Today, Ares is one of the few large lenders actively participating in private lending—the largest sub-asset class within private debt/private credit that focuses on lending to businesses. At Ares Wealth Management Solutions (AWMS), we are increasingly asked by advisors how and why this asset class has come into prominence and how to best communicate its significance to clients.
The key to understanding private lending history is understanding private equity history.
In a recent edition of our Private Market Insights newsletter, we provided a view as to why the asset class can be attractive in this environment. To further contextualize the asset class for your conversations with clients, we now look back at how private lending has evolved over the past 40 years—the journey has been fascinating.
The key to understanding private lending history is understanding private equity history. This is because the largest clients of private lenders are private equity firms (called “general partners” or “private equity sponsors”).
Private equity sponsors typically take out loans to finance their purchases of companies. Increasingly, they receive these loans from private lenders. However, it was not always this way…
The 1980s
- Private equity takes off—at this time it is mostly about financial engineering; for example, spinning-off underutilized parts of conglomerates and changing the debt/equity mix of a company to reduce taxes.
- Private equity transactions were primarily for sub-investment-grade companies. It was largely only possible for investment-grade borrowers to issue a bond or get a loan from a bank.
- As a result, investment banks went “down market” and began issuing “Junk bonds” (today more commonly referred to as “high-yield bonds”). This was the birth of the high-yield market and was how private equity sponsors funded their private equity purchases.
- In the late 1980s, “leveraged loans” (also called “bank loans” or “broadly syndicated loans”) were added alongside high-yield bonds as a tool to finance private equity purchases. While also sub-investment-grade and issued by investment banks, leveraged loans were floating rate and generally had collateral protection that high-yield bonds lacked.
- A frenzy of transactions and competition led to a private equity + high yield + leveraged loan bubble, which burst in 1989.
The 1990s
- Private equity transactions and high-yield bond issuance was subdued during the early 1990s.
- Consolidation of regional U.S. banks into larger, national banks began a multidecade decline of banks’ willingness to hold significant loans in the middle market. Instead, banks shifted toward larger customers and loans, leaving midsized companies largely unserved.
- Toward the end of the decade, private equity buyouts re-emerged, along with the high-yield bonds and leveraged loans required to finance them.
The 2000s
- In the early part of the decade, Business Development Companies (“BDCs”) became more popular as a tool for private, non-bank lenders to raise funds that they could use to make loans. A BDC has many of the same benefits and rules as a Real Estate Investment Trust (“REIT”):
- Avoids double taxation
- Required to pay out a percentage of earnings
- Available in publicly traded and nontraded structures
- Consolidation of regional U.S. banks into larger, national banks began a multidecade decline of banks’ willingness to hold significant loans in the middle market. Instead, banks shifted toward larger customers and loans, leaving midsized companies largely unserved.
- As commercial and industrial bank lending increasingly focused on larger borrowers, the market opportunity for making private loans to midsized companies, including those owned by private equity, expanded.
- The Global Financial Crisis further constrained banks from lending to companies. As a result, private lending funds and BDCs stepped up to fill the void.
Banks’ share of loan market
The 2010s through the present
- Today, there is greater overlap than ever between publicly traded bank loans/high-yield bonds, and private lending.
- Supported by investment performance, investor acceptance of the asset class grew and, in turn, drove further scaling of private lenders. This resulted in widening the opportunity set for private lenders, as they could service larger companies. Instead of competing in the blank spaces left behind by banks’ withdrawal from the market, private lenders now often compete directly with banks for large loans to large companies. They do so by offering:
- Speed and certainty of execution—no roadshows, syndication negotiations, structuring or credit ratings needed. The ability to move quickly without terms changing on the borrower due to prevailing market conditions can be extremely valuable.
- Confidentiality—in a public bank, syndication information is more likely to leak and attract increased competition for the purchasers.
- Simplicity—dealing with one primary lender with a single set of priorities and documents.
- Customization and flexibility—features like revolvers and delayed draw, as well as support for business plans that banks and capital markets-oriented lenders cannot provide.
- Peace of mind—one counterparty, and typically an easier work-out in case of a default and restructure scenario.
- Increasingly, private lenders compete for non-sponsored (i.e., non–private equity) lending as well. Private lenders increasingly source deal flow from direct relationships with management teams of both privately held and publicly traded companies.
- Private lending is growing overseas, particularly in Europe and Asia.
- While banks have shifted away from originating and holding middle market loans, they remain committed to the asset class—heavily investing in middle market private lending through credit facilities to private lenders.
Understanding how private lending has evolved over the past 40 years can help investors better understand this central strategy in the private-debt asset class.
North America private lending capital called (as % of buyout called)
It also suggests that there is significant scope to grow. Private equity sponsors increasingly use private loans to fund their buyouts. The growth in private equity dry powder suggests large increases in future demand for private lending. This has coincided with increased allocations to the asset class from both institutional and high-net-worth investors attracted by the yield, returns and diversification. We see significant white space for private lending to continue growing and taking market share from traditional lenders.
