Oh, there’s a lot of opportunities
If you know when to take them, you know?
There’s a lot of opportunities
If there aren’t, you can make them
Make or break them
Sell all private credit investments. Now!
That’s the kind of apocalyptic advice I’ve been getting lately from all sorts of investors. It’s the kind of advice being given in the wake of Donald Trump’s election as U.S. President (an event some view as apocalyptic in and of itself) and the Republicans assuming control of both houses of the U.S. Congress.
This is advice that hinges around two key pieces of logic; one economic, the other political. The economic theory is that the U.S. will embark on a massive program of fiscal stimulus involving government spending and tax cuts. This will lead to economic growth and a rise in U.S. interest rates, the latter of which, the view holds, is necessarily bad for credit investing because rising rates mean lower bond prices. The political theory posits that the private credit space has grown in large part because regulation has strangled banks’ lending ability. With the Republicans planning to repeal Dodd-Frank, banks will resurrect lending patterns from a decade ago, effectively eliminating private credit providers - like private equity firms - from the lending landscape.
We’ve been making the case for private credit for a long time now, and we believe as much as anyone that the U.S. election results have changed the investment landscape. However, while we appreciate a good apocalypse story as much as the next person, we’re not ready to recommend gold buried in the back yard as the best investment approach just yet. In fact, we’ll be so bold as to declare that we still believe private credit will do well in this next cycle.
But enough about us: Let’s look at how the election results might impact your private credit investments.
The U.S. election has changed the investment outlook. We had long argued for a period of sub-par growth, lower interest rates and a much longer economic recovery than anyone anticipated. It is possible (and we stress that word because the new U.S. administration and Congress haven’t even started work yet) that the U.S. will embark on a program of fiscal stimulus, resulting in faster growth and higher interest rates. The argument for higher rates is compelling because the Federal Reserve, perceiving a U.S. Congress more prone to fiscal stimulus, will likely raise rates in a way they might not have done without that prospect. So, count us as believers in a U.S. economic environment that features higher interest rates.
Aha, you say, higher rates are bad for credit investments. Why? Duh, everyone knows bonds go down when interest rates go up. Yes, that’s true; and if you have a fixed rate instrument issued before rates go up, then you’re looking at a probable capital loss. But, do you really believe that? Is that what you’re getting in your private credit portfolio? We’ll venture a guess that it’s not. In fact, we will continue to argue that you should be moving part of your public fixed income allocation (e.g., perhaps the part of the portfolio that is indeed in fixed rate, largely government paper) into private credit, much of which will float. That sounds like a good trade, perhaps even a better trade in a rising interest rate environment.
There’s another part of the “rising rates equals lower bond prices” argument that may or may not prove to be true.
That direct correlation assumes credit spreads remain the same, and that rarely happens. If the rising rates are the result of more robust economic growth, spreads may contract as credit risk is perceived as being reduced. Spread contraction can blunt a meaningful portion of the base rising rate environment for investors.
There’s a second argument that is endemic to all private market investing, and that is that everyone knows credit does poorly when rates go up. I bet when Pythagoras was formulating all those laws of mathematics, one of them was the Pythagorean Theorem of Private Markets Anecdotes. It states, “that which is anecdotally believed must be true.” For years we have railed against this industry’s refusal to use data to inform beliefs, let alone to make decisions. Our industry is like the answer to those college admission tests that ask for comparisons. “Data is to private equity as X is to Y.” Well, the answer for many of us appears to be “D. As oil is to water.”
So, let’s crank up our trusty database and look at what it tells us about private markets performance following a rate hike.
In Chart 1, we’re looking at funds that started investing after the U.S. Fed began hiking rates. The actual results paint quite a different picture from the anecdotal depiction. When interest rates start moving up, investors want to be leaning into credit. Surprised? I certainly was. I expected to see stronger performance in the equity portion of the balance sheet; investors wanting to build equity whether for the benefit of a growing economy or because a downturn was considered imminent, and buying cheap meant someday selling at a great profit. Nope. Debt was the place to be. It’s amazing (and alarming in its own way) to see what data actually says about market performance.
Nevertheless, it’s not really enough to declare the data says it’s true; therefore, we must follow it. The data tells you what happened, not why it happened; it doesn’t explain why prior cycles resulted in credit being the place to be when rates started going up. Historical findings may suggest a path, but today’s path might be different, because the environment has changed. Still, as we’ve all learned from past investment losses, following a theory that this time it’s different is a really poor investment strategy.
Instead, let’s consider some reasons why the events of the past could also apply today. One, higher interest rates mean higher returns, and that’s good for investors in credit instruments. Wow, that seems so obvious as I write it; but, if you’re anything like me, the obvious tends to be the thing most easily overlooked. With a higher interest rate, equity returns have to compete with a higher return on the credit instrument. Two, higher rates usually lead to slowing economic growth and, in a downturn, it’s preferable to be investing in debt rather than equity because of the relative safety to investor capital. Those make for two fairly powerful cases for leaning more into credit.
Duh, everyone knows bonds go down when interest rates go up.
From an economic perspective, the change in the U.S. outlook following the election leaves us more convinced that private credit is an important component of portfolios. There is one caveat, however. Our outlook for a longer-than-anticipated economic recovery likely will change. If the U.S. enters a period of increased fiscal stimulus and higher rates, then it is likely that we will see a return to a more normalized economic cycle in which a downturn will occur sooner than we would have anticipated only a few months ago.
Add to that the uncertainty over the Trump administration’s trade policies and you have an increased likelihood that volatility and a potential downturn become a more imminent possibility. What this scenario also means is that creditworthiness becomes much more important as investors build their private credit portfolios. Recall that the emergence of PE players as powerful participants in the credit markets post-dates the last significant recession. How will these players fare in a downturn? We all certainly hope (and, not coincidentally, have been told so by those same firms) that they will perform better than banks used to. We have not been through a cycle in which credit losses have been a feature of our private portfolios. I am not suggesting that day is upon us, but I am suggesting it is both more imminent (is that even a phrase?) and more important as a factor to consider as you build your portfolio.
The second argument for abandoning private credit contends that the political landscape has shifted and banks will now be free to re-engage in lending in a way they did prior to the Global Financial Crisis. They will crowd out the new PE players in this space.
We do believe that banks will, at the margins, increase lending activity. However, we don’t think it will be a result of regulatory changes. That is because we fundamentally don’t believe those changes will be enough to alter the secular shift that banks are making away from the kind of lending in which private market players are engaged.
Why do we think banks will increase lending activity then? Simple economics, really.
Rates moving up plus improved economic activity make lending a better money maker than buying government paper. Banks will follow the money and lend more. If this theory is correct, however, lending in general will increase, meaning there won’t be any crowding out of the private market participants. For that to happen, the new conventional wisdom that the regulatory environment will be so altered that banks will shift headlong into lending must be true, and we remain unconvinced.
Why do we think banks will increase lending activity? Simple economics, really.
Dodd-Frank in the U.S. may be one reason that banks have pulled back from lending, but it’s not the only reason. Remember, despite talk of repealing Dodd-Frank, there are a few other factors that should give us pause before asserting that the bank regime is reverting to 2005. For one thing, Trump has stated on occasion that, while he favors repeal of Dodd- Frank, he also favors bringing back the Glass-Steagall act that divided all commercial and investment bank activity in the U.S. Let’s try to imagine what banks would be doing if that type of legislation were to pass. I can assure you they wouldn’t be rushing out to make loans. In addition, there are many in the banking community that have gone on record espousing certain benefits of Dodd-Frank, so an outright repeal doesn’t even have full industry support. The real motivations behind banks pulling back from lending are a little more varied:
- Banks need to maintain higher capital requirements, particularly as a result of the Basel agreements. It is highly unlikely that those are going to be pulled back, and such requirements have at least as much (perhaps greater) impact on lending activity than any provisions of Dodd- Frank. Unless you believe that capital ratios are going back to 2005, lending is not going that way either.
- Regulatory oversight is unlikely to change dramatically. Congress may legislate, but, in the U.S., the Federal Reserve and the Office of the Comptroller of the Currency (OCC) regulate. Those regulators are not changing any time soon. The focus on credit quality, capital standards, lending practices and ratings will remain essentially unchanged. It is hard to envision a scenario where any of the regulators loosens the standards that they have spent nearly ten years applying to banks to get them to maintain healthy balance sheets and loan books.
- Market segmentation is also an important feature. We believe banks will continue to focus on the larger end of the lending spectrum. Over the last ten years, banks shed lots of staff and infrastructure. Re-entering the smaller end of the credit market, where private capital is more concentrated, would mean building those resources back up. It also would mean doing so in an environment where regulators haven’t changed much and the political climate is still uncertain as proposals and ideas make their way through government. Such a scenario is hard to envision.
We will continue to invest in private credit. Bigly.
In this political environment, banks will undoubtedly feel better about increasing their lending activity. We are skeptical, however, that doing so will change the outlook for the continued growth of the private credit players. That “shadow banking” world – the world in which financial intermediaries perform bank-like activity, such as the creation of credit, without being subject to regulatory oversight – will, in our view, continue to grow away from the traditional banking industry.
We remain bullish on the private credit markets, perhaps even more so because of the rising interest rate environment. We are very conscious of the increased credit risk that must be factored into these investment decisions, and we plan to talk more about the shift in the overall economic outlook in later articles. The increased sentiment against private credit for the reasons discussed in this piece actually make us feel better about the private credit environment. Maybe it’s the contrarian in us, but it was beginning to sound like a one-way trade for a time: Everyone was drinking the private credit Kool-Aid. Having some investors move away from the space because of the U.S. election is probably a good thing for the market and might eliminate capital coming in for the wrong reasons. (Here’s another data-based tidbit you might not know: 2016 will be the lowest year for private credit fundraising in the last five years.1 I don’t know about you, but I sort of like that statistic in this context.) Those of you who know us well know that, if we believe something with conviction, we will invest. Of course, we want to understand how a changing environment impacts those investments, but it will take more than anecdotal conjecture to cause us to invest somewhere else.
We will continue to invest in private credit. Bigly.
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