It is no secret that leveraged buyouts have become subject to significant scrutiny in recent times. Scepticism has prevailed in many corners, albeit to differing degrees, possibly because of rising interest rates and challenging macroeconomic conditions, the belief that capital structures are built upon unrealistic valuations, or a fear that older vintage funds have invested in businesses (both debt and equity) that are now under significant stress but have not been properly worked out.
In tandem, some commentators have continued to expound the imminent arrival of the infamous ‘wall of restructurings’, while doubt hangs over what constitutes a ‘restructuring’ in today’s market.
Alongside that scrutiny is an even worse-kept secret: how much liquidity exists in the equity and credit spaces. Unlike in 2008, there is no crunch when it comes to liquidity, only caution around its deployment. Regulators now appear keen to maintain a level of caution, with proposed reforms to regulate the circa $1.5 trillion private credit market aimed at limiting the amount of borrowed money that these funds can invest. Interestingly, there do not appear to be plans to regulate the equity markets that use this private debt.
An overzealous move?
As participants and observers review the proposed reforms, the debate appears to be centering on whether the regulation is an overzealous move by regulators that will negatively impact the growth needed in today’s global economy, or whether care is needed to ensure the long-term veracity of any asset class of this magnitude, whether for retail or wholesale investors.
In terms of those adopting the former position, many query why private credit, with its track record, is more in need of regulation than cryptocurrency. This is driven by the belief that damage to private credit on a large scale could severely undermine global markets and have a far bigger impact on the economy.
How should we examine the specific reforms? There are two main prongs to the proposals. The first is to limit the ability of a private credit fund to invest borrowed money.
The tenet of leveraged finance is that private equity funds borrow money, just like the tenet of public market investment is that investments are subject to significant risk. In the US in the 1920s, investors would borrow from banks to buy public market stocks; many ultimately viewed this as a major contributor to the Great Depression.
Layers of risk
Regulators are now concerned that having leverage that is itself deployed on a levered basis is overly risky and that ‘risk on top of risk’ is not good for the financial markets. However, one needs to look a little closer at the fundamentals to see if this is true. If the leverage borrowed by a credit fund is cheaper than what it is deploying from its limited partnership commitments, is that fund more or less on-risk?
Ultimately, it’s a question of risk allocation. By regulating borrowing, the suggestion is that lenders providing leverage to private credit funds are a less appropriate on-risk participant than the underlying LPs of that credit fund, who are perhaps more familiar with or more able to influence the micro risk as investors.
This may in turn suggest that retail investors in banks need more protection than wholesale LP credit fund investors. That is of course despite banks being subject to a plethora of stress and other risk-allocation dynamics, and the possible large-scale investors at both credit fund and fund lender level having similar LPs by way of pension funds or other similar investors.
The second prong relates to the ability of investors in private credit funds to withdraw funded commitments before the loans they hold have matured, unless they meet certain (as yet unspecified) criteria. The detail here is very limited but the thinking does appear to underscore regulators’ request that credit fund investors look carefully at their risk profile before deciding to invest.
Two market observations may be more relevant than we think today. The first is that the anticipated ‘wall of restructurings’ is analysed on some of the fundamentals of 2008, without looking at the key difference: the availability of liquidity.
What is a restructuring, and what ought to constitute one? For many, it is a word associated with negativity and loss.
Today, we might consider that the consensual processes undertaken by most lenders and borrowers are restructurings. After all, the convergence elements are compelling. Private credit is more able to be patient than banks, the crossover of LP investors at both borrower and lender level incentivises greater (or at least more efficient) alignment, and indeed, the global convergence of restructuring regimes has made outcomes more predictable and disincentivised protracted fights where they aren’t necessary.
The second observation is that investment is increasingly becoming democratised and is more accessible to retail investors than before. As such, if a retail investor wants to play in a higher-risk space, they can simply choose to do so. Regulating private credit will not, therefore, meaningfully protect an investor set on undertaking the type of higher-risk investments more traditionally taken by institutional investors.
Victim of its own success?
Private credit has attracted significant attention in recent years because of its vast successes.
It is unsurprising that regulators have turned their attention to it on that basis, even if other parts of the financial and investing sphere that may be more deserving of regulation remain largely unregulated. This won’t make much difference to how private credit conducts itself in terms of investment discipline, but legislators must be careful not to undermine – through over-regulation – the economic stability that credit markets have afforded the current economic environment when compared with the global financial crisis of 2008.
Aymen Mahmoud is a partner and co-head of London finance, restructuring and special situations at law firm McDermott Will and Emery