Skip to main content
pilogo-NEW
Subscribe
  • Subscribe
  • My Account
  • login
  • NEWS
    • Alternatives
    • Consultants
    • Defined Contribution
    • Frontlines
    • Hedge Funds
    • Investing / Portfolio Strategies
    • Money Management
    • Pension Funds
    • People Moves
    • Private Equity
    • Real Estate
    • Searches & Hires News
    • Special Reports
    • BlackFin closes third fund at €985 million, above its target
      Alerian acquires S-Network Global Indexes
      OMERS Ventures picks Uber veteran
      Neil Sheth
      More asset owners clamoring for multistrategy private credit
    • Mercer appoints global alternatives leader for wealth business
      KPMG offloads pension advisory unit to private equity firm
      Ascensus snaps up Nyhart in latest deal
      Willis Towers Watson exec promoted to lead retirement unit
    • Drew Carrington
      New data questions conventional wisdom
      Kathleen Long
      Plans enticing 401(k) savings even without employer contribution
      Joe Caldera
      Group acting to plug a gap in retirement
      Jean Young
      Analysis on stretching the match shows it doesn't work as intended
    • Ray Dalio book
      Dalio releases illustrated version of ‘Principles’ book
      Youngjae Ryu
      Korea Corporate Governance Forum set to debut Dec. 12
      MOney maze
      PLSA has tips for trustees of U.K. retirement funds
      Norm Champ
      Norm Champ shifts his focus to financial literacy in latest book
    • Macro hedge fund Stone Milliner shutting down
      James Medeiros
      Hedge fund managers are warming up to custom funds
      Louis Bacon
      Moore Capital's Louis Bacon to quit money management business
      James Yeh
      Citadel promotes James Yeh to president and co-CIO
    • CalPERS’ committee mulls new investment policies
      ESG worked in 2019, but questions remain for long term
      Wyoming investment board picks 2 for small-cap equities
      Pennsylvania Municipal Retirement looking for investment consultant
    • Mihir Worah
      PIMCO CIO for asset allocation and real assets to retire
      Icahn lays off workers as firm decamps to Miami
      Pacific Life hires head for new institutional arm
      1251 Capital acquires majority stake in Ziegler Capital
    • CalPERS’ committee mulls new investment policies
      Australian regulator lists underperforming funds
      PPF 7800 index funding deficit drops in November
      CDC, Laerernes commit to Amundi, EIB green bond program
    • Mihir Worah
      PIMCO CIO for asset allocation and real assets to retire
      OMERS Ventures picks Uber veteran
      Mercer appoints global alternatives leader for wealth business
      Apollo Global taps Bain Capital veteran to lead its Japan business
    • Parthenon Capital raises $2 billion with latest private equity fund
      Investindustrial raises €3.75 billion with seventh European buyout fund
      Sightway Capital closes first fund with $1.2 billion
      Private equity practices aired at House hearing
    • Schroders appoints real estate capital partners head
      CBRE acquires U.K. real estate debt investment business Laxfield Capital
      USAA to sell controlling interest in real estate unit
      Cold storage
      A hot time for those seeking the cold
    • Washington State Retirement hires Milliman as actuarial auditor
      Howard County allocates $7 million to venture capital
      Wisconsin deferred comp chooses Wilshire to analyze stable value options
      Illinois Teachers doles out $665 million to 5 alts managers
    • The best places to work in money management 2019
      Investment Consultants
      The 2019 Excellence & Innovation Awards
      Top-performing managers Q3 2019
  • Data
    • Research Center
    • Searches & Hires Database
    • Searches & Hires News
    • RFPs
    • Charts / Infographics
    • Sponsored Research
    • Trackers
    • Q3 2019 money manager M&A activity summary
      Q3 2019 legal overview report
      Q3 2019 searches and hires overview report
      P&I resources can give a leg up in winning new business
    • Washington State Retirement hires Milliman as actuarial auditor
      Howard County allocates $7 million to venture capital
      Wisconsin deferred comp chooses Wilshire to analyze stable value options
      Illinois Teachers doles out $665 million to 5 alts managers
    • Washington State Retirement hires Milliman as actuarial auditor
      Howard County allocates $7 million to venture capital
      Wisconsin deferred comp chooses Wilshire to analyze stable value options
      Illinois Teachers doles out $665 million to 5 alts managers
    • Transitional Manager Services
      457b DC PENSION PLAN
      Overlay and Passive Risk Balanced Investment Manager
      In-Kind Distribution Management Services (Private Markets) Provider Search
    • ESG worked in 2019, but questions remain for long term
      Latin America preparing for aging population
      To cheap large-caps go the spoils
      Only place to go is ... down
    • Institutional Investors: Shared Expectations, Divergent Paths
      Global Investor Study 2016
      Workplace Financial Wellness
    • U.S. Endowment Returns Tracker
      Pension Fund Returns Tracker
      Earnings Tracker
      Corporate Pension Contribution Tracker
  • Insights
    • Opinion
    • White Papers
    • Industry Voices
    • Other Views
    • Partner Content
    • Publisher's Update
    • Multiemployer fund legislation cartoon
      Multiemployer compromises needed
      SEC cartoon
      SEC rules need measured response
      High hopes for consistency and guidance from Scalia
      DC West poster
      Financial wellness gets spot at the table
    • Strengthen Your Core: Flexible Multi-Sector Strategies for a Low-Yield World
      WisdomTree Yield Enhanced U.S. Aggregate Bond Fund
      Automation, lower fees driving institutional interest in factor investing and smart beta strategies
      A Great Time to Be Agnostic?
    • Gerald Cooper
      Commentary: Single-asset deals – a structure benefiting GPs and LPs alike
      Gordon Latter, Timur Kaya Yontar and Frank Benham
      Commentary: Plan sponsors, do you know your credit risk?
      Timothy Boomer
      Commentary: For plan sponsors, derivatives shouldn’t be a dirty word
      Martin Vogt
      Commentary: Renewables investing makes inroads in the Caribbean, Central America
    • Commentary: Stronger partnership needed between shareholders, managers
      Commentary: Revised statement on corporate purpose misses the mark
      Commentary: The associated costs of DB terminations
      Commentary: Support the Butch Lewis Act
    • P&I Content Solutions
      EDHEC Research For Institutional Money Management - December 2019
      P&I Content Solutions
      Dynamic derisking: How an OCIO can help plan sponsors manage funding volatility
      P&I Content Solutions
      OCIO graduates from education phase
      P&I Content Solutions
      How to navigate the choppy investment waters expected in 2020
    • Everything Must Change
      Tomatoes & Investments
      Baby, it’s hot outside!
  • Multimedia
    • Videos
    • Webinars
    • Polls
    • Slideshows
    • Charts / Infographics
    • Excellence & Innovation Awards 2019: Laura Mittelstaedt
      DC West 2019
      Excellence & Innovation Awards 2019: Lisa Joe
      DC West 2019: Empower Retirement's Doug Peterson on cybersecurity
    • Finding the Positive in Negative Interest Rates
      How to Position Institutional Portfolios to Capitalize on China’s Growth
      Financial Wellness: Gaining an edge with plan sponsors
      Trends in Hedge Fund Investing
    • POLL: Creating a great workplace
      POLL: Shared values between money managers and plan sponsors
      POLL: Climate change's impact on investing
      POLL: Ultralong-term U.S. Treasury bonds
    • view gallery
      85 photos
      Best places to work in money management 2019
      view gallery
      21 photos
      The world's 20 largest retirement funds
      view gallery
      11 photos
      Top 10 DC money managers
      Top 15 managers by worldwide institutional AUM
    • ESG worked in 2019, but questions remain for long term
      Latin America preparing for aging population
  • Events
    • Conferences
    • Webinars
    • East Coast DC Conference
      Fixed Income & Credit
      DC Investment Lineup
      ESG Investing
    • Finding the Positive in Negative Interest Rates
      How to Position Institutional Portfolios to Capitalize on China’s Growth
      Financial Wellness: Gaining an edge with plan sponsors
      Trends in Hedge Fund Investing
  • Careers
  • Research Center
MENU
Breadcrumb
  1. Home
  2. INDUSTRY VOICES
November 20, 2018 12:00 AM

Commentary: The coming crackup in middle-market corporate credit

Richard J. Shinder
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print

    Despite the recent rise in U.S. Treasury rates, the bull market in corporate credit continues unabated. High-yield credit spreads — the additional compensation required by investors in subinvestment-grade credit for assuming such credit risk — are near their lowest levels since before the 2008 financial crisis. Whether observed in quantitative, broad capital markets terms (credit spreads, leverage ratios) or based upon the qualitative characteristics of higher-yielding instruments (such as the proliferation of covenant-light loans, and the nature and terms of financing agreements more generally), there is little doubt that the corporate credit markets are awash in liquidity.

    Any contemplation of a bull market for a security or commodity requires consideration of the inevitable future bear market in the instrument. The U.S. corporate credit markets are composed of two primary vehicles for allocating credit — loans and bonds — which in the modern financial era are often further decomposed through financial institutions' "originate and distribute" business models into varying intermediating stages and entities standing between the ultimate borrower and ultimate lender. Such financial vehicles — SIVs, CLOs, CDOs, total return swaps and the like — are seen by many to have been contributing factors to the deepening of the financial crisis. While some of these funding formats remain (and in certain cases have expanded post-crisis), the landscape and market architecture for the allocation of corporate credit has evolved substantially since 2009 as a consequence of legislative, regulatory and market-based actions taken in the years since. Structural changes impacting the market for corporate credit since the crisis include:

    • The implementation by the Federal Reserve (as well as the FDIC and OCC) of leveraged lending guidance for regulated commercial lending institutions.
    • The effective exit by large, national-footprint commercial lenders from SME (middle-market) lending.
    • Regional commercial lenders scaling back exposure to corporate credit (through diminished commercial and industrial lending activities).
    • The passage of Dodd-Frank and the related reduced role for risk mediators through proprietary and other trading restrictions.
    • A corresponding expansion in the market for alternative "direct" lenders (business development companies, private debt funds, private equity-sponsored lending funds, credit opportunities funds' direct investing strategies, etc.) to take the place of commercial lending institutions, particularly in the aforementioned middle market (often defined as companies with less than $50 million in EBITDA). These direct lenders have not only displaced traditional lending sources but reduced the reliance upon and changed the nature of intermediary funding vehicles and the broader corporate credit market architecture.
    Relaxed standards

    As capital markets broadly healed from their lowest ebb in early 2009, both traditional and alternative lenders relaxed corporate credit standards, as is customary during periods of economic expansion and capital markets recovery. However, the structural changes noted above have accelerated and exacerbated the weakening of such standards. The market opportunity created for alternative lenders to fill the void left by traditional commercial lending institutions has led to record amounts of capital raised to pursue private debt strategies, with $107 billion raised in 2017 alone, according to Preqin. As with many imbalanced supply/demand environments, a race to the bottom — in both pricing and terms — among providers of corporate credit has followed suit amid this heightened competition.

    In the 10th year of an economic expansion, it should not be surprising that (at long last, in the wake and wind-down of serial Federal Reserve interventions to sustain the recovery) long-term Treasury rates are finally rising. Similarly, as the U.S. economy enters late-cycle conditions, investors would expect credit spreads to eventually reverse their recent compression and similarly rise in the near future. So far, so ordinary.

    What remains to be seen — and no downturn is exactly like those that occurred previously — is how durable this new corporate credit market architecture proves to be. The regulatory and other structural changes noted previously have diffused corporate credit risk more broadly throughout the financial system, in many cases to corners (and parties) within it with little experience under bear market conditions. Moreover, middle-market credit intermediated by alternative lenders is marked by fund structures with structural disincentives (in many cases lacking scale, and seeking to reduce overhead in order to maximize carried interest) to invest in risk management; a generational loss of portfolio management/workout/distressed investing talent through the long 2009-2018 capital markets boom period; and the continued development of new financing platforms and vehicles untested by market hiccups, much less contractions.

    Lenders' collective lack of experience with market distress need not be a crisis in the making provided the credit markets' "plumbing" allows for distressed loans and bonds to move from weaker to stronger hands during periods of challenge, as is customary. Unfortunately, the same regulatory and structural changes noted above that have given rise to the growth in alternative lending have also served to diminish market-making activities, particularly at the lower end of the market. Dodd-Frank, the Volcker rule and other mandated market restrictions (even as relaxed more recently) have created less liquid, more opaque markets for middle-market credit and made market liquidity more difficult to assess on both the macro and micro level. In addition, the continued advancement of private equity in the past 30 years has given rise to a relatively higher percentage of private companies than in past market downturns, making it more difficult for market participants to form a value thesis quickly during times of transition. While none of these challenges are insurmountable, the role of market intermediation and risk transfer typically played by credit opportunities and special situations funds — which, along with market makers, have in previous crises been prepared to hold risk when weaker hands have not — may be of lesser utility in the next credit crisis as such funds are typically part of larger, diversified asset management platforms that, critically, will likely focus more on contemporaneous large-cap distressed investment opportunities. In other words, smaller companies/credits risk being "orphaned" in the next credit bust. Of course, even where such players exist to help facilitate workouts, these alternative asset managers may not have the patience (driven by relationship considerations) traditional commercial lenders often bring to such situations, potentially leading to more radical courses of action, resulting in value destruction and correspondingly lower creditor recoveries. Further, the relatively lesser degree of public-market access for and private equity capital available to such companies further limits the recapitalization toolkit available.

    But what of the middle-market lending community simply saving itself when the levee breaks? The omens are unpromising. Various self-help remedies — typically involving the deployment of incremental capital to "defend" a troubled borrower and a lender's existing credit exposure thereto — are less likely to be available to alternative lenders in the next downturn, as their fund structures in many cases may not allow for incremental capital formation, and as non-bank lenders, they cannot expect the same access to the Federal Reserve system so widely availed by banks during the financial crisis. Moreover, the middle market for corporate credit has traditionally been poorly served in times of crisis not only by market intermediaries and capital providers, but also by professional services firms. The agency community most expert in the workout of trouble companies — financial advisers, investment bankers, lawyers, consulting firms, etc. — are focused on their own return on investment and can be expected to stay (or move) upmarket during the next distressed cycle, just like the alternative investment community. As a small workout can take just as much work and effort as a large one, service providers will seek to scale and monetize their capabilities and intellectual property at their highest values. This may be the most daunting land mine awaiting the next middle-market credit downturn — while capital provision for such companies has been institutionalized, professional services risk management and workout infrastructure has not.

    With such financial market carnage in prospect, what can be done?

    What financial market regulation and practice do can also be undone. The focus should be on liquidity and regulatory changes, which often go hand in hand.

    A continued and sustained effort to relax prohibitions on market makers will better smooth the transition of corporate credit from weaker to stronger hands during the next market break. The ensuing market liquidity provided by such institutions need not resurrect the "hub and spoke" risk concentration construct of days gone by, but in the ideal case — by fostering price transparency and illuminating market depth — provide "point-to-point" investors in the post-crisis environment sufficient information and confidence to take risk when the need to induce capital participation is at its most urgent.

    Conversely, greater regulation of alternative lenders and asset managers more generally may bring necessary and belated discipline to credit underwriting standards. Structural underinvestment in portfolio management and workout capabilities results in mispriced credit and invites subsequent market disruption, the eventual costs of which are often socialized. A comprehensive post-crisis review of regulatory, compensation, and taxation policies and practices directed at the alternative asset management community is long overdue.

    Nobody can be certain when the next financial crisis will hit. What seems increasingly likely is that middle-market credit will be in its crosshairs when it does.

    Richard J. Shinder is head of Piper Jaffray & Co.'s restructuring and special situations group, New York. 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.

    Related Articles
    Investors in credit industry see danger ahead
    Managers see increased credit defaults in next 12 months, survey finds
    High yield, credit strategies lead the way for bond funds
    Recommended for You
    sponsored content
    Events
     
     
    Advertisement
    White Papers
    A Great Time to Be Agnostic?
    Shedding the Home-Country Bias
    Automation, lower fees driving institutional interest in factor investing and s…
    WisdomTree Yield Enhanced U.S. Aggregate Bond Fund
    Strengthen Your Core: Flexible Multi-Sector Strategies for a Low-Yield World
    View More
    Sponsored Content
    Partner Content
    How Big Data Delivers Solutions to ESG Investors
    How a Multisector Credit Approach Can Lower Risk, Increase Diversification
    ESG Investing Supplement
    Know Your DB Plan’s ‘Persona’ to Help Make the Right Strategy Choices
    Leveling the playing field for public employee retirement security
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    pilogo-NEW
    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    150 N. Michigan Ave.
    Chicago, IL 60601

    Contact Us

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    Pensions & Investments
    Copyright © 1996-2019. Crain Communications, Inc. All Rights Reserved.
    • NEWS
      • Alternatives
      • Consultants
      • Defined Contribution
      • Frontlines
      • Hedge Funds
      • Investing / Portfolio Strategies
      • Money Management
      • Pension Funds
      • People Moves
      • Private Equity
      • Real Estate
      • Searches & Hires News
      • Special Reports
    • Data
      • Research Center
      • Searches & Hires Database
      • Searches & Hires News
      • RFPs
      • Charts / Infographics
      • Sponsored Research
      • Trackers
    • Insights
      • Opinion
      • White Papers
      • Industry Voices
      • Other Views
      • Partner Content
      • Publisher's Update
    • Multimedia
      • Videos
      • Webinars
      • Polls
      • Slideshows
      • Charts / Infographics
    • Events
      • Conferences
      • Webinars
    • Careers
    • Research Center