The recent outcome of the U.S. elections brought a change in attitude toward regulations and monetary policies.
A Trump presidency suggests a meaningful reduction in certain regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act, among others. He also has provided a clear signal that the U.S. will end its accommodative monetary policy.
One wonders, therefore, what impact the new administration will have on direct lending activity in the United States.
The 2008-'09 global financial crisis and ensuing low-rate environment drove prices of traditional fixed-income assets to historic highs and corresponding yields to historic lows. Meanwhile, structural regulatory changes accelerated the multidecade trend of traditional capital providers retreating from the market. Together, these forces have created greater opportunity for private capital providers to fill a massive credit funding gap and charge a premium for doing so.
Banks in the U.S. (and around the world) have faced significant regulatory pressure stemming from the global financial crisis; risk-based capital charges for non-rated loans and Tier 1 capital ratio increases made it increasingly challenging for banks to provide loans to small- and middle-market companies. Whereas commercial bank deposits have increased substantially since 2011, the pace of growth for loans and leases has been much slower. Therefore, direct lending investment managers and business development companies emerged as a structural replacement for banks in the viewpoint of borrowers.
Rethinking the regulatory framework
There is a limit to what President Donald Trump can do to change regulations. He could reform Dodd-Frank, but Basel III is an international regulatory framework. The U.S. could relax certain thresholds that were set higher than the minimum required, but the new administration is not going to take the risk to overhaul this regulatory framework dramatically given the general consensus that Basel III capital requirements have strengthened U.S. banks.
It is also important to highlight that, contrary to Europe, the banks' consolidation process started in the U.S. well before the financial crisis. The total number of banks started declining in the early 1980s from more than 14,000 banks to around 5,000 today. Thus, the banks' market share of the lending activity through the leveraged loans market started to decline more than a decade before the global financial crisis. This has led to a situation where non-bank financial institutions have been dominating the market for some time now. This trend would be hard to reverse. Indeed, if banks wanted to make a comeback, this would require rebuilding a costly infrastructure and recruiting new teams to again target lending to small and medium enterprises. Talent would be very hard to attract given most professionals are now working for private credit funds where their remuneration package is more appealing than it would be at a bank.
Increase in interest rates
The tone regarding monetary policy and expected interest rate increases has changed since Mr. Trump was elected president. Following the first increase by 25 basis points after the November election, the Federal Open Market Committee raised its interest rate projections for 2017 for the first time in two years. The Fed now sees three quarter-point rate rises in 2017, rather than the two indicated after its September meeting.
We do not expect the increase in interest rates to have a major impact on direct lending activity. Indeed, sophisticated investors today understand that private credit strategies offer a certain level of diversification within their credit portfolio or private markets/alternative investment program, and overall investment portfolio. Private credit/direct lending strategies address a segment of the market that is hardly accessible by more traditional fixed-income strategies. In addition, there could be some pressure on the premium investors require to invest in private credit vs. public debt. However, given the increase in rates, the absolute returns are expected to increase and the premium will remain, even if it's smaller. Moreover, on the demand side, small- and middle-market companies or their respective private equity sponsors are becoming more interested in flexible solutions that direct lending managers can offer for their development or the development of their portfolio companies.
Private debt fund managers are much more inclined than banks to offer tailor-made solutions for specific situations. Some companies require capital for growth and are better off with bullet or payment-in-kind repayment structures, which banks are much more reluctant to provide. Private equity sponsors also have been very attracted by unitranche lending, which allows them to close a deal without having too many parties around the table when speed of execution matters.
Growth expectation and promotion of local companies
Finally, Mr. Trump's policies could favor U.S. middle-market companies, specifically the ones oriented toward domestic production. Indeed, the U.S. middle market is mainly composed of companies whose customers and revenues are predominantly U.S.-focused. Even if the economic policies in favor of small businesses that Mr. Trump outlined in his campaign are not implemented, it is expected that overall, the tax reforms should boost growth and directly affect the local economy and local companies. As a consequence, we should see an increase in debt demand from the midmarket segment.
Overall, we do not expect the recent outcome of the U.S. election to have a negative impact on direct lending activity in the United States. To the contrary, the expected GDP growth increase should benefit the midmarket segment. Middle-market companies are expected to increase their demand for flexible lending solutions that private credit fund managers are better equipped to offer than traditional bank lenders. To maintain an attractive premium in this growing and competitive area, it is critical for investors to understand how private credit managers differ in their offerings, from sourcing to exiting.
Elvire Perrin is managing director at Pavilion Alternatives Groups Ltd. in London. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.