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.
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.