For the better part of history, banks traditionally made money lending and asset managers made money taking equity positions. However, in the post-Lehman era, asset management has evolved into higher risk structures as prolonged low interest rates have made securing alpha/ above market yield virtually impossible.
Since the financial crisis, positions in the equities market has proven to be lucrative with annual returns averaging double digits (roughly 12.3%/year not accounting for reinvestment). However, as central banks globally are exponentially increasing their economic their respective economies, interest rates across the globe have tumbled to very low single digits or even sub-zero.
The charts below show the US 10 year and the S&P500 Price/Earnings Ratio. The takeaway here is as time has gone on, equities have become significantly more expensive and bond price have gone up/ yields have declined.
Inexpensive borrowing cuts both ways: it stimulates growth in corporate, real estate, and auto lending, however, cheap borrowing fuels abnormal amounts of speculation. For example, corporations have fundamentally shifted the way they use free cash. Low cost borrowing has stimulated share buybacks and leveraged buyouts more than it has stimulated investment into organic growth; this generalization is not to be over encompassing of the entire market. Often times, leveraged buyouts are significantly more cost effective in revving up business growth as the cost of hiring teams, building infrastructure (physical and intellectual), and rolling out new products/innovation.
Deal flow in 2016 has become scarce & the pressure to obtain yield has increased as equities have seen outflows. This combination has led to managers looking for new market niches to capitalize on.
Meanwhile, the banking world faces even greater scrutiny from Dodd-Frank and the 2015 announcement to increase capital reserves. In a note from Chairwoman Janet Yellen, “Financial firms must bear the costs that their failure would impose on others.” In other words, maintain more capital to reduce exposure to failures or slim down their businesses.
This meant banks had to focus on lending to the low risk/high credit market and eliminate middle market/higher risk (i.e. higher yield) lending. Following the Fed Chairwoman comments, Morgan Stanley CEO James Gorman said, “We’re not capital short, if anything, we’re capital heavy.”
A focus on high credit corporations leaves a large gap for the rest of corporations (this concept is applicable to real estate as well). Private equity funds such as Ares Capital, Blackstone, Prudential Group, and KKR, have poured billions into filling the gap left by traditional lending institutions; while the exact amount is difficult to pinpoint, estimates by Bloomberg range between $200B-$400B.
This lending, much like inexpensive borrowing, cuts both ways. Banks are stress tested to ensure healthy practices while PE debt funds, while underwritten internally, are not faced with the same set of eyes, but do have to answer to investors on an annual basis. On the flip side, this tranche of lending options provides capital where it is needed most: by small and mid-sized businesses who have no option besides higher borrowing costs provided by PE funds.
The chart below provides an example in the real estate world; as banks have begun to utter the forbidden world in real estate, “bubble,” private equity funds are providing financing to property owners and developers who otherwise have very few, if any, options.
For asset managers, they’re able to partake in deals and, if the deal goes sour, take over the asset below replacement cost. The market is beginning to see this across the board; first positions are providing investors with their downside risk basis softened if not eliminated via the repossession of the asset (this isn’t the case in the technology field as intellectual property which fails ends up being worthless).
As the credit cycle begins to turn and competition heats up, the chance of the risk/reward scale being skewed will increase. Add in a layer of a lack of auditing, and the probability of defaults will increase.
However, in the case of Blackstone, they’re the largest owners of real estate in the world; do they really need regulators telling them what deal pencils out?