Should a public utility be compensated like a hedge fund?
When the average businessperson thinks of alternative lending, the notion of direct lending platforms — business development companies, private debt funds and other specialty lenders — serving a public utility function does not likely come to mind.
Ask these same people whether they believe commercial banks provide a necessary service to a modern economy, however, and one can expect nodding agreement. It is well-established among academics, policymakers and practitioners that the allocation of credit from savers to borrowers is essential financial "plumbing," directing capital to its best uses, and that regulated lenders (along with functioning capital markets) exist in order to provide this service.
Since the 2008 financial crisis, a change in market architecture for the allocation of credit (particularly but not exclusively in the middle market) has occurred, with a considerable shift of market share away from traditional commercial banks to alternative lenders. This trend has accelerated further in the COVID-19 era. Preqin reported in February that fundraising for direct lending vehicles had increased 62% from January 2020; funds with direct lending investment mandates were targeting $150.3 billion as of January, compared to a target of $93 billion in January 2020.
While these alternative lenders have increasingly displaced banks as providers of direct credit to corporate borrowers, they are different from banks in a number of critical ways. While traditional commercial lenders must answer to various federal regulatory agencies, given the systemic risks their mismanagement may create, alternative lenders have virtually no such oversight. They also often contain incentive fee formats that encourage imprudent risk management and deter investment in critical business functions, including underwriting, portfolio management and workout (renegotiating the terms of a loan).
This nascent financial architecture remains largely untested in what is now a decadelong bull market for credit, one further extended by the Federal Reserve's COVID-era interventions. Since lending is critical to a healthy market economy, how durable will this new architecture prove to be?
Given the importance of efficient capital allocation to a market economy, it is imperative that the unacknowledged risks associated with this emerging market structure be addressed in advance of the next financial crisis. In order to do so, however, it is necessary to understand why direct lending stands apart from other alternative asset classes, and why a shift in credit provision from commercial banks to alternative lenders matters.
Private equity, real estate and hedge fund managers have raised capital from limited partners on a lightly regulated basis with incentive fee structures for decades, and it is difficult to argue that these strategies have increased the degree of systemic market risk. To the contrary, a more credible position is that the lighter regulation, nimbler mandates and financial alignment associated with such strategies have increased market efficiency and dampened market volatility. The reason these strategies have not meaningfully contributed to an increase in systemic market risk is that a failed investment thesis expressed by these vehicles internalizes losses and properly aligns manager incentive compensation with financial return. In periods of excessive equity market exuberance and subsequent correction, governmental market intervention is typically more theorized than manifested, and there are few examples in the modern era of the government socializing equity market losses.
By contrast, direct lending only began its rapid rise in the 2000s, which accelerated after the 2008 financial crisis. Direct lending funds have similar compensation structures to private equity and hedge funds (despite lower raw investment returns, fund-level returns are amplified by financial leverage). The importation of these fund structures into direct lending is unsurprising given that many of the sponsors of such funds are the same general partners that manage equity strategies. The limited regulation, use of leverage, and functional underinvestment previously noted allows GPs of these alternative lending funds to earn carried interest economics comparable to those realized by private equity and hedge fund managers.
Notwithstanding similar fund structures, there is a meaningful difference between equity and debt investing related to systemic risk and the impact of market failure on market participants and the taxpayer. While incentive fee structures may give rise to imprudent equity investing, speculation only indirectly impacts the real economy. The economic incentives of "swing for the fences" equity fund strategies do not entail moral hazard, as market losses are neither underwritten nor socialized. Lending strategies, however, do present a very real risk of such moral hazard. When a privately owned banking system's modus operandi strays from its utility function, the risk of future socialization of credit market losses rises materially. The interventions associated with the 2008 financial crisis are but one example of governmental action taken in service of maintaining functioning capital markets.
Credit market failures can create (or contribute to) economic crises, the costs of which are borne by the taxpayer. Credit, by definition, has an asymmetric risk profile (downside of a total principal loss, and "upside" of a modest contract rate of interest and return of principal); accordingly, credit-related losses are difficult to recoup organically in periods of market recovery. This inability to self-heal, along with the essentiality of credit intermediation — particularly critical during periods of market instability, as seen during COVID-19 — requires public intervention when markets fail.
Unfortunately, current policy is not directed to mitigating the future cost of market failures. The relaxation of business development company (BDC) leverage limitations, limited regulation, underinvestment in portfolio management and favorable tax treatment of carried interest compensation all remain inconsistent with the oversight required to assure alternative lenders' durability throughout the credit cycle.
Moreover, while no Bernie Madoff-sized frauds have been uncovered in the direct lending space, disclosure by public vehicles remains an issue, particularly relating to the "mark" (valuation) of illiquid credits, misleading information on portfolio composition and structure of investments, and obfuscation of what constitute recurring items. The simplest solution would be to regulate alternative lenders like banks. To do so would be to acknowledge that a shadow banking system is still a banking system. Regulations have a purpose and should be applied to institutions of similar mandate consistently.
That said, there are sound arguments for alternative lenders operating under a regulatory regime distinct from that of deposit-taking institutions. While credit intermediation is a utility function, protecting depositors is a distinct policy priority and deserving of greater regulatory attention. However, regulation specific to lending — leverage guidelines, asset categorization, reserve and infrastructure requirements, public disclosure and the like — should be applied consistently. Under a consistent lending regulatory regime, there still remains scope for encouraging innovation while avoiding incubating future systemic risk, such as with the regulation of systemically important financial institutions or "SIFIs."
Market risks do not exist in a vacuum, but within a particular historical context. Rabidly anti-market voices have gained greater purchase in developed market capitals around the world, and in the culture generally. While alternative lending has a legitimate role to play in a healthy market economy — as pure-play lending vehicles, with reasonably transparent risk/return profiles and a degree of creativity not typically observed of commercial lenders — the utility function of lending fits poorly with "risk capital" vehicles due to the inevitability of loss socialization.
Thankfully, the alternative lending industry has yet to experience a Lehman Brothers moment, given its relative infancy compared to other financial platforms. Given its rapid growth, however, the industry faces a clear choice: prudential self-regulation now, or more invasive "reform" later.
Richard J. Shinder is the founding and managing partner of Theatine Partners, a financial consultancy. He is based Greenwich, Conn. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
