Direct lending is unlikely to threaten financial stability, according to two finance professors who recently evaluated the three major channels through which the industry could pose a systemic risk. Penn State’s Young Soo Jang and Temple University’s Samuel Rosen examine several potential vulnerabilities, and they find that:
Fire sales are not a risk for direct lending given the structure of the industry.
Direct lenders have stricter lending standards and monitoring than banks.
There is no evidence that non-banks would reduce lending more than other lenders during a recession.
The paper, published earlier this year, investigates each of these channels and analyzes the extent to which they represent plausible risks to financial stability. It finds that the risk of fire sales is low because credit funds are not interconnected in the same way banks typically are. On loan monitoring, the paper concludes that direct lenders, in fact, impose stricter covenants than banks and require larger equity injections from private-equity firms during renegotiations, ensuring the private-equity firms have skin in the game. And finally, the paper finds little evidence that direct lenders would reduce lending more than banks would during a recession.
The risk of contagious fire sales is low in direct lending because, unlike banks, which tend to be highly interconnected, direct lenders do not loan to each other, the paper finds Direct lending funds typically use closed-end fund structures with limited redemption risk, making a run on a private lender highly improbable, in contrast to banks and open-end mutual funds that offer daily liquidity. Thus, there is little financial stability concern that the distress or failure of one firm cascades through the financial system by causing other firms to fail.
The paper also argues that selling by one direct lender is unlikely to trigger forced selling by other firms. That’s because direct lenders hold loans to term and do not typically trade them over the life of the loan. In addition, direct lenders’ loans are classified as level 3 assets, which means that their fair values are determined using models developed by third-party valuation companies. Therefore, the structure of direct lending funds makes fire sales improbable and limits the possibility of contagion.
The authors also rebut the claim that commercial relationships between private credit funds and private equity funds incentivize lax underwriting that creates financial stability risks. The evidence shows that direct lenders often impose stricter covenants on borrowers than banks do and require greater equity contributions from private-equity sponsors during periods of distress.
For example, one argument is that there is an imbalance in bargaining power between direct lenders and private equity sponsors because direct lenders rely on private equity sponsors for deal flows. According to this argument, the imbalance incentivizes lenders to be less aggressive in monitoring credit risk. However, the available evidence shows that direct lenders retain significant bargaining power in these relationships.
A related risk is that private equity firms with lending arms exploit this relationship by extending loans to themselves at terms below market standards. But empirical analysis and survey evidence shows this risk is mitigated by the fact that private-equity sponsored deals are rare and because there is a stigma associated with such transactions.
The authors also find little evidence that private credit funds would reduce their lending more than other firms during financial stress. This idea is difficult to test, given that there has not been an extended period of financial stress or a recession during the same period that direct lending has become a more important funding source for companies. The paper points to empirical evidence showing that direct lenders would reduce lending during a period of financial stress, but so would banks. But the paper also observes that no one has analyzed whether direct lenders and banks subject to the same adverse shock alter their lending patterns in different ways. Hence, there is little empirical basis for claiming that private lenders reduce lending by more or less than banks during periods of financial stress or economic downturns.
A further point the paper makes is that direct lenders’ behavior in response to an adverse financial or economic shock is unlikely to be the most important factor impacting credit provision. Monetary and fiscal policy actions in response to the negative shock would support lending by banks and direct lenders and mitigate the effects on credit provision. The effectiveness of those policies would outweigh the marginal differences between banks and direct lenders during a crisis, rendering the question moot.