In the aftermath of the global financial crisis as new rules were enacted to rein in risk, banks stepped back from some corporate lending and private equity firms eagerly jumped in. Now, according to at least one study, it looks like the transformation of the U.S. syndicated loan markets has been mostly a positive one.
New research shows that private equity firms can help reduce the credit risk of companies and pare the losses that lenders can expect to take. Private equity firms are able to do this by either reducing the volatility of sales and collateral backing loans — operational engineering — or by improving the financial situation of a distressed company.
The findings appeared in a new paper published last week by economists Sharjil Haque and Teng Wang of the Federal Reserve’s Board of Governors, along with Simon Mayer from HEC Paris. According to the researchers, the results suggest that the actions of private equity firms can “substitute for bank monitoring in containing credit risk.”
The authors used both PitchBook data and the Shared National Credit (SNC) register, which is maintained by the Federal Reserve, to obtain detailed loan-level information on U.S.-based syndicated loans with minimum commitments of $20 million. They analyzed 3,659 credit facilities issued by 1,574 different private-equity-backed borrowers and 467 private equity sponsors.
Initial results showed that lending that involves private equity firms — rather than traditional banks — does operate differently. When private equity firms are involved, lead arrangers — loan underwriters — hold on to a smaller piece of the overall loan. That means the lead underwriter has less “skin in the game.”
But researchers found the quality of the loans doesn’t decrease. Private-equity-backed loans also have fewer covenants, which makes them more friendly to borrowers. Even though critics have raised concerns about the lack of covenants, the study’s authors found this hasn’t led to an increase in credit risk.
Instead, when compared with their bank lenders, private equity-backed loans have lower expected losses.
“Quite surprisingly, PE-backed loans appear to have lower credit risk relative to comparable non-PE-backed loans, at least when measured by expected losses,” the researchers wrote.
The higher leverage of companies backed by private equity also is not posing higher risks, according to the researchers. “PE-backed companies tend to have higher leverage than non-PE-backed ones, and higher leverage is mechanically associated with higher credit risk,” the authors wrote. “But the findings show that private equity firms that do their due diligence, monitor companies, and engage with those companies when under financial distress can reduce credit risk.”
Private equity firms with a solid reputation or which have directly borrowed from the lead lender in the past are even better at managing credit risk, according to the report.
“When the lead lender places high trust in the PE sponsor backing the loan — [usually] because it knows the PE sponsor from a direct lending relationship — it associates a lower expected loss with the loan and therefore reduces monitoring and retention more strongly,” the paper’s authors wrote.
