Private Debt Growing Pains and Needed Reforms

Overview

Much has been written about the growth of the private debt markets and the potential threat to the overall economy. Recent failures of several firms have placed a spotlight and stoked additional concerns. While vigilance in the credit markets is needed for proper functioning, structural shifts in the funding markets mean private debt fills a critical void.

Structural Shifts

For hundreds of years, banks have been the primary source of funding for burgeoning enterprises. Provided a firm had sustainable revenues, profitability, and collateral, banks could be relied upon to provide a reasonable amount of funding to a wide variety of businesses. While some of that remains true today, banks have largely become more restrictive in response to shifts in their principal funding source: deposits. The watershed event was probably the collapse of Silicon Valley Bank (“SVB”), whereby the bank held supposedly risk-free assets that turned out to be anything but risk-free. The now well-reported problem was a repeat of the S&L crisis of 1980, whereby rapid increases in interest rates placed massive pressure on SVB’s assets, putting its capital base in jeopardy. While this risk has always been present in the banking world, the structural change was that depositors, upon learning of SVB’s problems, could and did rapidly shift deposits out of the bank thereby causing a bank run.

Bank runs are a perennial risk for banks, but SVB’s case was unique due to the rapidity of withdrawals facilitated by electronic banking. Via the web, funds could be shifted in seconds rather than days or weeks. While the government has recognized this problem historically and has provided some comfort by providing a backstop to deposits of $200K or less via FDIC insurance, such insurance does little for larger depositors and many moved funds regardless of the guarantees.

Post-SVB, as expected, regulators placed pressure on banks to limit the maturity of assets (i.e., loans).

The Need

While banks tightened the maturity and terms of loan portfolios, small and medium-sized businesses still needed funding for their operations. For example, a new production facility might require a five-to-seven-year payback period; a two-to-three-year loan does not fit. Compounding the problem is the fact that small and medium-sized businesses are critical for job creation and the growth of the economy. Small businesses firms with 249 or fewer employees contributed 55 percent of the total net job creation from 2013 to 2023.

Stepping into the void is a long-established source of capital: the so-called “private lenders.” Private lending (or private debt) has been around for ages. Of late it has received greater scrutiny because of its growth. The typical arrangement has been for insurance firms, or groups with ties to insurance firms, provide capital to those firms in need. From a structural perspective, this approach is advantageous in several ways:

1. Match Funding – providers of private debt typically have sources of capital which are longer term and therefore do not have to worry about a “run” on their funding source as banks do.
2. Little Community Threat – Banks provide multiple services to their community such as holding funds for meeting payroll, cashing checks, and other critical services. In contrast, private lenders typically have little “footprint” in the local community and therefore are less of a threat to the broader economy.
3. Little Government Exposure – as mentioned above, unlike banks, private debt is not backstopped by the federal government and therefore reduces risk to the financial system.
4. Flexibility – unlike banks, private debt can tailor the terms offered to borrower needs. At times, borrowers need longer term or flexible sources of funds to fund expansion or an acquisition. With concerns about longer-term exposures, banks might not be the ideal source.

Growing Pains

With rapid growth in any market, there are likely to be pains. We will provide our analysis of recent failures and possible “fixes”. (Noteworthy is the fact that we did not rate any of these and fortunately continue to support a superb track record.)

In reviewing the failures the words of Leo Tolstoy’s novel Anna Karenina comes to mind:

        "All happy families are alike; each unhappy family is unhappy in its own way."

I.  TriColor – the firm’s business is selling and lending to subprime auto credits. As is the case for many firms in the space, TriColor securitized its receivables and was awarded “AAA” or near- “AAA” ratings for its most senior tranches. True to history, when financial conditions for subprime borrowers weakened as a result of the exhaustion of COVID funds, weaker employment, and elevated interest rates, defaults rose. Supposedly some TriColor assets were fraudulently pledged to multiple lenders. Adding to the misery was the increased delinquencies, longer financing terms (see below) and a softer market for used vehicles. Unfortunately, the combination of negative factors severely undermined the firm’s ability to repay obligors.

‍

Figure I: Average Maturity of Used Car Loans at Finance Companies, Amount of Finance Weighted (source)‍

‍

Figure II: Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average (source)

Fix: From our perspective, this is a case of participants not being sensitive to the increase riskiness inherent in TriColor’s business. Structuring or securitizing obligations can help, but only at the margin. If the base business does not generate sufficient cash to support operations, even the most senior tranches will be in jeopardy. Regarding the fraudulent pledging of assets, typically UCC filings are maintained on vehicles and therefore lenders appear to have not conducted proper due diligence.

I.  First Brands – the firm’s business was producing aftermarket (i.e., not for the original vehicle manufacturers such as major automobile firms) auto parts such as filters, spark plugs, wiper blades, and brakes. The principal customers for First Brands were the auto part retailers such as AutoZone and Walmart. Given the fact that First Brand’s customers have been and remain in good shape, the problem lies elsewhere: the over-expansion of First Brands and the supposed masking of debt via off-balance sheet borrowing. Rollups are dicey in the sense that there is a digestion period whereby systems (accounting, inventory, invoicing, manufacturing, invoicing, etc.) need to be integrated to realize the expected savings. Integrating operations is time-consuming and complex. Additionally, the principals for First Brands had some legal difficulties in the past.

Fix: Lending needs to be tailored to the opportunities and risks. The more sophisticated lenders in the private debt space insist on cash being transferred to a central location, a restriction on asset expansion, and regular (often weekly) financial reporting. Given the fact that the underlying market remains sound the “trick” will be in deleveraging to the point that debt can be serviced.

II. Saks Global (“SKS”) – the parent of Saks Fifth Avenue and Nieman Marcus has not filed for bankruptcy but remains pressed. Like many retailers, SKS is a victim of shifting consumer tastes. In our view, it is a reduction in the demand for formal dressing due to fewer in-office hours, a shift to more casual wear, and an increasing comfort with online retailing. The drop in same store sales is sobering:

“Sales at Saks Fifth Avenue and Neiman Marcus have declined, with Saks' sales falling 16% and Neiman Marcus' sales falling 10% in the quarter that ended in June.”

Fix:  From a lender’s perspective, perhaps the best avenue is to recognize that fixing retailer problems is incredibly difficult and that a better approach might be that the apparel business, fashions are expected to change, and popular designs can be easily replicated for a fraction of the cost.

Some Perspective Please

The reality is that with any type of investment, there are likely to be some failures; even at the “AAA” levels there is a probability of default, albeit small. At the other end of the spectrum is venture investing or drug discovery, whereby the expectation is that most undertakings will fail, but that the winners more than make up for the losers. From a societal perspective, it is a mistake to insist that portfolios be risk-free as it would deprive asset owners of a reasonable rate of return and deprive the country of the leading source of job and GDP growth.

Our View

Egan-Jones is celebrating thirty years in providing ratings. We have helped the market by providing early warnings for Enron, WorldCom, Lehman Brothers, and others, and were named number one by Fortune magazine for our warnings about the Great Financial Crisis. While we maintain coverage of public companies, over the past decade we have become a market leader in private debt ratings and maintain a superb track record.

‍

Figure III: Terrific convergence record (hit rate) among public ratings

_{Hit rate}

_{The "Hits and Misses" aims to measure the extent to which the major rating firms converge toward our rating. For example, if we rate an issuer "BB" and another rater moves from "BBB" to "BBB-", such an action would be considered a "hit". If the rater withdraws a rating, then such action would be neither a "hit" nor "miss". Additionally, if we rate an issuer at a different level than the other raters and warn that they might take a divergent action and subsequently take a divergent action, then such is not counted as a "miss"}

Conclusion

Private debt fills a critical need in the market and has provided a valuable service to the economy. Nonetheless, vigilance is required particularly as it is subject to growing pains.    

‍