By Aditya Yadav

The United States has seen an overhaul in banking due to the Federal Reserve’s policies regarding interest rates. Needing to rein in risk in a volatile economy with high interest rates, banks have been reducing lending to private companies and individuals, reserving lending for those only with exemplary credit ratings.

Private and fledgling companies with no credit ratings are looking for capital, and with traditional banks reducing lending, they are turning to private asset and investment managers which dispense corporate loans with high interest rates. Private credit has been steadily gaining a foothold in the market ever since regulators cracked down on the risky lending techniques of banks during the 2008 financial crisis. And now, there has been a boom in private credit occurring due to the Federal Reserve’s “higher-for-longer” policy with respect to interest rates.

Traditional banking has been taking a hit for a while – high interest rates have taken down banks like Credit Suisse and Silicon Valley Bank in the last year, proving the risk profile of institutional banks to not be very robust. Alternative lenders have been filling the chasm that institutional banks have withdrawn from, and one example is concerned with the private debt market – where companies are able to refinance bank debt with private debt.

Alternative lenders are able to provide companies with fewer regulatory stipulations and overall greater freedom within the terms of their debt, which is proving to be very attractive for some businesses: in 2023, bank loans converted into private debt stands at $12.2 billion compared to 2022’s $11.1 billion – signifying a $1.1 billion increase.

In the past few years, private lenders have been steadily building credibility – a portion of the largest private lending managers right now (e.g., Ares, Apollo and Oaktree) increased their assets through private equity. Private equity, in effect, is the process in which a company acquires another using borrowed money. This borrowed money is secured with the collateral of the business being acquired as well as the assets of the acquiring company. This is what is called a “leveraged buyout” – “leveraged” here means “using debt.”

Private lending managers like Ares and Apollo were able to grow their assets under management significantly through leveraged buyouts – saddling already debt-distressed companies with more debt until the acquiring company is able to effectively take over the business. Private lenders like Ares, Apollo and Oaktree have now transitioned into the high-potential (due to very low regulation – or even under-regulation) private debt industry, which is projected to become a trillion-dollar market.

A reason why private lending can be so attractive is that it is much less stringent than institutional bank lending – but this lack of stringency is offset by the high interest rates private loans garner: “Private-credit funds don’t require borrowers to get credit ratings, and they guarantee completion of buyout loans. Banks, meanwhile, might back out when markets turned rocky. But private credit loans have tougher covenants, prohibiting borrowers from selling assets or raising new debt to get cash. Private loans also charged average interest rates five percentage points higher than comparable debt in the bank market over the past 10 years.”

Alternative lenders, rising to prominence due to fewer rigorous requirements for borrowers to take out loans, are taking on high levels of risk and delving into below-investment-grade lending. Due to fewer regulations, the mobility of alternative lenders is of a much higher order than institutional banks, allowing private lenders to optimally recoup losses caused by a defaulting borrower.

One technique some private lenders are using is to form partnerships with insurance companies – combining sub-investment-grade lending with large portions of investment-grade loans – effectively increasing their risk tolerance.

In the years leading up to the pandemic, it was in effect a high-yield world for private lending – government subsidies ensured fewer loan defaults and private lenders were beating institutional banks with higher year-over-year returns.

Now, in a world of higher interest rates and lower investment returns, alternative lending is cementing its position above institutional banks after securing its foundation in the years leading up to the pandemic: “Investors wanted yield, and the government wanted credit risk away from the taxpayer . . . That created the environment for this market to mature.”

There has been pushback from Democrats for more regulations for alternative lenders – this new private lending market has assumed the position of a shadow-banking system, in which these lenders which act as banks are able to consolidate and spread outside the regulations of the banking system, proving to be opaque and hidden. “Lack of visibility will make it difficult to see where risk bubbles may be building.”

There is a familiar aura that surrounds the private lending market akin to the 2008 crisis, where risk is not individualized and brought to the fore (i.e., institutional banks) but is instead amalgamated and veiled by private lenders where risk now becomes systemic risk.  Systemic risk now emerging due to under-regulation could be a sign of an impending financial collapse.

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