IDEIAS

Alternative capital providers supplanting traditional lenders is now a familiar tale. Banks, facing heightened capital regulations following the Global Financial Crisis, retrenched from corporate lending, effectively launching direct lending as a mainstream asset class. As traditional lenders face further headwinds, we believe the next chapter in the private credit story is the migration of asset-backed finance (ABF) toward alternative capital providers. While the asset class isn’t new – lending against contractual revenue streams has historically been a cornerstone of bank and insurance company activity – the fundamental transition lies in who now provides the capital. Asset-backed financing may become increasingly unfavorable for banks, and insurers generally stick to the investment grade corner of the ABF market. Even among private lenders, who are estimated to currently provide less than 5% of asset-back financing within the $5.5 trillion universe, there are still significant barriers to entry, with a complexity that mandates experience across corporate lending, real estate lending, and structured credit. (See Figure 1.)

Figure 1: Private Credit Involvement in ABF Is Nascent

                     

Source: Oliver Wyman estimate1

The Regulatory Squeeze

Ongoing efforts to reduce the systemic risk presented by banking institutions have manifested in a succession of regulatory changes. One of the most impactful facets of these regulations is the requirement for banks to hold more capital, which may improve bank liquidity levels but also reduce their return on equity. (See Figure 2.) Because this capital is measured as a percentage of the bank’s assets (i.e., outstanding loans), activity that grows the asset side of the equation increasingly necessitates careful consideration. Importantly, asset base is calculated on a risk-weighted basis, meaning riskier lending activities, such as loans to small businesses or against repayments from individual borrowers, require banks to hold more capital.

Figure 2: The Average Capital Requirements for Large U.S. Banks Have Steadily Increased

Source: The Federal Reserve2

The implementation of these new regulations, primarily enacted via the Basel III accords, has steadily progressed since the Global Financial Crisis but is imminently coming to a head in the form of the Basel III endgame. This refers to the culmination of the Basel III rules, with a 2025 compliance date for large U.S. banks, followed by a three-year transition period. The most stringent rules would fall on the largest, and therefore most systemically important, banks: the 37 largest banks in the U.S. would meet the proposed $100 billion asset threshold, representing over 75% of all bank assets in the country.³

Along with higher capital requirements, the Basel III endgame will constrain the usage of internal bank models for calculating risk-weighted assets, with a standardized model effectively able to overrule internal outputs. Unrated assets – common within the ABF universe – face a 100% risk weighting regardless of their true risk,⁴ requiring banks to hold an outsized amount of capital, thus potentially rendering this lending unfavorable for banks.

Additional Headwinds

Increases to regulatory capital only add to the pressure on banks from quantitative tightening and a string of sector-specific stresses, including the decline of brick-and mortar retailers and an increase in vacant office buildings.

One challenge new to bank lenders has been the unreliability of deposits. (See Figure 3.) While bank loans often have long maturities, deposits can be withdrawn almost immediately. This isn’t a worry for private credit lenders, who offer their investors only limited liquidity in order to ensure stable capital. Based on the practice of fractional reserve banking – in which banks retain a portion of customer deposits as reserves and lend the rest – a reduction in deposits is naturally followed by a reduction in lending activity.

The 2023 regional banking crisis highlights the liquidity risk inherent in this model. The deposits held by Silicon Valley Bank, the headline casualty, were lent out via long duration bonds, which decreased in value as interest rates rose. When customers sought to withdraw their deposits, this asset-liability mismatch was ultimately fatal for the bank. Given this instability, banks have become more measured when providing the illiquid financing associated with ABF.

Figure 3: Deposit Instability Has Made Bank Lending More Challenging in Recent Years

Source: Board of Governors of the Federal Reserve System (U.S.)

Bank Reprioritization

The upshot of this? Banks find certain lending activities increasingly inefficient, with no end in sight to this shift. As a result of tougher capital charges, banks are either (a) refocusing lending activity on their biggest (and safest) client base or (b) targeting lending toward situations where they stand to earn fees and attract deposits. Lending is estimated to have accounted for only 21% of banks’ total revenue in 2023, down from 26% in 2019.⁵ In the U.S., bank lending as a percentage of GDP has dropped by nearly ten percentage points since the Global Financial Crisis. (See Figure 4.)

Figure 4: Bank Provision of Credit Has Declined as a Percentage of U.S. GDP

Source: The World Bank

A Financing Void

As banks continue to shift their focus, what does this mean for alternative lenders? It’s important to note that alternative lenders currently play a smaller role in ABF than in mainstream direct corporate lending. Banks started to retreat from corporate direct lending quite some time ago, and direct lending presented a more natural extension for leveraged finance practitioners, who flocked to the space. Many companies now issue both public senior loans and private loans, with the due diligence processes for these types of loans having a high degree of overlap. Direct lenders continue to dominate the private debt landscape, with nearly $200bn of combined dry powder to deploy.⁶ On the other hand, ABF represents a new frontier for most managers, with additional barriers to entry. (See Figure 5.)

Figure 5: Private Credit Capital Has Grown Substantially but Remains Tilted Toward Mainstream Direct Lending

Source: Preqin

We believe the most underserved portion of the ABF universe is the ‘‘core’’ segment that sits between senior, investment grade lending and the opportunistic end of the risk spectrum. The investment grade portion of ABF, with the lowest perceived risk and lowest expected returns, is well addressed by insurance buyers and other investment grade-focused ABF platforms. U.S. insurers hold a whopping $8.5 trillion⁷ in total cash and invested assets; they value the cash flows generated by ABF, but regulation demands an investment grade rating to ensure favorable capital treatment. For most ABF packages, investment grade ratings only extend to senior financing, therefore leaving mezzanine and junior capital financing to other parties. Additionally, many transactions don’t support ratings at all (e.g., short-term facilities, which are incompatible with rating agency criteria). In short, insurance capital won’t be able to fill the void left by retreating banks.

Meanwhile, private equity, opportunistic credit investors, and specialty finance platforms require higher returns than those generally offered by the core portion of ABF. As a result, we anticipate alternative lenders will increasingly provide essential capital in the core ABF segment where traditional senior lenders, such as insurers and banks, are unable or unwilling to operate.

ABF Sector Spotlight

Among the wide range of esoteric ABF verticals, we’ve chosen to showcase three sectors we believe may be at the center of the ABF evolution.

(1) Aircraft Leasing: Fleeting Supply

Since 2019, aircraft production has significantly declined, largely due to delays and quality control issues at major manufacturers like Boeing, Airbus, and Pratt & Whitney. (See Figure 6.) This has led to unprecedented order backlogs and higher aircraft lease rates.

Global airline traffic has now surpassed pre-pandemic levels, and aircraft producers have been unable to meet the increased demand. Due to the extremely limited supply of new planes, airlines have no choice but to put aside idealized fleet planning and prioritize leasing and purchasing midlife assets.

We believe the current supply-demand imbalance, which is expected to persist until 2030 or beyond, presents a rare opportunity for appropriately resourced aircraft investors to step in and provide financing to proven aircraft leasing platforms and originators.

Figure 6: 2024 Aircraft Deliveries Are Likely to Remain Below 2017 Levels

Source: AerCap, as of May 2024

Note: Represents narrowbody aircraft (i.e., single-aisle airliners)

(2) Synthetic Risk Transfer (SRT): Coming to America

Synthetic risk transfer (i.e., when a bank enters into a contract with an investor, whereby the investor assumes the risk of any future losses in a credit pool in exchange for coupon income) allows banks to “sell” risk without taking the immediate balance sheet impact of a below-par sale. Many banks lent aggressively at the historically low rates from 2009-21 and now find themselves with a balance sheet full of low-interest, long-duration assets.

Selling these assets in today’s elevated interest rate environment would create a book equity loss, potentially impacting capital ratios and market perception, as well as endangering the bank’s relationship with the underlying borrowers. Banks are increasingly using SRT as a tool to effectively amortize the “cost” of that sale over several years.

In 2023, SRT issuance in Europe was over ten times the volume in the U.S.⁸ It is estimated that the U.S. market will quickly begin to catch up, with a fourfold increase projected for 2024. (See Figure 7.) Moreover, we believe the most attractive SRT opportunities will be those associated with pools of niche assets that require specialized knowledge, avoiding the overly competitive auctions associated with ‘‘vanilla’’ SRT, such as corporate loans or subscription facilities.

Figure 7: SRT Volume Is Projected to Grow Substantially in the U.S.

Source: Bank of America estimates, as of March 2024

(3) Consumer Credit: Lender Exodus

The unsecured consumer sector underwent a negative performance shock in 2022-23 after experiencing two years of robust performance, rapid origination growth, and inexpensive funding. This downturn was driven by inflated credit scores, machine learning models misled by pandemic-related stimulus measures, and high inflation. Subsequent to this volatility, many capital providers have exited this space entirely.

Due to the deterioration in performance, originators have tightened their credit underwriting standards and increased Annual Percentage Rates, which has created a more favorable outlook for new investments as performance begins to improve.

In the unsecured consumer sector, we’ve seen loans originated through personal interaction (e.g., in-branch, at medical offices, or at point of sale) perform significantly better than those originated online or without personal interaction. Therefore, we believe investors, when looking to provide financing to thoughtful consumer lenders or purchase discounted pools of consumer loans, should favor loans originated through personal interaction and used to finance essential spending.

What Next?

We believe we’re witnessing a permanent, secular shift in the financing ecosystem, as ABF transforms from an asset class dominated by banks and insurers into an investible alternative credit opportunity. We don’t expect banks to meaningfully loosen credit standards and regain their lost market share in the near future, and we expect insurers to maintain their focus on lower-returning, investment grade lending. Thus, we believe asset-backed finance isn’t a short-term opportunity, but rather the next frontier of private credit.

However, ABF shouldn’t be viewed as a homogenous, easily accessible asset class. While we believe experienced managers can control risk, we believe those who don’t appreciate the complexity of the asset class – or who fail to conduct adequate due diligence – are at risk of getting burnt.

Credit Markets: Key Trends, Risks, and Opportunities to Monitor in 4Q2024

(1) The Trajectory for Interest Rates in the U.S. Remains Unclear Despite the First Cut

In September 2024, the U.S. Federal Reserve reduced interest rates by 50 bps, bringing the federal funds rate to the new target range of 4.75-5.00%. This ended the interest rate hiking cycle that began in March 2022 and resulted in a 525 bps rise over the period. Given the September rate cut was largely priced in by market participants, the impact on Treasury yields was limited.

The Fed’s action was long awaited after a series of ‘‘false starts’’ to the rate cutting cycle, whereby many market participants priced in aggressive interest rate cuts that then didn’t materialize. (See Figure 8.) Credit investors seeking to drive performance through duration exposure were left frustrated, while the best returns were often achieved through high-income assets with limited interest rate sensitivity, including senior loans and structured credit.

Figure 8: The Actual Fed Funds Rate in 2024 Has Diverged from the Market Prediction at the Start of the Year

Source: Bloomberg

This significant cut was followed by exceptional U.S. jobs data at the start of October. Total nonfarm payroll employment in September increased by more than 250,000 jobs, well above the consensus expectation of roughly 140,000 jobs.⁹ This apparent affirmation of the resilience of the U.S. labor market, and subsequent increase in uncertainty surrounding the trajectory of interest rates, led to a rise in Treasury yields.

For those that bet heavily on aggressive interest rate cuts, this proved to be another tough pill to swallow. As Howard Marks often reminds us, investors should always be conscious of where we are in the market cycle – but never make bets based on macroeconomic predictions.

(2) Favorable Conditions May Support a Rise in M&A and LBO Volume

Primary leveraged finance markets experienced a meaningful surge late in the third quarter of 2024, following the usual summer lull: senior loan and high yield bond issuance was robust in September, with over $140 billion of combined volume, a 70% increase from the same period in 2023.¹⁰

Debt issuance over the last two years has been dominated by refinancings as private equity sponsors have found limited exit opportunities for their portfolio companies. The headwinds to LBO and M&A activity are well known: elevated financing costs after a historic rise in interest rates, stubbornly high equity valuations, concerns about economic growth, and, in more recent months, the uncertainty around the 2024 U.S. Presidential election.

Some of these challenges now seem to be abating. While interest rates will likely remain elevated, the first interest rate cut from the Fed in September marked the end of the hiking cycle. At the same time, the economic outlook (especially in the U.S.) appears more robust, with strong labor market data and a surprisingly resilient consumer. Another catalyst is limited partners pressing their investment managers for cash: distributions from closed-end funds have been delayed, with the median hold period for exited private equity portfolio companies recently exceeding seven years, leaving LPs pushing for exits.¹¹

With this, we’re beginning to see signs of life in the M&A and LBO space. Importantly, the third quarter of 2024 saw the highest amount of non-refinancing loan issuance since 1Q2022. (See Figure 9.) Moreover, more LBOs were funded through the broadly syndicated loan market than through direct lending during the period.¹² This shift was largely due to significant investor demand, particularly from CLOs, which has reduced the cost of financing in the public market. We anticipate that once the uncertainty surrounding the U.S. election is removed, a new wave of M&A and LBO activity could emerge.

Figure 9: New Loan Supply Is Showing Signs of Recovery

Source: PitchBook LCD

(3) Private Debt Defaults Remain Limited, But Pay Attention to PIK

Performance in the private debt markets has remained strong in 2024, with business development companies (BDCs) returning an exceptional 10.7% year-to-date.¹³ While we’ve seen an uptick in defaults this year, the current default rate of 2.0% remains manageable, and below the default rate in the broadly syndicated loan market.¹⁴

What has kept private debt markets so buoyant? Firstly, companies have been supported by surprisingly resilient consumer expenditure. Secondly, sponsors have proactively reduced costs in their portfolio companies and passed on input price increases to end consumers. These sponsors have also collaborated with lenders to promptly address potential liquidity issues.

However, there are still several reasons for lenders to exercise caution. Issuers of floating-rate debt are likely to be exposed to higher borrowing costs for longer than they’d previously anticipated, as the market consensus around the trajectory for interest rate cuts has proven to be overly ambitious. This may put further pressure on interest coverage, particularly given that we’ve seen slowing EBITDA growth among middle-market companies.

As borrowers begin to feel the impact of these mounting pressures, we’ve observed a shift toward alternative financing solutions. The most prominent is the rise in borrowers turning to payment-in-kind (PIK) instead of making their coupon payments in cash. For example, the percentage of PIK income for BDCs has risen by nearly 200 bps since 2023. (See Figure 10.) This can alleviate liquidity pressure on borrowers, but it presents a risk for lenders who (a) miss out on regular cash payments and (b) face uncertainty regarding delivery of accrued interest or potential equity upside. While not all PIK is inherently bad, it remains crucial for managers to diligently monitor these developments.

Figure 10: PIK Constitutes an Increasing Percentage of Private Credit Income

Source: Fitch Ratings