Tag: Lending

Global Financial Markets Rethink

Expert financial analysts are suggesting that many of the presumptions that have driven the global financial markets in 2024 are quickly being rethought. Speculation that the Federal Reserve may well cut interest rates faster than predicted has given way to doubt over the economy of the United States, prompting investors to redeploy their investments in the currency and bond markets. The shift in sentiment has also been driven by a slew of disappointing results in corporate earnings, together with scepticism from shareholders that the huge investments in AI* (artificial intelligence) by tech companies may not pay off as soon as was originally expected. 

Indeed, analysts advise how investors were caught by surprise when results for Alphabet Inc (google parent) showed how much had been invested in technology, but any returns were not reflected in the revenue figures. Interestingly, while still up 12%, this year the Nasdaq 100 index has fallen circa 9% from its record high on July 10th, wiping out USD23 Trillion from its market value. Many experts have pronounced that the AI frenzy no longer looks as positive as it was before. 

*Artificial Intelligence – The bull market up to June 2024 has boosted the S&P 500 market capitalisation by USD9 Trillion (fuelled by AI stocks) since the Federal Reserve pivoted away from rate hikes in August 2023. Experts advise that performance is extremely concentrated in a few mega-cap names and could make the effect of any major decline in big tech stocks more pronounced.

Another example of the “rethink” is where investors have been borrowing in low yielding yen to invest in higher yields such as the Mexican Peso, the New Zealand Dollar, and the Australian Dollar. However, it appears that these transactions are a thing of the past as the gap between the BOJ’s (Bank of Japan) and its counterparts is set to come closer to each other.  Elsewhere, experts advise that the European and United States Equity markets in 2024 have been driven by the general agreement that inflation was slowly coming under control, however they feel that now the US economy is becoming weaker and weaker, changing the perception towards equities. 

In Sub-Saharan Africa, analysts advise that a somewhat laboured return to the international capital markets has run straight into a stop sign basically due to uncertainty over the November presidential election which has given global investors the jitters. There are 49 governments in the region and only five (Benin, Cameroon, Ivory Coast, Kenya, and Senegal) have managed to sell US Dollar bonds in 2024 in a combined amount of USD6.2 Billion which is much lower for the same period in 2022*. In fact those countries within emerging markets will see high yield borrowings classed as higher risk if former President Donald Trump wins the upcoming election, as experts feel he will favour fiscal expansion negating any reduction in the already high global borrowing costs.

*Sub Saharan Africa – The whole region was denied access to overseas capital for two years due to rising global interest rates and the devastation of war. 

As the US election approaches, it will be interesting to see how the different markets react, though currently there seems to be a massive “rethink” to how global markets will be driven. Whoever wins the White House, it appears that investor sentiment at least for the being is moving to safer havens.

Private Equity Companies/Partners/Owners are Engaged in Standard and Exotic Loans

Over the last three or four decades executives of private equity companies ruled the roost where investors from all over the world would beat a path to their front door looking to invest in their next big fund. However, times have changed, declining valuations and much higher interest rates have made it harder to sell assets, raise new money for investments and fund distributions to their investors. 

Today the biggest investors or backers of these private equity funds have turned the tables and are demanding more from private equity owners/directors, such as if we invest you now have to invest more of your own money. Throughout the private equity industry, company directors/owners /partners are having to take on debt and pledge their personal assets (homes, paintings, yachts etc) in order to appease their larger investors.

In 2023, contributions to equity from the private equity sector was circa 2% and in 2024 is circa 5%, and according to analysts, in some cases as high as 20%. In order for some of these executives to raise the requisite amount of cash, they have been taking out high interest loans where the rate is anywhere between 10% and 20%, and some banks, so experts advise, are demanding collateral of all personal assets. Such is the need for more cash in the private equity sector, some money managers are now scrambling to get cash, and  private lenders such as Oak Capital Management are making funds available. 

Apart from the personal loans the industry has seen loans that have been rarely used before. Below are a few examples.

*Manco Loan – This is a relatively new loan where appetite is going through the roof. Taken by the entity or management company that oversees the private equity investment, the collateral consists of cash flows such as equity returns or fee streams. This loan is usually used for funding an individual partners’ equity stake in a private equity fund, succession planning (focuses on maintaining a company’s talent and ensuring a smooth transition should existing leadership leave) and seeding new strategies. Currently there is no data available for the size of outstanding loans, but experts suggest that deal sizes range from USD50 Million to USD350 Million.

*Net-Asset-Value or NAV Funding- This form of finance is usually backed by a pool of portfolio companies within a fund, where the funds are utilised by private equity companies to help return money to investors. However, experts in this area advise that this form of finance is likely to dilute returns at later dates and effectively leaves the fund paying an interest rate that is not to everyone’s liking. Estimates from analysts and experts alike suggest this form of financing will increase circa 700% by 2030 to USD 700 Billion.

*Collateralised Fund Obligations – This form of finance bundles stakes in funds holding private equity owned companies, which are then packaged into one security. Risk categories go from senior to equity tranches and coupons are paid from the cash flows generated by the companies. If the investment goes south the equity tranche takes the first loss, but as it is the riskiest tranche interest payments  according to experts are 20%.

In an industry sector that has been used to cheap money from 2010 to 2021, this scrambled rush for loans sees a marked reversal of fortunes. The industry has been facing geopolitical and economic uncertainty plus much higher interest rates which in 2024 has seen takeover volumes down by 50%. Indeed, cash on hand at private equity companies is, according to recent data released, at its lowest mark since 2008 (Global Financial Crisis). Furthermore, experts advise the more influential investors (e.g., state pension providers and sovereign wealth funds) have said they will only commit to new funds if capital in the old funds are released first. 

The private equity industry is valued by analysts at circa USD8 Trillion and has undergone a real cultural change with the balance of power shifting away from the private equity companies to the Limited Partners or LP’s (investors). It is suggested that before too long, these LP’s could cut out the middleman and set up their own in-house private equity companies. This will leave the current players in the market struggling to find the best investment deals to offer a smaller number of investors.

Bad Debts and Chinese Banks 

Chinese banks have for years been reluctant to disclose any information on poorly performing loans or outright bad debts. They go to extraordinary lengths to hide these problems usually teaming up with an AMC (Asset Management Company)* where a transaction takes place that removes these loans from their books. So it came as a surprise when the Bank of Jiujiang on the 19th of March 2024 announced that profits for the previous year will probably fall by Circa 30% due to loans performing poorly.

*AMC’s – Chinese Asset Management Companies came into existence in 1998 and were established by the Ministry of Finance with the purpose of professionally managing third-party assets and was considered at that time to be a major landmark in the development of China’s financial system. It marked the transition from an unregulated environment to one where these specialist companies would operate with a defined set of financial parameters, regulations, and standards. 

The deal with AMC’s to hide these bad debts or poorly performing loans is as follows. First, the bank lends to the AMC who in return purchases the toxic loan(s) from the bank. Within the contract between the two parties it stipulates that the AMC will avoid any and all credit risks in regard to the toxic loans they are purchasing. Furthermore, the contract is also riddled with confidentiality clauses that keep either party from disclosing the arrangement, indeed sometimes even to courts. The result is that when the bank comes to declare their profits for the year to their investors they can produce a relatively clean balance sheet. 

For a long time the financial regulators were hoodwinked into believing that many of the banks were actually solving their bad debt problem, when in fact things were just getting worse and a number of experts suggest for literally hundreds of banks across China these toxic loans now represent a ticking time bomb. However, NAFR (The National Administration of Financial Regulation established 10th March 2023) the new financial regulatory body has caught on to these subterfuges and have been handing out fines left right and centre some in the region of Yuan200 Million (USD30 Million). Indeed, NAFR, with new heightened enforcement capabilities, are taking debt concealment much more seriously. 

Sadly for the banking institutions many AMC’s have themselves become distressed and are now reluctant to take more bad debt on board. Some decades ago China actually created four centrally controlled AMC’s to take on bad debt and are now currently struggling with one needing a bail out in 2021 to the tune of USD6.6 Billion. This is becoming a runaway freight train of bad debt, and with Bank of Jiujiang’s bad loan book increasing 700% between 2015 and the end of 2023, the whole banking system may soon become imperilled. 

 The Continuing March Upwards of Private Credit

Private credit can trace its roots back to the 1980’s where companies with strong credit/borrowing records were being loaned funds directly from insurance companies. However, post the 2007 – 2009 Global Financial Crisis, private credit really came into its own as an alternative to bank lending, especially as financial regulators were cracking down on those deposit taking institutions who were involved in risky lending. In today’s market, private credit has become a major contender in the loans market, and a serious rival to banks and similar lending institutions.

As of June 2023, data released shows that global closed-end private debt funds* have assets under management of circa USD1.7 Trillion, whereas as of close of business December 2015 global assets under management were circa USD500 Billion. Indeed, expert money managers suggest that by 2028, due to possible massive shifts in the financial markets, borrowers would flock to the front door of private credit funds, boosting the value of the global private debt market to USD3.5 Trillion. 

Closed-End Fund – This fund is a type of mutual fund, and in order to raise capital or investment, the fund issues a fixed number of shares through a one-time initial public offering (IPO). The shares can be bought and sold on a stock exchange if the fund is quoted, but no new money can be received into the fund once the IPO closes. Access to closed-end funds is only available during a New Fund Offer (NFO).

Open-End Fund – As opposed to a closed-end fund, the open-end fund such as mutual funds and exchange-traded funds (ETF’s) accept new capital on a constant basis and also issue new shares. 

Mutual Fund – This is an investment opportunity where monies/investments are received from a wide range of individuals and pooled together in order to purchase a wide range of stocks, bonds and other securities. Funds are managed by professional money managers and are structured to match the prospectus where the investment objectives are stated.

Private credit is responsible for providing a vast amount of financial resources into a number of differing investment strategies, some of which are outlined below.

1.     Mezzanine Finance – Mezzanine loans or capital can be structured either as subordinated debt or as equity which is usually in the form of preferred stock. Mezzanine financing is recognised as a capital resource which can often be seen as subordinated debt and sits between higher risk equity and less risky senior debt. To facilitate the explanation of mezzanine debt, below are the definitions of senior debt and subordinated debt.

·      Senior Debt – often issued in the form of senior notes and also known as a senior loan, is a debt that will be paid first by the borrowing company. In other words, it takes priority over other unsecured debt and in the event the borrowing company goes into liquidation, owners of senior debt will be the first to be repaid.

·      Subordinated Debt – or as the name implies junior debt, is usually the last type of debt to be repaid. It has a lower status to senior debt and hence the name subordinated debt. Typically, subordinated debt or loans will carry a lower credit rating and will therefore offer a higher return than senior debt.

2.     Venture Debt – Venture debt, sometimes referred to as venture lending, is a certain type of debt lending to venture-backed companies. A venture-backed company that receives venture debt is defined as companies who are at the start-up stage of their existence and rely on venture capital to expand their business. Typically the company has yet to make a profit, and loan size is usually based on the company’s recurring revenue

3.     Distressed Debt – Private credit funds are known a). for buying up corporate debt that is currently trading well under its original value and b). where companies are in difficulties to provide new financing, with a view to make a profit when the company either liquidates or restructures. 

4.     Direct Lending – This type of lending by private credit funds, (aka unitranche loans), are typically a senior term loan (first lien and the least) but can also involve credit lines and second lien loans which are subordinated to the first lien. 

5.     Special Situations –  As the subject suggests, loans in this case are applicable when a special situation or event occurs, and the company’s profitability or growth (a company’s metrics) are not taken into account when lending decisions are made.

A number of experts have asked the question: will private credit stand a sustained protracted recession? Private credit fund managers have answered that in many cases their loans are safer as they are locked in for longer than your standard lending institutions. However, the uncertainty that surrounds the terms in the private credit market means that in a recession no one really knows how far valuations would fall, and as a result would investors in funds that are struggling be able to sell out their positions. 

Regulators in the United States, the United Kingdom and the European Union are looking at expanding regulation in the private credit market. Indeed, regulators in the EU are putting strictures in place which ensure that private credit funds will diversify risk, and will cap leverage, whereby funds use borrowed funds to enhance profits. However, it appears that regulation will remain somewhat opaque as there seems to be a lack of appetite to bring regulation in line with banks and other lending institutions. This of course may reflect the attitudes of many governments, who seem happy to encourage private credit investment that they deem too risky for banks.