Are PE-Backed Loans Considered Less-Risky?
The Federal Reserve recently released a white paper titled ‘How Private Equity Fuels Non-Bank Lending’, exploring the relationship between PE-backed syndicated loans and active bank monitoring. It’s very technical and riveting for anyone who loves Good Will Hunting and regression analysis:
2024015pap.pdf (federalreserve.gov)
For the rest of us who prefer the punchline, I’ll briefly summarize some key points. While the research specifically focuses on the US syndicated CLO market, I believe this is equally-applicable to direct private lending. In particular:
PE-backed loans are associated with lower expected losses and loss given default, which are measures of expected ex-ante credit risk;
PE sponsors’ actions (such as engagement with management and due diligence) substitute for bank monitoring;
High sponsor reputation and strong lender-sponsor relationship are associated with lower perceived risk.
On a separate but interesting note, PE-backed term loans are more likely covenant-lite than comparable non-PE backed loans (~3% higher probability of being cov-lite). However, this could be due to the lower-perceived default risk.
Lastly, as the author points out:
“Traditionally, bank debt was the most important source of financing for private firms. A fundamental role of banks is to produce information via screening and monitoring of borrowers. However, [this] analysis reveals that PE sponsors’ monitoring or due diligence substitutes for bank monitoring and information production. Therefore, a broader implication is that, with the rise of private equity, information production in private markets shifts from banks toward PE investors.”
