Private Credit: A Rapidly Emerging Asset Class. Authored by the Aequitas Private Credit Team

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1 Private Credit: A Rapidly Emerging Asset Class Authored by the Aequitas Private Credit Team Thought Leadership Resource Library September acp@aequitascapital.com

2 Private Credit: A Rapidly Emerging Asset Class It has been said that money makes the world go round, but it s really credit that keeps the wheels of commerce turning. Since the worldwide financial collapse in , credit and access to capital through traditional channels has been severely reduced. This difficulty in securing credit has hurt both consumers and businesses, and in turn has slowed the economic recovery in the U.S. and many other parts of the world. A 2013 report from the Small Business Administration noted that access to capital for small businesses is one of the biggest policy issues in the United States today policymakers need to ensure that entrepreneurs and creditworthy firms are able to secure adequate financial resources for growth and success. Ensuring that these firms have adequate access to financial capital enables them to continue to drive innovation, growth, and job creation in the U.S. economy. 1 The difficulty in securing capital for startup companies and accelerating growth for established firms is not a recent problem. A study 2

3 Private credit also allows investors to participate in the real economy. by the Cleveland Federal Reserve based on FDIC data found that banks have been exiting the small business loan market for over a decade resulting in a decline in the share of small business loans in banks portfolios. 2 The recession in 2008 and 2009 only added to a credit problem that began while the economy was still in expansion mode. After being severely burned during the mortgage crisis, banks have tightened their lending practices, making it much harder for businesses and individual consumers to borrow money to start or expand a business, buy a home, or go to college (see Figure 1). These disenfranchised borrowers still have a need for capital and so have been forced to seek alternative access to credit. Volume ($ billions) $56B decline Figure 1 SOURCE: Federal Deposit Insurance Corporation and the Federal Reserve. SMALL BUSINESS LOAN VOLUME The current credit crisis took shape alongside monumental changes within the banking industry, which is increasingly concentrated. Banking giants such as Chase, Wells Fargo, and Bank of America have fueled their own growth by buying up regional and local institutions, which has created ripples affecting broad swaths of the economy. Throughout the country, community banks have been either swallowed up by the giants or just gone out of business, and their local, personalized approach to banking has been replaced by a more centralized and bureaucratic way of doing business. NEW PLAYERS FILL THE VOID As traditional banking institutions have retreated from segments of the industry they used to dominate, such as small business loans, new opportunities have arisen for nonbank lenders. These nonbank firms have leveraged technology to develop a more efficient and flexible way to approach lending than the big banks. This kind of lending goes by a number of different names; however, it is simply a loan offered by an entity that is not a bank. It does not matter if the money comes from peer-to-peer lenders like Prosper and Lending Club, multi-billion dollar asset managers like Apollo Global Management or The Blackstone Group, or an alternative investment provider and asset-based lending firm such as Aequitas. It is all private credit. At its most basic definition, peer-to-peer ( P2P ) lending allows one individual to lend money to another individual via an online platform. It is the area of private credit receiving the most attention these days and is becoming an important economic factor around the world with the United States, United Kingdom, and China leading the way. Growth in the U.S. has been particularly strong with the two biggest players, Lending Club and Prosper, reporting loans of just over $3 billion in the 12-months ending March 31, 2014, largely to consumers looking to consolidate and reduce payments on credit card debt3 (see Figure 2). 3

4 While direct investment in P2P lending is an attractive option for self-directed individual investors, for those who have the benefit of professional advisors and are accredited, a pooled private credit investment could be a better option. A number of hedge funds and other alternative investment providers have created funds and private notes invested in loans purchased from P2P firms. Among the advantages of this approach is that a firm has already done the due diligence and a larger investment can be made without the advisor having to sort through hundreds of individual loans. 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% CREDIT CARD PRICING VS. RISK Credit card rates Net chargeoffs Figure 2 SOURCE: Federal Reserve. Commercial Bank Interest Rate on Credit Card Plans, All Accounts (TERMBCCALLNS), not seasonally adjusted. Many of these firms have enjoyed significant growth in recent years because they have a number of advantages over traditional lenders. One primary advantage is that these lenders interact with their clients online. They are not burdened with multiple brick-and-mortar branches and redundant personnel. They do not have the legacy systems or bureaucratic processes that the major banks have built up through their long histories, which has allowed them to reduce costs, increase efficiency, and reduce wait times for borrowers. A study conducted by McKinsey projected that by the end of 2015, Lending Club will be able to offer loans for 400 to 500 basis points less than an equivalent banking business4. An examination of the data leads to the conclusion that banks have been selling higher interest rate loans to their customers for years. By making the entire loan process more efficient, nonbank lenders are able to offer loans under more favorable terms to the borrowers while still attaining a greater degree of profitability. Outside of the P2P realm, private credit firms can focus on specific niches where they might have unique expertise or some other advantage, such as financial technology or healthcare, rather than serving as lenders to the world at large. Major nonbank lenders to businesses include CAN Capital, which claims to have provided small- and midsized business with $3.6 billion in loans since 19985, and OnDeck, which made an estimated $475 million in small business loans in By comparison, the Small Business Administration named Wells Fargo, which according to its annual report extended $18.9 billion in new loan commitments to small businesse loans in 2013, as the largest of their top 100 bank lenders. Another competitive advantage for nonbank lenders is that they are not bound by the same regulations as banks nor are they subject to the same level of oversight. Governmental actions, such as the regulations created under Dodd-Frank, and the addition of new powers such as the Consumer Financial Protection Bureau, have restricted some bank activities and caused many of them to rethink their practices in the face of intensified scrutiny. 4

5 WHY RIAS SHOULD CARE ABOUT PRIVATE CREDIT If they didn t know it already, one of the primary lessons Registered Investment Advisers ( RIAs ) and their clients learned from the financial crisis, when both equities and bonds collapsed simultaneously, was the importance of diversification within investment portfolios and an asset allocation strategy including non-correlated asset classes. Over the last few years, a wide range of alternative investment strategies have been made available to a wider audience, such as commodities, managed futures, private equity, and private credit. Private credit also allows investors to participate in the real economy. Investing in loans that allow a business to expand and hire new workers, or even a hospital, to be constructed makes a contribution to the economic recovery while also helping to achieve long-term financial goals. There are several reasons why this is an ideal time for RIAs to add private credit to their clients investment portfolios. The first thing to consider is that interest rates and credit spreads are currently at historic lows, and most experts agree they are likely to stay that way for some time to come. In this environment, the traditional fixed income instruments that an advisor can buy from a broker (e.g. corporate bonds, high-yield, emerging market bonds, agency mortgage securities) have little to offer in terms of attractive yield. That is an unpleasant fact facing every fixed income investor, whether novice or an experienced multi-billion dollar pension fund. In the bond market, looking for higher yields also means taking on more risk, a prospect many investors dread after seeing what happened to their riskier investments in RIAs who are new to the world of private credit may not fully understand why this is an exceptionally favorable period to make credit investments because they misinterpret the risks. Most advisors look to GDP growth or stock market performance as the primary barometers of economic health. But when it comes to credit, the key metric is default rates, and these are at or near 20-year lows today. Default rate data also helps demonstrate that private credit is not correlated with other asset classes. In , when public stock and bond markets were tanking, private credit was virtually unaffected. The reason many RIAs have been attracted to private credit as an alternative asset for client portfolios is that in the current environment the asset class offers mostly good news: The yields are higher than traditional fixed income vehicles historically found in the market; The risk/return ratio is typically greater compared to what is available in the open market; There is flexibility. The advisor can choose a duration that matches the client s need. Currently there are many private credit investments with relatively short duration, which can help positioning for when rates do eventually rise. 5

6 The biggest downside in private credit, as with many alternative investments, is the issue of liquidity. Unlike holders of corporate or government bonds who can always find a buyer, the investor in private credit must be willing to wait and hold the investment to maturity, which is typically in the range of one to three years. A certain minimum level of liquidity is necessary in every portfolio, but too often in response to their liquidity needs investors are herded into the traditional fixed income markets of publicly traded bonds. This herding effect causes a supply/demand imbalance, which leads to inflated prices for those publicly traded bonds (and hence relatively low yields). In contrast, private credit offers an illiquidity premium of bps of yield per annum, in exchange for locking-up those assets for up to three years. An astute RIA will set up clients with two buckets of fixed income: (a) a liquid bucket, which is designed to ensure flexibility and availability of cash in any scenario, and (b) a less liquid bucket which is designed to maximize return and capture the illiquidity premium where it exists. CONCLUSION While interest rates and credit spreads remain low, traditional fixed income instruments simply cannot provide the cash flow that most investors require. Private credit investments can offer considerably higher yields without a commensurate increase in risk. Since private credit has emerged as an important asset class it has also become easier for RIAs to find suitable investment opportunities for their clients. The options range from direct P2P loans, to funds and private notes designed for accredited investors. Once they complete their due diligence to find the right partners offering the best investment opportunities for their clients, RIAs may agree that private credit is indeed the emerging asset class of the decade. ENDNOTE REFERENCES 1. Robb, Alicia, and San Rafael. Access to Capital Among Young Firms, Minority-owned Firms, Women-owned Firms, and High-tech Firms. Working paper no. SBAHQ-11-M SBA Office of Advocacy, Apr Web. 2. Marie Wiersch, Ann, and Scott Shane. Why Small Business Lending Isn t What It Used to Be. Rep. The Federal Reserve Bank of Cleveland, 14 Aug Web. 3. Renton, Peter. Peer to Peer Lending. Lend Academy. N.p., July Web. 4. Laplanche, Renaud. LendIt 2013: Intro & Keynote, Renaud Laplanche CEO of Lending Club. LendIt Conference. New York, NY. 20 June Web. 5. Blake, Brock. Small Business Loans: Should The SBA Make Room For Alternative Lenders? Editorial. Forbes, 8 Apr Web Most Active SBA 7(a) Lenders. Rep. N.p., Web. 7. Wells Fargo & Company Annual Report Rep. N.p., n.d. Web. 6

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