Board Minutes from the Chairman: April 2024

The Golden Age of Private Credit

I looked back and noted that in my June 2023 edition of “Board Minutes from the Chairman” we briefly discussed the nonbank lending space, sometimes referred to as shadow banking, with its significant influx of private equity. Upon further reflection, I recalled a previously penned article from 1992 entitled “The Dawn of the Financial Architect”, a piece I wrote about the tail end of the savings and loan crisis (S&L) and the formation of the RTC or the Resolution Trust Corporation. The article’s vantage point was written from my perspective as a financial intermediary at the time, providing recapitalization solutions to our many borrower and developer clients.

Like most market collapses, the S&L crisis was caused by the lack of liquidity from financial institutions, which was further exacerbated by banks’ inadequate net worth requirements and the excess development of the 1980’s. The “financial architect” aided in designing, implementing, and accessing new lending solutions restoring transactional predictability.

Today’s funding and pending resolve to the market’s needed recapitalization can be looked at similarly with the emergence of today’s “financial engineer” and their craft of private credit. This smart and opportunistic new capital has arrived with a variety of financial solutions and a premium placed on the needed variability and customization to the myriad of capital needs for both borrowers and lending institutions. Private credit has grown rapidly since the 2008 Global Financial Crisis from approximately $375 billion in assets under management globally to over $1.6 trillion by March 2023 with BlackRock now projecting that private credit will exceed $3.5 trillion by 2028.

Private credit encompasses a multitude of debt instruments provided by non-bank entities with funding from a diverse group of investors including insurance companies, pension funds, endowments, sovereign wealth funds, retail investors, high net worths, and family offices. These investors are often attracted to private credit as a higher yielding fixed income investment product.

Private credit lends itself to a diverse array of borrowers/collateral types including corporations, real assets (like aircraft, ships, railcars, equipment financing), and all forms of real estate. This space also provides flexible financing solutions for less tangible assets such as intellectual property, litigation claims and account receivables. Given the privately negotiated nature of the industry, private credit offers a broad spectrum of structuring options tailored to various investment strategies and risk appetites.

Real estate borrowers with over a trillion dollars of bank loans to refinance in the next 12 months are keenly aware of this growing capital supply chain. The remortgaging of banks’ current debt might prognosticate a future with fewer banks and an ongoing reliance on private credit to serve this capital-intensive industry.

In the 1980’s, there were 14,000 banks. Today, we have 4,200 banks with the biggest core banks managing through their exposure to commercial real estate, versus smaller and regional banks who are more vulnerable to further downsizing and consolidation due to their outsized real estate portfolios. This scaling back of banks will not be done precipitously as the federal government has clearly indicated its willingness to backstop depositors and provide certain allowances to the current mending and extending of loans by banks. However, this accommodation will not last indefinitely with the pending increase in bank regulation including Basel III/IV 2.0 establishing new standards for credit and operational risk along with certain valuation adjustments.

Private credit can provide a perfect solution for this bank retrenchment and consolidation which might predict a permanence in not only today’s market recapitalization but in the regular bidding of commercial and mortgage origination. Its arrival will not be without regulatory review by policymakers as questions arise about the asset class’s potential overleveraging, its risk of predatory lending and the associated borrower vulnerability as to their inability to refinance this new high-octane debt.

Additional concerns could include the asset class’s lack of transparency and questions of proper valuation, limiting regulators’ ability to understand and monitor the potential links between the private credit market and the greater financial market during times of financial stress.

Industry participants today might refute these concerns by explaining that banks themselves are not only more highly levered but do not have the long-term lockup from investors that private credit has. The recent demise of SVB and Signature banks, the run-on bank deposits and subsequent forced sale of assets highlighted this vulnerability.

Our own company has participated for years as a lender/investor in this private credit arena, with a more formalized engagement since 2013 where we have actively supplied capital commitments approximating $1 billion. We built this division with prudent leverage and long-term private equity, allowing for appropriate latitude in customizing our credit investments. Interestingly, much of this lending would not be considered rescue capital but instead more conventional construction or bridge real estate lending.

In most circumstances, borrowers and/or brokers have sought to work with Buchanan due to our structuring optionality and real estate operational expertise versus the less predictable funding alternatives.

The growing private credit paradigm and stability of the asset class is affirming Buchanan’s continued efforts to further its own investor base. Importantly, today’s “financial engineer” has recognized the need to not replace banks but expand and supplement banks’ abilities with prudent risk return protocols in allowing real estate operators to predictably run their businesses. Equally important to this partnership is that the private credit alternative has not been missed by this investor class as most investors now seek to begin or increase their allocations to the private credit arena.