"Financiers Concerned Over 'Leverage on Leverage'"

Financiers are increasingly worried about 'leverage on leverage' in private credit markets. This concern, highlighted in "Navigating the Market," underscores the growing complexity and potential risks in financial landscapes, prompting a closer examination of its implications and potential impacts.

May 11 (Reuters) - During the Milken Institute conference in Los Angeles, prominent financiers are drawing parallels between the current debt surge in private markets and the risk-taking era preceding the 2008 financial crisis. Conversations with numerous stakeholders in the $1.7 trillion private credit market reveal widespread concerns about escalating debt levels and the market's relative lack of regulatory oversight.

Their primary apprehension revolves around loans extended to private equity funds for already leveraged portfolio companies, a trend that has surged amidst a prolonged period of low interest rates, inhibiting firms' asset sales. Notably, the borrowed funds often serve to fulfill investor dividends, meeting payout obligations for entities like pensions and endowments. This cycle also facilitates fund managers in soliciting fresh investments from clients, thereby augmenting fee revenues. Moreover, the funds are frequently allocated to support underperforming portfolio businesses, foster their expansion, or finance new acquisitions.

David Hunt, CEO of PGIM, Prudential Financial's $1.3 trillion asset management arm, highlighted the challenges faced by private equity firms amidst a prolonged inability to divest from numerous portfolio companies. Hunt emphasized the resultant cash flow strains, prompting firms to resort to additional leverage at the fund level, thus compounding risks. He underscored the urgency for liquidity, cautioning about potential vulnerabilities in the private equity fund loan market.

Private credit has experienced remarkable growth in recent years, driven by banks scaling down their balance sheets in response to stricter regulations. Leading fund managers like Oaktree Capital Management, Apollo Global Management, and Ares Management, alongside prominent Wall Street institutions such as Goldman Sachs and Morgan Stanley, have actively participated in this expanding market. In the United States, the scale of private credit now rivals that of leveraged loans and high yield bond markets.

The immense scale of the market raises alarm over potential risks associated with excessive debt levels and complex financial maneuvers. Losses triggered by economic downturns or unforeseen shocks could pose significant threats to overall financial stability. Additionally, the lack of transparency within the market may erode confidence and complicate regulatory responses, mirroring challenges observed in shadow banking sectors like China. A financier revealed attending a recent forum where regulators from major agencies sought insights into the interplay between banks and private credit markets, aiming to grasp the situation's implications for banking system health and regulatory intervention capabilities in times of need.

DOWNSIDE PROTECTION

Indeed, according to some financiers, while a downturn could result in losses and diminish investor returns, the likelihood of private credit market issues triggering a widespread financial crisis remains minimal. One financier mentioned their firm's stringent underwriting practices, which involve thorough assessments and the inclusion of safeguards. For instance, when dealing with sophisticated private equity firms, they implement measures preventing asset removal from the collateral pool or additional debt accumulation. However, concerns persist among financiers about the broader market. Tony Yoseloff of Davidson Kempner Capital Management, citing Bank of America data, highlighted that 22% of direct lending borrowers exhibit negative operating cash flow, with 8% having insufficient cash reserves for more than two years, indicating potential vulnerabilities.

LOWER RETURNS

The rapid expansion of the private credit market has intensified competition, driven by an influx of capital and participants, alongside growing competition from public markets. Consequently, interest rates on loans have decreased recently, leading to concerns about a potential race to the bottom. Many anticipate an increase in default rates during economic slowdowns, resulting in reduced recoveries for lenders.

While some financiers noted investor pressure on private equity firms to secure loans for dividend payments, Christopher Ailman of the California State Teachers’ Retirement System expressed reservations. Ailman criticized the trend, stating a preference for firms to avoid adding leverage. He attributed this behavior to general partners' reliance on management fees, noting a stagnant market. Ailman highlighted the cyclical nature of seeking investor commitments for subsequent funds after utilizing loans for dividends, illustrating a recurring pattern within the industry.

Source: Reuters‍