Thursday, 30 March 2017
Last updated 4 hours ago
Feb 23 2017 | 4:21pm ET
Editor’s note: The arrival of the Trump Administration has raised questions among private debt participants whether the promised repeal or revision of Dodd-Frank will dramatically loosen crisis-era regulatory restrictions and thus heighten competition from traditional banks or, as explored by Nick Veronis and Caroline Rasmussen of iCapital Network, will the private, alternative direct lending sector maintain its dominance of the fast-growing space?
Direct Lending – The Trump Effect
By Nick Veronis and Caroline Rasmussen
President Donald Trump’s promises to “dismantle” the Dodd-Frank Act are making waves in the direct lending community and causing advisors and their clients to wonder whether this will heighten competition in the busy market for private debt.
This is due to the wide-ranging impact Dodd-Frank has had on traditional bank lending. An extensive piece of financial market legislation intended to prevent the collapse of another major bank such as Lehman Brothers, the Dodd-Frank Act effectively precluded banks from certain lending activities by requiring them to hold higher capital reserves against new loans.
Since Dodd-Frank’s enactment, private debt funds have moved in to court former bank clients, accounting for 88% of the institutional loan market by 2015. Though banks’ share of the private debt market had been on the decline well before the crisis (going from 71% to 45% from 1994 to 2000 and dropping to just 18% in 2006), Dodd-Frank’s heightened capital adequacy measures, combined with the collective pullback from lending after 2008, helped create a gap in the supply of loans to private companies.
Banks Continue to Lose Market Share
Importantly, direct lenders have become vital players from the perspective of private company management teams as well as the private equity firms looking to buy and sell these companies. Compared to negotiating a loan from a bank, which can take months, or going to the public markets for financing (which introduces unpredictability as to the final interest rate on the loans), direct lenders can often move quickly and provide companies with certainty of price. In addition, direct loans are more easily customized to fit the needs of a given deal. These advantages have made direct lenders an attractive financing solution to the private markets and contributed to the steady growth of their market share over the past two decades.
With this shift in the private debt landscape as a backdrop, advisors and individual investors have become increasingly interested in private debt funds. The attractive floating yields offered by many private loans as well as the often more favorable terms and protections they feature relative to traditional bonds and other forms of public debt have made these investments very appealing, particularly in the low rate environment of recent years. In addition, private credit funds offer exposure to the large and growing universe of non-listed U.S. middle market companies, which generate $10+ trillion in annual revenue and account for a third of U.S. jobs. This exposure is often lacking in typical portfolios weighted towards public equities, which essentially only offer access to large-cap issuers.
So what would a rollback of Dodd-Frank mean for the direct lending marketplace, and could it impact private debt fund investing opportunities for advisors and their clients?
It is important to recall the context in which Dodd-Frank was enacted, the global - albeit voluntary - Basel III agreement among central banks and bank supervisory authorities to standardize capital and leverage requirements. As a result of this global framework, it is doubtful that the overarching dynamic of increased capital levels at banks will be reversed, even if parts of the Act are restructured.
Moreover, while Trump could effectively roll back Dodd-Frank by instructing regulators to enforce the law more lightly, wholesale repeal would require action by Congress, a process that is unlikely to unfold smoothly. Even with relaxed U.S. regulatory oversight, banks may not be anxious to return to the full range of lending practices they engaged in prior to 2008, which added incremental risk and volatility to balance sheets. According to Michael Arougheti, president at debt-focused Ares Management, many banks that were active in the market in the past are now “attacking the space differently” by enlisting private debt funds as their primary partners to put up capital for loans.
In any case, whether changes in bank lending behavior were driven primarily by enhanced regulations or a desire to avoid repeating the same mistakes that led to the global financial crisis, private direct lenders have successfully established themselves as key, long-term credit providers to the private market. In doing so they have not only usurped the dominant role that traditional banks used to play, but improved on it by offering quicker, more easily managed and more creative debt financing solutions.
While increased competition from banks may impact smaller, less established private direct lenders, large credit groups with significant dealflow are unlikely to be negatively affected, or only marginally so, in part because a significant shortfall still exists between the demand for private loans and current supply.
Regardless of any regulatory changes, sentiment remains broadly negative toward public fixed income, which combined with private debt funds’ appeal means the overall “Trump effect” is likely to be negligible. The sector will likely continue increasing its share of investor portfolios, and the market looks set to continue growing in 2017 and beyond.
Nick Veronis and Caroline Rasmussen are co-founder and vice president, respectively, of iCapital Network, an online platform focused on democratizing access to alternative investments for high-net-worth investors and their financial advisors.