How the biggest private equity firms became the new banks

Mark Vandevelde 
Painted guitars hang to dry after being lacquered at the Gibson Guitar Corp. factory in Nashville, Tennessee.
Jeff Adkins | Bloomberg | Getty Images

Gibson Brands is the legendary guitar maker based in Tennessee that has made instruments for Jimi Hendrix and Keith Richards. Now, a legal brawl between two of America's biggest investment firms means the faltering rock'n'roll emblem has also become a symbol of the shifting hierarchy in global finance.

Bankruptcy proceedings in Delaware have brought a crashing end to Gibson's plan to reinvent itself by selling smart speakers and guitars that tune themselves. They have also set up a courtroom battle between Blackstone and KKR, two of America's most powerful financial firms, which are among the biggest lenders to the company.

Which firm wins this skirmish matters less than a bigger victory that belongs to them both. Founded by former bankers, they are part of a group of private equity firms which has spent the years since the financial crisis quietly supplanting their former colleagues in the banking world. By setting up huge lending arms, they have been transformed from heavyweight dealmakers that took stakes in companies into the principal bankers for a large tract of corporate America.

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Until the financial crisis, private equity investors hewed closely to the "buyout" playbook pioneered by Henry Kravis and George Roberts when they founded KKR in the 1970s. Acquiring companies whole, they would cut costs and load them up with huge amounts of debt while paying the bank back at a low interest rate.

Now the biggest firms have all but pivoted from private equity to private debt, joining a new breed of lightly regulated asset managers that have filled the void as banks are forced to retreat from risky deals.

Unlike banks, which are dependent on deposits and other short-term funding, these funds raise money from long-term investors such as insurance companies and pension funds. Many of the companies they lend to are owned by other private equity investors. The funds provide a crucial source of credit for companies that cannot tap the bond markets, their advocates contend.

"Banks have had to recapitalize and build larger capital cushions, and combined with recessions and weak recoveries, they really weren't extending a lot of credit," says Susan Lund, a partner at the consultancy McKinsey.

Ten years after the crisis, the rapid expansion in private credit raises the question of whether risks have simply been transferred to a different, less regulated part of the market. "It's true that this is opaque," says Ms. Lund. "But it does not have systemic risk. If the company doesn't repay the investors will lose, and that's where it ends."

Howard Marks, the founder of Oaktree Capital Management who has made billions of dollars investing in distressed debt and profiting from the fallout of credit busts, agrees — up to a point.

"The raw material of this lending boom is not as fallacious as subprime [mortgages]," he says, comparing the borrower-friendly terms of today's corporate loans with the fraudulent loans obtained by tens of thousands of homeowners whose defaults later brought the banking system close to collapse.

But he adds that such judgments must always be uncertain. The pre-crisis mortgages were "something nobody caught", he recalls. "You say: 'What idiots. It's obvious that was all fallacious. Why didn't anybody catch it at the time?' Because we don't see the flaws until the things are tested."

As the US enters a 10th year of economic expansion with interest rates still near historic lows, some believe the harshest test is about to start.

Michael Patterson has more reason than most to worry about the potential fallout when that growth streak ends. From his position in charge of senior lending funds at one of America's biggest private credit firms he has watched rivals make bullish calls, relying on economic expansion, he says, to cover their mistakes.

"[People think that] things usually grow and therefore if I'm overly aggressive lending today it'll kind of catch up over time," he says. "That has worked for a decade. We are acutely aware of it."

Mr. Patterson is a partner in a firm that was once known as Highbridge Principal Strategies. That changed in 2016 when the former owner, JPMorgan Chase, sold the business to its senior staff. Regulators insisted on a change of name, fretting that investors might assume America's biggest bank still stood behind the newly independent firm, according to a person briefed on the deal.

The rebranded HPS has raised debt funds worth $20bn in the past decade, according to data from Preqin, putting it alongside private equity firms Blackstone, Apollo and Ares among the 10 biggest providers of private credit.

Private credit funds are still small in comparison with the $12tn global non-financial corporate bond market which now accounts for one-fifth of borrowing by companies other than banks. There, too, credit quality has been deteriorating; most of the growth in bond issuance has involved companies that are either on the lowest rung of investment grade ratings or else firmly in junk territory.

Still, private credit funds have carved out a niche by charging more for their money while promising borrowers greater certainty and less hassle.

"If you're a company that is purchasing a competitor and believe you're doing so at a really attractive price, you don't have time to do a bond roadshow over the next three months," says Mr. Patterson. Nor do borrowers want to worry about how a distant geopolitical crisis might move the bond markets. "That's not how private credit when done well works," he says. "I don't need to worry about, oh, the market just moved so I'm going to [alter the agreed interest rate] on your deal."

Nordic Aviation Capital, a leasing company with a fleet of 500 smaller planes used on regional routes, had even bigger problems when it tried to raise debt financing five years ago.

"The banks were scared of aviation, scared of [what to them were] unknown businesses, and they were basically scared to get into fixed assets," says chief executive Soren Overgaard. He also talked to insurance companies, which are large debt investors, and received offers from small banks that were willing to take risks, "but the pricing on that was totally insane".

Nordic typifies the kind of borrowers that have turned to private funds: neither "normal" enough to meet standard banking requirements, nor big enough to merit attention, they can find themselves shut out of the banking system. Lenders such as HPS "don't have the same capital requirements as a bank does [so] they're not bound by the same regulatory framework", says Mr. Overgaard. "I guess the banks like to put things into boxes, and if you don't fit into a box, tough luck."

Having watched returns dwindle over a decade when interest rates were close to zero and central banks vied with portfolio managers to buy bonds, pension funds and insurers have raced to commit money to what many see as a lucrative new asset class. Average annual returns for private credit funds have exceeded 5 per cent over every five-year period since 1992, according to figures compiled by Hamilton Lane, a firm that advises public pension funds and others on investments worth more than $400bn.

Drew Schardt, the firm's head of credit investments, says that even bottom-quartile credit funds perform reasonably well, in contrast to private equity, where returns are heavily dependent on the manager's pedigree.

Three of the four biggest US private equity firms now manage more money in credit funds than in their private equity arms. That is a marked turnround from decade ago, when debt funds accounted for about one-fifth of their assets. All told, private debt funds have amassed a $160bn war chest of capital that has not yet been lent out, twice what they had a decade ago and enough to support perhaps $360bn of business lending once bank debt is added on top.

It is a strategy that has proved especially lucrative for the handful of firms such as Blackstone, KKR and Ares Management that have listed on the stock market, because it provides a more constant flow of revenue than the traditional private equity model.

"These firms have figured out that the markets do not place much value on carried interest [the 20 per cent share of investment profits that is traditionally paid to fund managers]," says a banker who holds talks with dozens of private equity funds every year. "Recurring management fees which you get every year is a language stock market investors understand. So you become asset gatherers. If you can grow your credit business faster than the equity side, even with lower returns [for investors], that's highly profitable."

Apollo Global Management has taken the idea furthest. Not content with persuading investors to put money into its credit funds, it set up an insurance company that invests its entire balance sheet with the firm. That company, Athene, has struck deals with traditional insurers such as Aviva to assume responsibility for annuity contracts. These convert the wealth amassed by a retiring worker into a promise to pay an annual sum, leaving the insurer responsible for investing the assets and generating a return big enough to cover the lifetime payments.

As Athene's assets grow, Apollo charges larger fees for investing them in a suite of credit products that encompasses senior loans, collateralized loan obligations and high-yield bonds sold by companies with poor credit ratings.

Apollo's insurance land-grab has placed $97bn on its books. That is more than triple the size of the entire credit portfolio that Apollo managed a decade ago, and more than one-third of all the assets it manages today. It has also given the firm significant influence over a regulated insurance business that is responsible for the incomes of thousands of retired workers, increasing the stakes if investments go wrong.

"The seven worst words in the world are: Too much money chasing too few deals," says Oaktree's Mr. Marks. "You can raise a lot of money if you're a credit manager today. But then you have to put it to work, or sit on it and have people complain that you didn't do what you said you were going to do. So people are competing to make loans."

One result of such fierce competition could be increased risk-taking. Strong covenants were attached to fewer than 30 per cent of the leveraged loans written in the US last year, according to a tally by the IMF, leaving creditors with little power to intervene if management teams behave recklessly or a company's profit heads south.

With interest rates expected to rise, that could be in prospect for a sizeable number of businesses whose cash flow offers little headroom above their interest payments. McKinsey calculates that 6 percent of US corporate bonds have been issued by companies which need to spend two-thirds of their earnings before interest, tax, depreciation and amortization in order to meet their interest payments — leaving them in a perilous position when they are forced to refinance at higher rates.

Those that have taken out variable-rate loans could face a more immediate threat, compounded by changes in the ways companies calculate profit that may make their debt riskier than it looks. One-quarter of last year's buyouts involved "adjusted" ebitda, which inflates profits by adding back some costs that are usually deducted, flattering a borrower's stated leverage ratios.

"Real leverage is actually significantly higher today," Mr. Patterson reckons, even though the difference does not always register in reported profit numbers. "We will see a series of unanticipated bankruptcies, because the reported numbers are historically inconsistent. I'm not calling the time; I have no idea."

If that forecast is correct, it will mean losses for at least some of the asset management firms gathering assets — and fees — in sections of the credit system where banks now fear to tread. Optimists, including McKinsey's Ms. Lund, say the asset managers now responsible for an outsized share of risky lending are neither as indebted nor as important as the banks. "It's not to say nobody loses," she says. "People do, and that's painful, but it doesn't have the systemic widespread effects, as those losers aren't the bank themselves."

But the differences between banks and asset managers are subtle. Funds that raise their money from public pension funds are capable of inflicting losses on powerful political constituencies, even if they cannot bring down the banking system. And while asset managers are usually far less leveraged than banks — typically matching a dollar of equity with every dollar or two of debt, compared with the $20 or $30 that banks were borrowing ahead of the crisis — they often have far fewer safe assets such as US government bonds.

"So which is riskier," Mr. Marks asks, "an entity that's 32 times levered and has a diverse loan book, or one that's two times levered and has a book of all the somewhat unseemly loans?"

The question, he says, may be unanswerable. "It all comes down in the end to judgment. Let's say that they go into a deal that I say I won't do because it's too risky. Am I a fuddy-duddy and are they astute? Or are they nutty and going to get wiped out?"

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