The New Shadow Banks: Private Equity Becomes Private Credit

As regulators have sought to curb bank instability, in many cases, the result hasn’t been risk reduction, but merely the transfer of the same risks to different players. Increasingly, the new risk takers are investors. One place this has occurred on a large scale, yet gotten very little notice, is how private equity funds, whose business model depends on high levels of borrowing, have gone into the shadow banking business to supplant banks as their debt suppliers.

A combination of regulatory intervention and residual memory of the 2007-2008 buyout frenzy has restrained some of the worst behavior. The Volcker Rule forced the banks that were active in private equity to shed most of these assets. Globally, annual buyout fundraising amounts remain a quarter below their peaks of 2007 and 2008. In Europe the total value of buyout transactions in 2015, although up a quarter on prior year according to the Centre for Management Buyout Research, was still half that recorded in 2007. Extreme behaviours such as quick flips and repeat dividend recaps have been partly curtailed by the European Union’s Alternative Investment Fund Managers Directive. US bank regulators have guidelines for banks to limit leverage assigned to LBOs to 6 times EBITDA. And the worst performing fund managers have been shunned by LPs – natural selection has operated as intended by preventing incompetent managers from gorging themselves on fees for another ten-year vintage. No doubt it will take a little while for these zombie funds to disappear, but if LPs remain disciplined and strong-willed, disappear they shall.

Yet a new source of risk, that of PE groups “diversifying” their fee-earning activities by building private debt businesses, is now almost entirely outside regulatory reach. Whilst several of these investors had arguably been very active on the credit side for years and can claim real expertise, others piled on opportunistically as their levered portfolio companies were in dire need of balance-sheet restructuring. And frankly the initial nibbling quickly turned into a feast, so discounted were some of these companies’ LBO loans. In 2009 and 2010, a vast array of mega-buyout debt tranches were trading well below par, with high-profile transactions like Caesars and TXU seeing their unsecured loans hit 20 cents on the dollar or less. It was too tempting an occasion for some PE groups to resist.

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