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10 years later: Alternatives

Investors in credit industry see danger ahead

Daniel B. Zwirn doesn’t believe institutional investors will step in to fill the gaps — like the federal government did previously —if another credit crisis occurs.

Leverage is on the rise, but many managers say it's different this time

When banks pulled back after the global financial crisis, private capital swooped in to fill the void.

Credit strategies of all types have been booming. Still, credit industry investors say warning signs are beginning to flash. Leverage is creeping up in the underlying transactions and credit managers are adding debt to their portfolios, debt with strings attached.

One of the biggest sectors of credit and debt strategies — direct lending — barely existed before the Great Recession. In the first four months of 2018, five direct lending funds closed on a combined $4.6 billion; in all of 2009, seven direct lending funds closed on a total of $1.1 billion, according to London-based alternative investments research firm Preqin.

"Going into the crisis we were pretty conservative in the deals we were doing and capital we were raising because we didn't see good value," said Joe McCurdy, a New York-based managing director and head of origination in the corporate credit group at Guggenheim Partners. Guggenheim had $78.5 billion in credit as of June 30.

Since the global financial crisis, the opportunity set has grown, Mr. McCurdy said.

Banks have continuously pulled back from lending because of a combination of stricter regulations and bank executives' belief they can get a better return on equity elsewhere. Meanwhile, expected lower returns in equities and fixed income have pushed institutional investors to move into credit strategies across alternative investment asset classes.

Indeed, global private credit managers' combined assets under management have tripled in size over the past decade to a record $667 billion as of Dec. 31, according to Preqin.

Managers among the non-bank lenders also have grown since the crisis, to the point that they do not always have to find a partner to make large loans, Mr. McCurdy said. "A handful of us have grown and so we can do larger transactions on our own," he said. "If we team up, we can do $1 billion and $1.5 billion loans. Pre-crisis, that just didn't exist."

In the first half of 2018, Guggenheim invested more than $2.5 billion of directly negotiated and private middle-market loans across first lien, second lien, unitranche and other structures.

The five credit managers estimated by Preqin to have the most private credit dry powder as of June 30 are GSO Capital Partners (which is Blackstone Group's credit business), Oaktree Capital Management (OAK) LP (OAK), Ares Management LP, Intermediate Capital Group PLC and HPS Investment Partners LLC.

A relatively recent phenomenon, industry insiders say, is money manager investment in real estate debt strategies.

"Perhaps the most important way the sector has grown is the degree to which its capital base has broadened," said Adam Ruggiero, Whippany, N.J.-based director and head of real estate research at MetLife Investment Management. "Until recently, real estate debt remained largely the purview of banks and life insurance companies."

Life insurance companies' share of total commercial mortgage originations increased to around 25% in 2009-11 from only 10% at the market's peak in 2007, he said. But more recently, the share of commercial mortgage originations for life insurance companies has dropped; it was 15% in 2017, he said, referring to Mortgage Banking Association data.

MetLife Investment Management has originated an average of $8 billion to $10 billion in commercial mortgages annually for the past 10 years on behalf of MetLife's general accounts' liabilities, said Gary N. Otten, MetLife Investment Management's managing director and head of real estate debt strategies.

MetLife has been investing in real estate debt for more than 100 years from its general account, Mr. Ruggiero added. MetLife Investment Management began investing in real estate debt for institutional investors since the global financial crisis.

" MetLife Investment Management launched the third-party investment management platform for commercial mortgages in late 2012 and executed its initial mandate in April 2013," Mr. Otten said.

Banks before the global financial crisis had played a big part in providing the debt for leveraged buyouts, said Tom Newberry, who now is New York-based partner and head of private credit funds at CVC Credit Partners, which manages about $18.7 billion. Before the crisis, Mr. Newberry ran the loan credit desk at Credit Suisse Group AG.

In 2006-07, lending got aggressive, Mr. Newberry said. "The crisis wiped out years of (bank) profit."

The collateralized loan obligation market had been the primary buyer of credit risk from banks, and that market had slowed down, he explained. "It got pretty difficult to move the risk" off of bank balance sheets, he said. In 2009-10, banks were more focused on moving risk than on doing new deals, he added.

This left room for non-banks to take up "a bigger and bigger piece of the market," even assuming roles that banks used to play in larger transactions, Mr. Newberry said.

Now, credit managers are doing larger deals and are syndicating loans — divvying them up with other lenders, keeping the slices of debt they want. While the original lender is finding other credit managers and financial institutions to take slices, it still is sitting in the fund that originated the loan, Mr. Newberry explained.

At the same time, the managers are leveraging the funds, he said.

LPs at risk

"The people at risk are the (limited partners) of the fund," he said. In a downturn, all lenders — banks and non-banks — typically cut lending. "LPs may not understand that there is a chance that they may be stuck with concentrated risk," Mr. Newberry said.

And unlike the banks during the crisis, the federal government is not likely to bail out non-bank lenders.

"I think there is not even a remote chance these guys are going to get rescued in any way by the government," said Daniel B. Zwirn, New York-based CEO of Arena Investors LP, a money manager and merchant bank funded with investor capital.

What's more, many middle-market corporate lenders are financed by investment banks.

"The loan collateral has diminished materially over the last several years," he said.

"As an example, independent of the performance of the collateral, if the S&P 500 goes down 20%, they (banks) can call the loan or force you (the borrower) to put up more margin," he said. "It's fair to assume there will be middle-market lenders who will wake up with their collateral taken. It's similar to the (asset-backed securities), structured credit and mortgage spaces in 2007."

In the end, it will be the limited partners that will suffer investment losses.

"The result is in certain instances, managers will be changed. If middle-market corporate lenders are leveraged, their lenders will take the collateral back and sell loans to distressed buyers," Mr. Zwirn said.

And institutional investors will be in no position to play the role the federal government played in the downturn and buy the loans, he said.

"The notion that LPs will be some sort of backstop is not realistic. ... (The downturn) will correlate to other issues they have. When the bullets are flying, many of them will be under their desks and will not be aggressively buying debt," Mr. Zwirn said.

Solidifying power

"The evolution of the alternative credit market since the crisis has been amazing," said Christopher J. Flynn, Boston-based CEO of credit manager THL Credit Advisors LLC. Credit managers have grown rapidly since the recession. THL Credit opened its doors in 2007 and now has $15 billion in assets under management.

A combination of banks turning inward to mend their balance sheets and new bank regulations contributed to giving "the alternative lender space the opportunity to solidify its position of power," Mr. Flynn said.

The rise of credit manager lenders has changed lending, he said. Before the financial crisis, banks provided the first lien loan, with the riskier second lien and mezzanine loans offered by non-bank lenders, he said.

Since the global financial crisis, new structures — such as unitranche or senior stretch loans that combine senior and junior debt in a single financing — give private equity firms financing strategies to buy companies they didn't have before, Mr. Flynn said.

"Historically, alternative lenders were only speaking for a small portion (of the financing), now (they are) speaking for the entire thing," Mr. Flynn said.

What's more, it has become easier for credit managers to raise capital, he noted.

"The (limited partner) base has gotten more sophisticated as well," Mr. Flynn said.

Credit managers that tried to raise funds in 2008 and 2009 found they were shuttled between investors' fixed-income groups and private equity groups, he said.

"Today, investors have sophisticated teams focused on alternative credit strategies ... and they have allocations to an asset class that didn't fit into their world seven or eight years ago," Mr. Flynn said.

However, there are things that "give me pause," he said.

Credit managers have larger balance sheets of loans than ever before, which they will have to manage during a recession, he said. Like banks, they will lend less in a recession and use their capital to tend to their balance sheets.

If the manager is small, it might not have the fee income to pay a large team of executives to work through its loans and make sure the staff get paid.

What's more, credit managers are leveraging their portfolios to boost returns, Mr. Flynn said.

"It is artificial, not sustainable ... and it is mispricing risk," he said.