides of the Atlantic have recently been in varying states of panic. While the extent of the fallout remains to be seen in publicly traded markets, the combination of three of the top four largest bank collapses ever in the U.S. and the fall of Credit Suisse is almost certain to have some lasting impacts on the market beyond just the next few weeks. One of those impacts will likely be a retrenchment in bank lending. In the spirit of a never-let-a-good-crisis-go-to-waste framework, we believe that is very likely to open up a lasting pocket of opportunity for non-bank lenders to take market share while still delivering attractive risk-adjusted returns to end investors.
How the Global Financial Crisis spurred growth in non-bank lending
While non-bank lenders in the U.S. generally trace their roots to the 1980s passage of legislation that created the structure of a business development company, the market remained fairly small for decades as banks typically offered better terms to all but the most unique and/or highly levered borrowers.
The 2008 global financial crisis (and subsequent regulation) changed all that. Banks consolidated and cut back on lending to improve their existing troubled balance sheets, and regulators put in place new rules that further constrained bank lending going forward. The net effect was that banks significantly reduced the credit they might offer to small and medium-sized businesses. The non-bank lending market stepped in to fill the void and grew substantially in both size and diversity.
Capital drawn into private debt quickly doubled in the post-GFC years compared to the years immediately prior and continued to grow from there. Importantly, it did so with particularly compelling results for investors. The median credit manager produced double-digit IRRs (internal rate of return) in both 2009 and 2010 vintages, which typically represent loans originating over the subsequent two to four years. Those results were produced in spite of the fact that nearly all loans are floating rates and LIBOR rates were only slightly above zero throughout most of those funds’ lives. It truly was the first golden age for private credit and non-bank lending.
Private credit likely to Benefit from pressures facing U.S. regional banks
Now, let's look at what's happening today. First Republic Bank, Silicon Valley Bank, and Signature Bank are gone. Other regional banks still appear stressed. Regulators are taking tough questions from Congress. One has to think bank CEOs will be doing the same shortly. The situation is not as severe as in 2008 at this point, but it surely rhymes. Three significant regional banks no longer have balance sheets to offer, but the bigger impact may be that other regional banks face a challenging market to raise capital even if they did want to do more loans. Recent earnings releases show depositors are still leaving regional banks. Regulators are likely to encourage those banks to be even more conservative in their lending. And, as a cherry on top, many regional banks were significant lenders into the commercial property market, a market that might well be in the eye of the storm this cycle in terms of fundamental credit, due to the poor outlook in both retail and office property. Banks are likely going to present even less competition for non-bank lenders in the foreseeable future.
Opportunities also present beyond the U.S.
The opportunity isn't just isolated to the U.S. market. Banking stress extended over the Atlantic quickly as we saw the first global systemically important bank (“G-SIB") disappear over a weekend as Credit Suisse was forcibly merged with longtime Swiss rival UBS. Credit Suisse itself wasn't a major lender to small and medium-sized businesses, but unlike the U.S., other major banks in Europe continued to be significant lenders in that space post-GFC.
The shock news of the Credit Suisse takeover was ultimately their full write-down of the firm's additional tier one (AT1) contingent capital notes without the complete wipeout of common equity holders first. AT1 notes were widely issued by banks across Europe to raise capital without diluting equity, and not surprisingly the market reacted very poorly to the news. While UK and EU regulators rushed to reassure the market that AT1 notes wouldn't be treated so under their respective jurisdiction, pricing AT1 debt remains more expensive for banks than it was prior. Ultimately, an increase in the costs to raise capital translates to less room for new loans or much higher premiums to create them. That's where we expect non-bank lenders in Europe are likely to step in to provide that scarce capital to worthy borrowers.
The bottom line: Private credit likely to grow
In sum, depositors are leaving regional banks, raising capital is becoming more expensive for banks globally, and regulators are turning a sharp eye toward bank balance sheets. This is causing all signs to point to declining competition for lending to small- and medium-sized businesses. We anticipate that non-bank lending opportunities will grow as banks retreat. Due to the rising cost of bank capital, non-bank lenders will not have to sacrifice returns to gain that market share—a win for both managers and investors.
1 Based on data from Cobalt LP by Hamilton Lane comparing the average quarterly contribution into private credit funds in aggregate over the 4 years after the GFC (2009-2012) to the years immediately before (2004-2007).
2 Source: Cobalt LP by Hamilton Lane as of 9/30/2022.
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