Stay informed with free updates
Simply sign up to the US & Canadian companies myFT Digest — delivered directly to your inbox.
The growth of private credit presents an opportunity rather than a threat to Wall Street’s biggest banks, according to Wall Street’s biggest banks, some of whose recent deep dives on the topic nevertheless betray more than a hint of worry.
Bank of America analysts got the ball rolling in early October, penning more than 10,000 words on why still-dominant traditional lenders and upstart private credit vehicles like KKR and Apollo (which account for a fifth of the global leveraged finance market) should work together in direct lending as “partners, not competitors”.
Bank lending to [non-depository financial institutions] has increased 300% since 2015, while their [commercial and industrial] lending has increased only 50% over the same period.
Thus, banks are complementing NDFIs in their PC lending through their forward fund flow arrangements.
Morgan Stanley got in on the act this week.
Its analysts opened their (25,000 word) take on the evolving role of wholesale banks with an admission that it and its peers could stand to lose between $35bn and $50bn of credit revenues (equivalent to between 8 per cent and 11 per cent of their annual credit-related revenue in 2023) over the next three years, as private players continue to chip away at public bond markets and bank-led direct financing.
This is “not necessarily bad news for banks,” Morgan Stanley assures; private debt’s encroachment on to their post-GFC-vacated turf is simultaneously a $15bn “revenue opportunity” across financing, origination, distribution, structuring, servicing, trading and hedging.
The sunny optimism of section one is nowhere to be found in section two, however.
The gradual electronification of liquid credit markets has “opened the door to non-bank market makers” with “powerful algorithms” who are slowly displacing banks’ market-making operations for broadly syndicated loans, Morgan Stanley writes:
Banks with major markets businesses have also leaned into automated bond trading technology, but are facing tough competition from [the] next generation of trading firms. As Liquid Credit market structures and dynamics start to resemble parts of Equities and Macro, value capture and market share is shifting toward these non-bank players, who have the technical and technological prowess and risk appetite to outcompete banks.
Threats come not single spies but in battalions. Surging demand from yield-hungry US life insurer accounts has allowed private credit to also make serious inroads in asset-based financing and infrastructure finance, MS says. About 35 per cent of Apollo’s total credit assets under management is now dedicated to ABF strategies, for example, almost double that of three years ago.
Per MS:
Banks will continue to play a key role in origination, warehouse financing, structuring, and servicing of ABF lending given their entrenched customer relationships — but Credit managers will hold an increasing proportion of these loans, either originating directly or in partnership with banks.
But even in the servicing space, banks are under pressure from the likes of Alter Domus, Citco and SS&C, all of which “were faster to build capabilities serving the private credit ecosystem”.
Many banks will have to partner with private credit firms to stay relevant. And to be fair, lots of them have been building out that business for years. (Morgan Stanley’s analysts tip Goldman Sachs, an “early pioneer” in PC which currently holds around $144bn of PC assets under supervision, to enjoy the biggest boost among the largest banks.)
Actually maybe collaboration isn’t such a good thing after all, MS adds.
Despite the recent surge in partnerships, the strategic rationale behind many of them remains unclear, and the outlook for these collaborations is uncertain. There are challenges on both sides:
For banks, partnerships, especially exclusive ones, may erode the power of their broader distribution capabilities.
For managers, the pace and rigidity of the bank origination process, particularly during periods of stress, may limit their ability to meet expectations.
For both parties, the mechanics and economics of holistic Private Credit origination partnerships are untested, especially during significant credit downturns where losses materialize, and aligning origination flows to the risk appetite of the investment partner is challenging.
Another potential problem: the further removed a bank gets from the underlying asset it funds, the more challenging it is to analyse the risks of those asset bases.
For example, a bank may provide lender financing to a Private Credit manager, who then provides a NAV loan to a private equity sponsor, which also receives a subscription line from the same bank. The bank may also provide portfolio company financing to the underlying asset. These multiple overlapping exposures are difficult to track, as the financing is often provided by different parts of the bank or by different banks.
Private credit has grown up with a ZIRP silver spoon in its mouth, against a backdrop of generally benign credit conditions and low default rates. It is also relatively lightly regulated. Underwriting standards may not always have been of the highest quality. So “an uptick in default rates and asset markdowns could have unforeseen consequences,” MS warns.
Whatever happens, the rise of liquid credit and private credit is “locked in,” the bank concludes. Morgan Stanley doesn’t seem at all worried by this, so you (probably) shouldn’t be, either.
