Filling the void

NationsBank’s USD 65 billion acquisition of BankAmerica Corp in 1998 is still the largest ever banking M&A deal. The merged entity, which took on the name of Bank of America, created a financial juggernaut with assets of almost USD 575 billion that served more than 30 million customers and two million businesses at the time.¹ It immediately became the largest bank in the US at the time by assets and exemplifies a period in which bigger was most definitely better.

Even before then, it was clear that consolidation had taken hold of the US banking industry. In 1994 BankAmerica Corp acquired Continental Illinois for USD 2 billion, which was followed by Chemical Bank’s USD 10 billion buyout of Chase Manhattan Corporation, which was finalized in 1996, with the merged company keeping the Chase name. Then came NationsBank’s mega deal in 1998, with Bank One Corporation’s USD 21 billion acquisition of First Chicago NBD taking place in the same year. Two years after that Chase announced its USD 30 billion takeover of JP Morgan, becoming JP Morgan Chase, now the world’s biggest bank, which then in 2004 acquired Bank One – as well as the services of a certain Jamie Dimon.

Deals got bolder, larger and more frequent and, by the time NationsBank made its USD 65 billion blockbuster purchase, M&A deals within the banking sector were already coming thick and fast. According to the Federal Deposit Insurance Corporation, an independent agency of the US government that protects bank depositors, there were almost 14,500 insured commercial banks in the US in 1980. By 2022, that had dropped to just over 4,000.²

Just reading through the list is dizzying but, while those flurry of M&A deals filled thousands of newspaper columns and made dealmakers very rich, they also inadvertently helped give birth to a now vibrant and important alternative lending market. Indeed, private credit – in which loans are extended by non-bank lenders to smaller and riskier borrowers – was once a niche corner of the alternative investment landscape.

Today, assets are predicted to jump to a mighty USD 2.8 trillion by 2028, according to data firm Preqin.³

Today, assets are predicted to jump to a mighty USD 2.8 trillion by 2028, according to data firm Preqin.³ So how did the growth materialize? Well, as banks got bigger during the 1990s and morphed into national banking platforms, they also changed their lending habits – pulling money away from small and mid-sized businesses towards larger corporate borrowers. While capital adequacy guidelines and risk retention rules at the time limited the total volume of non-investment grade corporate credit banks could originate, heads were also turned by the lucrative cross-selling opportunities larger corporate borrowers presented.

Smaller tickets were set aside as bigger clients, who needed multibillion dollar credit issuances, were also more likely to generate ancillary fees from services such as M&A advisory, equity capital markets and treasury management. At the same time, despite both being equally time and labor intensive, it was far more lucrative for banks to originate a USD 100 million loan than a USD 1 million one. The upshot is that smaller and mid-sized clients began to be ignored, creating opportunities for others to step in and tend to those left behind – though at this stage it was certainly not preordained that private capital would take the reins.

John Popp, Global Head of UBS Credit Investments Group, points to the gradual repeal of parts of the Glass-Steagall Act during the 1990s as a critical precursor to the banking M&A wave. Franklin Roosevelt first signed the Glass-Steagall rules into law in 1933 as part of a number of measures adopted during the President’s first 100 days to rebuild trust in banks as well as the country’s economy in the wake of the Great Depression. The act separated commercial and investment banking and prohibited bankers from using money from deposits to chase high-risk investments.

Its removal meant that, between 1999 and 2024, there were more than 8,000 'business combinations' between commercial and industrial banks, savings and loans institutions, and credit unions, according to the FDIC.⁴ “As Glass-Steagall began to erode through the 1980s and 1990s, bank merger activity accelerated, and banks actively focused on reducing their lending books,” says Popp. “Banks did not want to lend as much as they had previously, but they also wanted to generate all the ancillary fees associated with lending.”

Popp also draws parallels to the heyday of junk bond trading under Michael Milken, the controversial investment banker who helped usher in a new wave of leveraged buyouts and significantly altered the make-up of corporate America.

While there were clearly other dynamics at play, this period also got market participants used to the concept that, although smaller companies are riskier to finance, doing so is worthwhile because higher yields offset the greater losses. The 'first disintermediation' of banks came in the wake of the junk bond trading boom during the 1980s, says Popp, when banks transitioned from what he calls the “storage business to the moving business”.

“A bank can be a lender or an arranger. Traditionally, banks would lend and hold that risk on their balance sheets, often syndicating the risk among other banks. But the development of leveraged finance and junk bonds in the 1980s allowed the role of banks to change to that of an arranger. They shifted into the moving business, but importantly still maintained relationships, earned fees and acted as a central point of contact for borrowers,” he says.

GFC, COVID and rising rates

Although it was then that the seeds were sowed for today’s bustling private credit market, it was not until more than a quarter of a century later, with the collapse of Lehman Brothers and the onset of the global financial crisis (GFC) in 2008, that the asset class truly took off. And the numbers map this trajectory out.

According to figures from Preqin, assets under management within private credit funds totalled just USD 44 billion in 2000. Ten years later this had grown to more than USD 310 billion. Now the market stands at an eye watering USD 1.52 trillion. “The 2008 crisis re-assigned risk appetites and allocations,” says Rodrigo Trelles, Co-Head of UBS O'Connor Capital Solutions. “The global financial crisis was critical in terms of the private credit expansion.”

The more recent outbreak of COVID and resultant lockdowns in the US as well as Europe and Asia provided the same market dislocations as the 2008 crisis and hence the same subsequent boost to private credit. “Multiple managers (including us) were very busy between March and June of 2020,” says Trelles. “The existing bank regulatory framework limits risk-taking for banks and diminishes their ability to provide liquidity in periods of stress. On the other hand, many alternative managers thrive in dislocation events, which create unique opportunities for them to provide liquidity at an attractive price.”

Popp agrees: “The GFC drove banks to largely exit lending to small and medium enterprise business. But, like all things, a crisis accelerates trends that were already in place. ”Indeed, while the 2008 economic crisis brought with it a litany of problems, it also created opportunities; with the resultant retrenchment among traditional lenders, who had their own balance sheets to repair, creating a lending vacuum that non-bank players gladly filled. The outcome is that the rise of private credit funds, also known as alternative lending, shadow lending and private debt, has been nothing short of breathtaking.

Baxter Wasson, Co-Head of UBS O'Connor Capital Solutions, reiterates the important role the 2008 crisis played: “In the wake of the GFC there was a pullback in lending by banks, and so a supply and demand imbalance emerged across the board, which became very favorable for new lenders. And that's what allowed them to create such strong transactions with such attractive pricing.”

Spiking interest rates also played their part…

Spiking interest rates also played their part, increasing the attractiveness of the floating rate nature of the asset class. The US Federal Reserve has increased rates 11 times since March 2022, which included four 75 basis point jumps, with the headline rate now in the range of 5.25% to 5.5%.

Although the last hike came in July last year, the growing sense is that rates could now stay higher for longer as the Fed continues to try and wrestle inflation down to the central bank’s 2% target. Meanwhile, the European Central Bank increased interest rates 10 times since July 2022, though recently cut by 0.25% to leave the headline rate at 4.25%.

The Fed Chair Jerome Powell said at a press conference in Washington in May: “The recent data have clearly not given us greater confidence (that inflation is heading sustainably to 2%) and instead indicate that it’s likely to take longer than expected to achieve that confidence.”

At the start of the year, financial markets were pricing in five or six Fed rate cuts in 2024. That has now dropped to one or two. Kevin Lawi, Managing Director, UBS Credit Investments Group, believes this “higher for longer” scenario should settle investors’ fears that they might have already missed the boat in terms of the attractive returns that have been on offer within private credit.

On a historical basis, private credit returns in a zero-rate world, which is much of what we lived through during the last decade, were 7% to 8% unleveraged, according to Lawi. “Today we're at a 300-plus basis point premium to that, and so individual deals may yield over 10%,” he says.

Indeed, many factors point to the private debt market swelling at an even faster pace in the future, especially in light of the regional banking crisis in the US last year where Silicon Valley Bank (SVB) experienced a severe bank run and disappeared from the market almost overnight after US regulators were forced to take control of the West Coast lender. It triggered a contagion that eventually spread to Europe.

Edoardo Rulli, Chief Investment Officer, Head of UBS Hedge Fund Solutions, says the “disintermediation” of banks “shows no signs of slowing down” in the wake of SVB’s demise, with calls for banks to increase their capital ratios, providing an even greater footing for the private debt market. What the future holds for the asset class is a question for allocators, says Popp, but “the private credit market is already very big and successful”.

Upper/middle market direct lending could take the trajectory of the syndicated loan market. And while niche strategies should see growth, the core upper/middle market strategy has already arrived. Rulli adds that there are very good reasons why institutions and, increasingly, retail investors might invest, “whether through retirement accounts or otherwise, money will continue to be allocated to private markets”.

Trelles agrees: “Private credit still has a lot of room to capture market share from other sectors, such as syndicated loans, high yield, asset backed securities and real estate. The key is for institutional investors to get comfortable with the different sub-asset classes within private credit.” Rulli puts things more bluntly: “In my view, the growth story will continue.”

But what of the growth stories elsewhere? And what does the future of bank-lending disruption look like?

The democratization of alternative investments is one trend that has the potential to radically change the investment landscape. Increasingly, swathes of retail investors find themselves waiting on the sidelines for the right price and entry point. The so-called 'liquid alternative' market was one of the investment industry’s early attempts at tapping into the unrealized demand of retail investors for private equity and hedge funds. The demand was strong, but performance issues have somewhat stifled interest, although assets in these vehicles have jumped sharply, growing from almost USD 14 billion in 2003 to nearly USD 250 billion at the end of last year, according to data from financial research firm Morningstar.⁵

The untapped potential is the prize. Historically, alternatives have not been part of the typical retail investor portfolio. However, this is quickly changing as cash-strapped governments across the globe look for ways to make it easier for alternatives and small investors to meet.

According to the consultancy Bain and Co., the opportunity can be captured in two numbers: 50% and 16%. Individual investors hold roughly 50% of the estimated USD 275 trillion to USD 295 trillion of global assets under management. Yet those same investors represent just 16% of AUM held by alternative investment funds. “Retail investors account for half of all wealth globally. No wonder alternative funds have them in their sights,” Bain says.⁶

However, the future of alternative lending and the disintermediation of banks will no doubt be governed by the world’s regulators. At the end of last year, US regulators cleared the way to increase oversight of asset managers, hedge funds and other non-banks they believe pose risks to the financial system. Meanwhile, in the UK the Bank of England’s deputy governor Sarah Breeden recently said regulators need broader oversight of financial firms to prevent a crisis in the vast non-bank sector turning into a credit crunch and wreaking havoc on the economy. “A shift in the willingness of market-based finance to lend to corporates, particularly those perhaps that are highly leveraged, would have significant implications for the real economy,” she said.

In closing, Popp says: “The disintermediation of lending from banks to private players represents a significant shift in the financial landscape. Private debt presents a wealth of opportunities for investors and borrowers alike. However, navigating this complex and rapidly evolving market requires careful attention to regulatory changes.”

¹ Securities & Exchange Commission, October 9, 1998
² The definitive history of private credit, Wall Street Fintech, Feb 13, 2024
³ Private debt – An expected but uncertain “Golden Moment”?, Earnst & Young, data from Preqin, 8 January 2024
⁴ The definitive history of private credit, Wall Street Fintech, Feb 13, 2024
⁵ The dangerous democratization of alternatives, Caprock, February 21, 2024
⁶ Why Private Equity Is Targeting Individual Investors, Global Private Equity Report, Bain & Co, February 27, 2023
The views expressed herein are as of the date of this article unless otherwise stated. It is believed to be reliable; however, its accuracy cannot be guaranteed. All such information is subject to change without notice.