Private capital versus the banks

By: Kamran Anwar

U.S. mid-market corporates regularly solicit funds from capital markets to help finance their operations. In Europe, most mid-market firms still obtain their financing from banks, but this is changing.

Basel III requires banks to make additional capital allowances on their balance sheets when making loans, particularly when the borrower is considered risky or low investment grade. While Basel III deters irresponsible lending practices at banks, it also cuts off financing for mid-market companies.

As a result, private lenders are turning to credit markets for uncorrelated returns and a reliable source of fixed income revenues. The Deloitte alternative lender deal tracker found European private deal flow increased 29% in the third quarter of 2016.

Most private debt funds provide financing at six or seven percent above LIBOR. These rates may be higher than at banks, but private debt funds are more flexible and efficient. According to Preqin, the private debt industry grew from $483 billion (end of 2014) to $523 billion (June, 2015).

46% of investors said they would increase their private debt allocation over 2016. Regulations such as Solvency II which impose risk-weighted capital obligations on European insurance companies, and assign low capital charges to debt instruments, could also increase private debt fund allocations.

Private debt funds face some challenges. Low interest rates deter banks from making loans, but an increase in interest rates (possible under the current U.S. administration) could encourage banks to reclaim their share of lending activity.

More worrying for private debt funds is that the market has grown so rapidly that there may not be enough creditworthy corporates to lend to. This has stunted the expansion of peer-2-peer (P2P) lenders who saw significant initial growth but whose progress slowed when reliable (and safe) loans became finite.

As lending opportunities are constrained, private debt funds risk financing unsound borrowers who could default. While this is less likely to be a problem for larger firms who have industry-leading knowledge about credit markets, it’s a big concern at smaller private debt funds.

Some firms are niche lenders and provide financing to under-served market segments with growth potential and reliable income (e.g. software development firms).

Private lenders must be disciplined, understand the risks involved, and ensure there are protections to claw back capital in a worst case scenario. At the very least, managers in the mid-market lending space must hire people with banking experience.

To learn more about credit markets, contact solution@sscinc.com.