The Big Idea

The competition to fund US companies

| December 9, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

On a recent Sunday, despite sunshine and beaches right outside, attendees at the annual Southern California gathering of the CLO market packed into a hotel ballroom to hear about a hot topic: private debt. Debt capital by most accounts has poured into private lending in recent years, with the focus usually on the pace of growth and the size of the market. It seemed like the right time to try to go beyond enthusiasm to put some context around the market.

Private lending competes with bonds and bank loans

Private lending has long competed to fund US companies, usually facing off against corporate bonds and bank loans. Loans from insurers, business development companies, finance companies and other private lenders started the 2000s funding nearly 8% of balance sheets, rose to 10% before the Global Financial Crisis and then dropped in half by 2016 before rebounding back to 10% today (Exhibit 1). Much of the competition in the last two decades has been with corporate bonds, with bond share of funding broadly moving in the opposite direction of private loans. Loans from banks and other depositories have also lost share to private loans and bonds, starting the 2000s at around 10% of US company balance sheets, dropping toward 3% a decade later and only rebounding to around 5% today. These different sources of funds compete on different grounds—rate, maturity, covenants, speed and certainty of execution, flexibility before and after origination, borrower size, business sector, leverage and other factors.

Exhibit 1: Private loans compete with bonds, bank loans to fund US companies

Note: Data show each source of funds as a share of total nonfinancial corporate liabilities. Other liabilities include CP, muni bonds, mortgage loans, FDI through intra-company loans, trade payables, taxes due, equity and other.
Source: Federal Reserve Financial Accounts of the United States, Santander US Capital Markets

Within private lending, leveraged loans compete with other funding sources

Within the arena of private lending to companies, providers of leveraged loans compete against other forms of private debt. Leveraged lending made steady inroads against other forms of private corporate funding from the early 2000s through mid-2016, approaching 80% of non-depository corporate funding (Exhibit 2). Since then, the share has dropped toward 50%. Today there is $1.4 trillion of outstanding leveraged loans and almost $1.3 trillion of other private lending to companies. Private lending beyond leveraged loans has clearly grown aggressively.

Exhibit 2: Leveraged loans compete with other forms of private corporate funds

Note: Data show par balance of outstanding US leveraged loans and show other private loans to US nonfinancial corporate business as the difference between total non-depository loans and leveraged loans.
Source: Federal Reserve Financial Accounts of the United States, Morningstar/LCD, Santander US Capital Markets

The terms of competition

The lack of consistent public information on the terms of both leveraged loans and other private loans—especially on the non-price terms—makes it hard to understand how private loans compete against other sources of funds and against each other. But a new paper from researchers at the Federal Reserve Board takes advantage of detailed regulatory filings from 2012 into 2022 on 337,000 bank loans to 136,000 borrowers to shed some light. Those filings allow the researchers to track both traditional bank loans from a single lender and syndicated loans at least in part held by banks, setting up at least a comparison between banks loans and the largest part of the leveraged loan market. The data also show bank internal risk ratings and modifications over time in loans’ rate or spread, maturity, the collateral or size of commitment and allow the researchers to pair a subsample of the loans with information about their standing on covenants. The information on ratings and covenants and changing loan terms help paint a picture of lender response to changes in borrower creditworthiness. The data and analysis lead to some surprising results:

  • Loans get modified frequently, with around 40% getting modified at least once
  • Single-lender loans get modified less frequently than average and overwhelming get maturity extensions rather than other modifications
  • Syndicated loans get modified more frequently than average and most commonly get rate or margin modifications that can come throughout the life of the loan
  • A sharp drop in loan rating raises the odds of modification, although syndicated loans with deteriorating ratings are much more likely to get modified than single-lender
  • Covenant violations are associated with modifications, but modifications are a broad phenomenon that happen even for syndicated loans that have not violated covenants

These results suggest a clear contrast between traditional bank loans and syndicated loans, especially in lender response to changes in the creditworthiness of the borrower. Although some analysts have argued that borrowers would have an easier time negotiating changes with a single lender, loan syndicates seem much more responsive to borrowers than single lenders in this study. Syndicated lenders seem to respond not just based on credit distress or covenant violations and not just approaching maturity, suggesting that syndicated loans get continually modified or renegotiated after origination.

The apparent flexibility of loan syndicates explains the common observation that private equity sponsors prefer to borrow in the broadly syndicated leveraged loan market because they need flexibility to manage the evolving balance sheet of their acquisitions. That may be why leveraged loans steadily gained share in funding US companies for most of the last two decades. Companies that borrow from a single lender either in the leveraged loan market or from banks may have more stable balance sheets that do not need the flexibility of the syndicated market.

That leaves open the question of why companies have reached outside of the leveraged loan market since 2016 for other sources of private debt. At a recent S&P conference, senior representatives from both Apollo and Blackstone, large direct lenders, argued that speed and certainty of loan execution, speed and ease of modification during the life of the loan and privacy are major selling points for their borrowers. Often the loan inquiry comes from other private equity investors that need fast and certain execution on a loan to win an acquisition—faster and more certain execution than provided by a loan syndicate. If that is a major motivation, it would seem that large borrowers from direct lenders eventually would return to the syndicated leveraged loan market once the urgency of acquisition passed.

Good prospects for non-depository lending

Private lenders have good reason to expect plenty of opportunity in the next few years thanks in part to bank regulators. Requirements for more capital and more liquidity are likely to prompt banks to cede more segments of the lending market to private lenders—including both middle market and broadly syndicated leveraged loans as well as to direct lenders of other stripes. The competition between leveraged lending and direct lending is likely to broaden and heat up.

Even though banks may lose some of the lending market to other providers of funds, there’s a silver lining for banks: those nonbank providers themselves will likely turn to banks to finance their growing portfolios of debt. The same regulatory filings that shed light on loan modifications also show a significant rise in lending to nonbank financial institutions in the last five years (Exhibit 3). One door closes, but another opens.

Exhibit 3: Bank financing of nonbank lenders has grown in recent years

Source: Federal Reserve Financial Stability Report 2023, Santander US Capital Markets

* * *

The view in rates

Fed funds futures lost some of their enthusiasm for rate cuts after the December 8 jobs data, reducing the implied probability of a first cut in March to less than 50% and reducing projected cumulative cuts by December to less than five. The Fed has entered the quiet period ahead of the December meeting, so it will have nothing to say before then to shape market expectations. Fed Chair Powell is almost certain to address market expectations for rate cuts at the FOMC meeting on December 13. If he jawbones against the cuts, rates should rise. If he says little and implicitly endorses market expectations, rates should fall. In either case, implied volatility should drop after the meeting.

Other key market levels:

  • Fed RRP balances closed Friday at $821 billion as the facility continues to decline, up $53 billion in the last week but continuing to trend down. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
  • Setting on 3-month term SOFR traded Friday at 537 bp, roughly unchanged again since late August
  • Further out the curve, the 2-year note closed Friday at 4.72%, up 18 bp in the last week. Given the likely Fed path, fair value on the 2-year note is closer to 5.00%. The 10-year note closed at 4.23%, up 3 bp in the last week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -49, flatter by 15 bp on the week. The 5s30s closed Friday at 6 bp, flatter by 20 bp.
  • Breakeven 10-year inflation traded Friday at 223 bp, unchanged in the last week. The 10-year real rate finished the week at 200 bp, up 2 bp in the last week.

The view in spreads

Despite the market adjustment on the latest jobs data, the market still seems too aggressive about Fed easing next year. Spreads on risk assets also seem too tight. Policy is likely to remain relatively tight through the first half of the year, and resulting lower liquidity is likely to offset stability in policy and keep volatility elevated. Spreads should widen from current levels and remain volatile. The Bloomberg investment grade cash corporate bond index OAS closed Friday at 139 bp, unchanged in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 148 bp, tighter by12 bp. Par 30-year MBS TOAS closed Friday at 40 bp, tighter by 4 bp. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so the subsequent widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, but a lot will depend on how long rates remain high. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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