Friday Letter: A sigh of relief for now

Private equity executives got a reprieve earlier this month. 

They’d been for a chat with US regulators, who confirmed that they weren’t the targets of a new wave of regulation. The Federal Reserve Bank, the Office of the Comptroller of Currency (which is part of the US Treasury), and other governing bodies are apparently weighing whether banks are taking on too much risk again, using too much leverage and issuing loans to companies with poor credit profiles.  

These governing bodies and others are also weighing imposing further restrictions on bank lending, especially when it comes to sub-investment grade companies.

Banks then are still front and centre when it comes to regulators’ thinking in the US.

Which begs the question: who is regulating private lenders? Is anyone? Or should they be?

What’s both funny and interesting about this recent meeting is that the private equity industry isn’t actually regulated by the Fed or the OCC, but it seems to be a net positive that the lobbying group and Feds are having these conversations already. The private equity industry is well-established, with lobbying groups like the PEGCC in the US, or the BVCA and EVCA in the UK and Europe respectively. Such groups have engaging with regulators over a long period, and successfully too – take the AIFMD, which in its original pre-consultation format was the very definition of a sledgehammer being used to crack a nut, but which was softened to the point of palatability by the buyout industry during several years of dialogue.

Banks of course have been locked in a similar dialogue with regulators since the crisis, and it appears that they’re now steeling themselves for another few rounds in the ring.

But what of the private debt industry? Thus far, it’s been largely free of scrutiny, but there’s sufficient concern that that might change.

There has already been talk of underwriting standards and covenants deteriorating in debt products issued by banks and alternative lenders. Leverage multiples are creeping up, and the reappearance of US style covenant-lite deals in Europe has also caused some to raise questions about a return to pre-crisis excesses.

Yet as Tony James of the Blackstone Group said earlier this year during an earnings call, anything which restricts the banks’ ability to lend will benefit private debt funds. He’s been vociferous in arguing that what he calls “market-based lenders” shouldn’t be lumped in with banks because they don’t pose a systemic threat in the way traditional lenders do. Private (equity and debt) fund managers are beholden to their investors, and losses, should they occur, are limited to that pool of stakeholders. Institutional LPs, particularly the large US pensions, still have the recourse of the courts in the event they feel there has been a misdemeanour, but ultimately the effects of any underperformance should be relatively self-contained.

The SEC has also been fairly public about investigating the asset management industry to determine whether asset managers are “systematically important financial institutions,” or SIFIs as the term has come to be known. So far they’ve started with Fidelity, BlackRock and Vanguard: extremely large asset managers who are big players in mutual funds and ETFs, which are widely used by regular “Mom & Pop” investors and required to be more financially sound than firms who only cater to institutions and other investors with relatively deep pockets. Still, the traditional asset management industry has largely pushed back against this label, with Larry Fink, BlackRock’s chief executive, and others often declaring that asset managers can’t be systemically important because they are merely agents that act on their clients’ behalf—extensions of the “prudent fiduciaries.” They are though also there to make returns on their clients’ behalf and in a market environment where there aren’t a lot of places to go for good performance, it wouldn’t be surprising if they gobble up undue risk of some sort in a bid to deliver it.

And while this hasn’t yet directly applied to the private investment industry, private equity and debt firms are asset managers. And some are starting to fret that if the SIFI label is attached to traditional asset managers, it won’t be long before alternative fund managers come under scrutiny.

Private debt managers are, for now, viewing the impending bank regulations as a positive for them, as they’ll be able to pick up more of the slack left over by banks that can no longer play in these assets, but it’s probably only a matter of time before the regulators, of whichever kind, come knocking on their doors as well. Question is: how are they preparing themselves? Pre-emptive meetings with the watchdogs are probably a good start.