By Samuel A. Schwartz, Transactional Attorney, Brownstein Hyatt Farber Schreck
Prior to the Great Recession, private equity firms were historically devoted to buy outs and smaller loans that traditional banks had no interest in funding. Since that time, according to estimates by the private equity firm Ares Management, nonbanks held more than half a trillion dollars’ worth of loans to midsize companies at the end of 2017, up from approximately $300 billion in 2012.
Traditionally, banking is about finding businesses and looking for ways to raise capital from the market, while private equity is about finding high-net-worth funds and then placing those funds with investment opportunities in other businesses.
Generally, private equity firms are now competing with banks for business loans, because private equity does not have to meet the same strict criteria faced by traditional banks. Indeed, private equity firms are more lightly regulated and often have an influx of cash on hand. Private equity companies are also often staffed thinner and can make faster decisions. Faster decisions lead to more transactions.
This influx of money has the private equity lending market poised to grow, as private equity firms of all sizes are looking to get in on the action. Private equity firms have been moving into real estate, hedge funds and even insurance, much of which started during the recession.
For example, Las Vegas saw an influx of private equity firms buying residential homes and leasing them to consumers. In fact, many markets around the United States saw buying by private equity firms during the Great Recession and many of those firms still own those houses (which is partly to blame for historically low inventories across the country). Simply put, private equity is stepping into the void left by traditional banking.
The number of non-banks lending is expected to continue growing, as well as the level of lending by those parties. Recent examples include investment firms raising billions in cash to put solely toward business lending, partnering to create business-development company platforms focused on business loans, and buying and expanding existing lenders to increase business in that area.
The math bears this change out as well, as business-loan growth at banks is only up 3.6 percent in the first quarter of 2017, while non-bank commercial loans grew 7.5 percent in the first quarter from a year earlier.
At its core, direct lending is a way for banks to shed many of their riskier businesses as the private equity firms encroach on the banks’ turf. Direct loans also typically earn more in a rising-rate environment, and borrowers may be unprepared for a jump in interest costs. That risk, combined with increasingly lenient terms and the relative inexperience of some direct lenders, could become a bigger issue in a downturn. Bankruptcy lawyers will tell you to expect as much in the near future.
Bank regulators are starting to take note of the change in lending practices. U.S. Comptroller of the Currency Joseph Otting said in the report, “A lot of that risk didn’t go way, it was just displaced outside the banking industry.”
What is the moral of this story? Borrowers beware—your new non-traditional lender may seem like a better fit at the outset of a loan. However, should a default occur, private equity firms are far better equipped to take control of a distressed company.
In other words, borrowers should be wary of private lenders that may be more in the business of “loan to own”—and not in the business to simply collect interest.