Whipsaw trading in shares of regional banks this week made it clear the fallout from three federal bank seizures was far from over. Some investors are betting against even seemingly healthy banks like PacWest, and regulators are gearing up to tack on new capital constraints for small and medium-size lenders.
Large banks, though raking in cash, are facing their own constraints, saddled with loans written before interest rates started rising.
That means businesses large and small may soon need to look elsewhere for loans. And a growing cohort of nonbanks, which don’t take deposits — including giant investment firms like Apollo Global Management, Ares Management and Blackstone — are chomping at the bit to step into the vacuum.
For the last decade, these institutions and others like them have aggressively scooped up and extended loans, helping to grow the private credit industry sixfold since 2013, to $850 billion, according to the financial data provider Preqin.
Now, as other lenders slow down, the large investment firms see an opportunity.
“It actually is good for players like us to step into the breach where, you know, everybody else has vacated the space,” Rishi Kapoor, a co-chief executive of Investcorp, said on the stage of the Milken Institute’s global conference this week.
But the shift in loans from banks to nonbanks comes with risk. Private credit has exploded partly because its providers are not subject to the same financial regulations put on banks after the financial crisis. What does it mean for America’s loans to be moving to less-regulated entities at the same time the country is facing a potential recession?
The rise of shadow banks
Institutions that make loans but aren’t banks are known (much to their chagrin) as “shadow banks.” They include pension funds, money market funds and asset managers.
Because shadow banks don’t take in deposits, they’re not subject to the same regulations as banks, which allows them to take greater risks. And so far, their riskier bets have been profitable: Returns on private credit since 2000 exceeded the public benchmark by 300 basis points, according to Hamilton Lane, an investment management firm.
These big returns make private credit an appealing business for institutions that once focused mostly on private equity, particularly when interest rates were low. Apollo, for example, now has more than $392 billion in its alternative lending business. Its affiliate, Atlas SP Partners, recently provided $1.4 billion in cash to the beleaguered bank PacWest. Blackstone has $291 billion in credit and insurance assets under management.
Private equity firms are also some of shadow banks’ biggest customers. Because regulations limit how many loans banks can keep on their books, banks have stepped back from underwriting leveraged buyouts as they struggle to sell debt that they committed before interest rates rose.
“We’ve demonstrated over time to be a reliable form of capital that’s really emerged at the forefront, as banks, in this environment at least, have retrenched,” Mark Jenkins, head of global credit at Carlyle, told DealBook.
Direct lending may get another boost as regional banks pull back, particularly in commercial real estate like office buildings, where landlords may be looking to refinance at least $1.5 trillion in mortgage contracts over the next two years, Morgan Stanley analysts estimate. America’s regional banks have accounted for about three quarters of these kinds of loans, Morgan Stanley’s research shows.
“Real estate is going to have to find a new home and I think private credit firms are a pretty large place for that,” Michael Patterson, governing partner at HPS Investment Partners, told DealBook. More broadly, he said: “Reduced credit availability for corporates, large and small, is a thing, and I think private credit is a big part of the solution.”
Untested territory
Direct lending at this scale has never been tested: Nearly all its decade-long growth has happened amid cheap money and outside the pressures of a recession. The industry’s opacity means it’s nearly impossible to know what fault lines exist before they break.
At the same time, shadow lenders are increasingly extending credit to firms that traditional banks won’t touch, like small and midsize enterprises. “These aren’t necessarily companies with credit ratings,” Cameron Joyce, the deputy head of research insights at Preqin, told DealBook.
And, while private credit firms market themselves as able to offer more creative credit, and move faster in doing so, that agility comes at a cost. These firms often command a higher rate and tougher terms than their more traditional peers.
“Many of the new ‘shadow bank’ market makers are fair-weather friends,” Jamie Dimon, the chief executive of JPMorgan Chase wrote in his recent annual letter. “They do not step in to help clients in tough times.” Some worry that could mean swifter foreclosures on the businesses that tap their loans.
On Regulators’ radar
In Washington, shadow banks have been a point of focus, if not quite alarm, for years. As credit conditions tighten, they’re getting an even closer look.
The I.M.F. has called for tougher regulatory oversight, and U.S. Treasury Secretary Janet Yellen said last month that she wanted to make it easier to designate nonbanks as systemically important, which would enable regulators to tighten scrutiny.
But given the urgency of the regional bank crisis, there may be little appetite to further disrupt what could be an increasingly fragile financial system.
“I don’t know that they pose the same kind of risks that the big wipeout of a lot of regional banks would pose,” Ron Klain, the former White House chief of staff, said about shadow banks in an interview in April. “I think it’s something that people will keep their eyes on.”
Industry insiders argue that many private credit firms are just as friendly to borrowers and focused on repeat customers as banks are. These firms have no depositors, so only their own investors would be hurt by a bad bet, they say. Because they are not lending against customer cash — a form of leverage — they are not vulnerable to a run on the bank.
“Our clients and counterparties have learned there is inherent safety in dealing with us,” Blackstone’s chief executive, Steve Schwarzman, told analysts in March. “We don’t operate with the risk profile of financial firms that have fallen into trouble, almost always due to the combination of a highly leveraged balance sheet and a mismatch of assets and liabilities.”
But problems at private funds have in the past caused pain beyond the firm, like when Long Term Capital Management collapsed in 1998, bringing down markets across the globe. The more shadow banks lend to each other, the more interconnected they become, augmenting the risk of a cascading effect that could ripple into the broader economy.
“They will say, ‘we have a good control on our risk,’ but you generate these returns somehow — these higher returns,” said Andrew Park, a senior policy analyst at the advocacy group Americans for Financial Reform. “There is no free lunch on that.”
Bernhard Warner contributed reporting.
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