Rise in non-bank lending could mean murkier view on risks

The financing market for leveraged buyouts is thawing. This sunnier outlook is only partially the result of easing attitudes at lending banks. Instead, look to trends in securitisation markets.

So far in 2024, the pricing of new, so-called collateralised loan obligations has hit record levels. Globally, $30bn worth of CLOs have been assembled, according to data provider LCD. The managers of these capital pools buy up pieces of multiple bank loans, often stemming from private equity deals. The debt is then transformed into bonds at various credit ratings with principal and interest paid back when the borrowing companies send the CLO their obligation payments.

CLOs are now mainstream. The market functions mostly well, though in recent years they have proved tricky when underlying borrowers go through bankruptcy restructurings.

Broader securitisation and asset-backed lending have proliferated too. Private capital firms have raised trillions of dollars either in dedicated funds or with insurance liabilities to create massive financial firepower. Meanwhile, bank lending has been constrained for regulatory reasons. 

The result is secured corporate lending that has migrated to the securities market or asset managers. The benefit is ostensibly a lower cost of capital. Security investors only take on the precise pieces of risk they want. But as credit conditions remain mostly benign, despite elevated base rates, it is unclear how well the underlying risk of various tranches is understood.

Insurance regulators, for example, have been investigating potential credit rating arbitrage by private capital firms. Here, CLO tranches can get a better credit rating than underlying loans.

Still, the trend towards non-bank lending looks unstoppable. Asset manager KKR estimates that private, asset-based lending — a particular niche of the broader securitised finance — will go from a $5tn market to nearly $8bn between 2022 and 2027. Within that total are consumer and auto loans, student debt, equipment finance and even more newfangled products such as music royalties.

Banks will not be completely displaced. They can provide underwriting expertise, liquidity and back leverage for fund-based lenders. They often maintain a crucial underlying relationship with companies and borrowers.

Banks’ greatest attribute is that their customer deposits, while potentially unstable, remain the cheapest cost of funds. Capital markets-based lending attempts to compensate for that discrepancy through the alchemy of securities built to segment risk precisely. It appears to be working for now. But on Wall Street, hubris and excess are always just around the corner.