When Tony James piped up on behalf of ‘market-based lending’ in an opinion piece in the Wall Street Journal last month we here at Private Debt Investor took note, as did many in the market. Perhaps regulators did too.
James defines ‘market-based lending’ as “The provision of capital by loans or investments to some companies by other companies that are not banks”. He cited insurers, credit funds, hedge funds and private equity groups as examples.
Until now, most industry grandees have kept their heads firmly below the parapet as far as credit funds are concerned. That’s been fine, because as an asset class private debt has enjoyed relatively little scrutiny, and certainly very little hostility – in contrast to private equity, for example, which has enjoyed less than favourable coverage in recent years.
So why now? James is perhaps cognisant that there’s a window of opportunity here. A window to make the case for non-bank lending. A window to convince regulators that far from posing a risk, private debt funds are a way of de-risking the system. And a shop window for his firm’s own, vast, credit operation, GSO Capital Partners.
On the latter point, GSO hardly needs a cheerleader. It’s a capital-raising machine, with $65 billion of assets under management and counting, having closed its latest rescue lending fund on $5 billion last year. It’s bigger now than Blackstone’s buyout arm with which the firm made its name.
No wonder James cares about this business. He argues – persuasively – that market-based financing does not represent a systemic threat in the way banks do. But in almost the same breath, he points out that “market-based finance in the US amounts to trillions of dollars and is significantly larger than the country’s entire banking system”.
It’s brave to suggest that an asset class with that level of exposure does not represent any form of systemic risk, and to an extent his argument has weight. Banks do concentrate risk, whereas funds disperse it across a large number of sophisticated investors. Funds don’t borrow from central banks like the Federal Reserve, and they draw commitments, James points out, from “well-advised institutional investors who know what they are getting themselves into, and understand the associated risks”.
Bank depositors, he argues, do not typically know how a bank will invest their money, or how risky those investments will be.
His key point is that in funds, investments don’t create counter-party risk and aren’t made in support of a common debt structure. Losses in one fund don’t contaminate the whole ecosystem.
All of this begs the question, why is James saying this now? It suggests he fears the heavy hand of regulation coming private debt’s way.
He argues: “Some regulation may be appropriate for nonbank entities that present bank-like risks to financial stability or that lend to consumers. But let’s not forget that it was the regulated entities that were the source of almost all the systemic risk in the financial crisis.
“Regulations are far from a panacea and would need to be carefully constructed to ensure that the enormous economic benefits of market-based financing are not lost through inappropriate and stifling regulatory policies established for large, deposit-taking banks,” he wrote.
This sounds a lot like the arguments extended by James himself and his peers midway through the buyout boom. He can point at others and say “It wasn’t us”, but the point of regulation isn’t to safeguard against a crisis that’s already happened, it’s to prevent a future one (of potentially a different variety) occurring. Given the size and growth of market-based financing, it is only prudent for regulators to consider the impact it has on economies and question whether it poses any risks.
It’s worth pointing out too that those “sophisticated investors” he speaks of include public pension funds, many of which are struggling desperately to fund their liabilities. The latter point has become an issue of great import in the US, where a growing number of politicians point to the mismanagement of Detroit’s public pension system as a harbinger of future calamity. If the funds to which those pensions commit capital underperform, or if there’s another crisis around the corner, all that locked up exposure will have an impact.
James then has made a sensible play, foregrounding the valuable role non-bank financing has to play in supporting economic growth and, importantly, drawing a dividing line between the banking community and private debt funds. He’ll be hoping that regulators aren’t tempted to cross that line.