First Republic, Shadow banks, and Private Equity

Your weekend edition of the Private Capital Insider

Author

Equifund: Weekend Edition
April 29, 2023

Welcome to the Weekend Edition of
The Private Capital Insider

The headline story we’re not going to spend a ton of time on is First Republic Bank’s stock going into a freefall, making it the fourth bank failure in just as many weeks.

Instead, we’re going to talk about how the increasing instability in the banking system is continuing to give rise to an empire of “Shadow Banks,” that threaten the long-term stability of our financial system…

How Private Equity has become the de facto winner of the current string of bank failures…

And a “mailbag” of our poll results from last weekend's issue, with some of our favorite comments from our readers.

Let’s dive in,

-Equifund Publishing

The Gameboard

Shadow Banking: The True Winner of Financial Crises

The International Monetary Fund recently warned of “vulnerabilities” among so-called non-bank financial institutions – often referred to broadly as “Shadow Banks” – saying global financial stability could hinge on their resilience.

Translation? People are getting nervous about the vast amount of financial assets that DO NOT show up on conventional balance sheets of investment banks…

And the vast amounts of credit, issued by non-bank lenders, who DO NOT have the same regulatory requirements that actual banks do.

Here’s why this matters.

According to the Financial Stability Board (FSB), a body of global regulators and government officials, non-banks had about $239 trillion on their books in 2021, accounting for just under half of the world’s total financial assets.

And now, with First Republic Bank, the fourth bank failure in just as many weeks…

It means a perfect storm for private equity and alternative asset management firms – like Ares Management and Blackstone – whose massive private credit businesses live outside the banking sector, where traditional lenders like JPMorgan and Bank of America reign.

According to Ranesh Ramanathan, an attorney who advises fund managers and their portfolio companies on taking out non-traditional loans,

"Borrowers used to look at these banks and say, 'Look, the banks, they've been around forever. They're stable. I can always count on the banks being there for me.'

And now when something like this happens, all of a sudden the question is: 'Wait a minute. Can I? Is it really that stable?'"

On one hand, this is certainly a huge opportunity for those with strong Private Credit divisions, and can take advantage of the increasing demand for debt capital…

On the other, it represents one of the biggest systemic threats in our financial system that most people aren’t aware of.

Private equity is another segment of the financial markets where the lack of marking to market is a systemic problem. In this case, fund managers have been allowed to apply arcane models to value their own portfolios and collect performance fees.

The result has been asset values and performance trends that have diverged dramatically from real-world public mark-to-market values and trends.

But with the tide truly going out, however, the mark-to-fantasy valuation feature is morphing into a major bug, as clients realize what has really been going on.

Inflows drying up, and a backlog of outflows are problems for these richly priced and highly leveraged companies, with thin and sometimes negative tangible common equity.

Crescat Capital, LLC

For those that don’t speak analyst, here’s what’s going on.

Private equity has a huge role in the broader credit markets – mainly corporate debt, commercial real estate, and subprime lending.

Thanks to the recent shenanigans with banks – not to mention the whole interest rate thing – we’re likely going to see a highly predictable series of events occur:

  1. Banks begin to consolidate and focus on larger loans

  2. Liquidity dries up in the lower and middle markets as lending standards tighten

  3. Non-bank lenders fill the void, but with less regulatory oversight, and are willing to lend to less qualified borrowers

In case you’re thinking “We’ve seen this before, haven’t we?”

You have!

It started in the 1980s with a series of banking (de)regulations. These moves helped to accelerate a trend toward greater consolidation and conglomeration in the banking sector, with more than 4,300 bank mergers in the 1980s, and more than 6,000 in the 1990s.

In turn, liquidity started to dry up in the lower-middle and middle markets; Private Equity stepped in to fill the void and birthed a generation of “Barbarians at the Gate.”

As traditional sources of public capital financing became less available and regulatory burdens on public companies made public capital less desirable, private equity and private debt capital filled the void. Along the way, demand naturally increased as investors were attracted to the potentially strong and consistent return

Long story short, this led to the subprime mortgage crisis in 2007… which led to the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010… of which the Trump administration fiddled with in 2018.

Specifically, the new rules loosened restrictions on institutions with under $250 billion in assets, and eliminated the need for them to pass stress tests – which has become the often cited “smoking gun” for why the SVB collapse happened in the first place.

And now, everyone is beginning to ask about the “elephant” in the Private Equity room…

“Are you telling us the truth about the value of the assets you’re holding?”

While the SEC has generally steered clear of regulating the $18 trillion field of private funds, under a new proposal from federal regulators, they would be required to provide investors with quarterly investment statements regarding fees and returns.

Spoiler alert: PE firms aren’t happy about it.

“The private equity industry supports transparency and disclosure, and we work closely with our investors to ensure they have the information they need to make the best investment decisions,” said Drew Maloney, president of the American Investment Council, an industry group. “We are concerned that these new regulations are unnecessary and will not strengthen pension returns or help companies innovate and compete in a global marketplace.”

Prediction

In the same way that PE filled the void in the 1980s, and entered into its 30-year climb to dominance…

I’m predicting that in this next banking consolidation cycle, the “non-bank lender” that steps in to fill the void in the lower-middle and middle-market is Retail Investors.

As Wall Street firms seek to expand retail access to private markets, they aren’t going to be able to hide behind the claim that “our investors are rich enough to fend for themselves.”

For firms seeking to tap into the vast resources available in Retail, it means inviting an enormous number of eyeballs and scrutiny that (hopefully) lead to greater accountability from PE.

Players

Private Equity: Vulture Capitalists or Business Icons?

Private Equity is a term we tend to throw around broadly when describing a large section of the Private Capital ecosystem.

And while we certainly find the above market returns generated by PE as an asset class appealing, there’s a dark side to PE returns that deserves some attention…

PE firms make absurd amounts of money when they buy a company… but the companies they buy are far more likely to go bankrupt than ones they don’t buy.

Why do PE firms succeed when the companies they buy so often fail?

“In part, it’s because firms are generally insulated from the consequences of their actions, and benefit from hard-fought tax benefits that allow many of their executives to often pay lower rates than you and I do.

Together, this means that firms enjoy disproportionate benefits when their plans succeed, and suffer fewer consequences when they fail.

As in nearly every private equity acquisition, private equity firms benefit from a legal double standard: They have effective control over the companies their funds buy, but are rarely held responsible for those companies’ actions.

This mismatch helps to explain why private equity firms often make such risky or shortsighted moves that imperil their own businesses.

When firms, through their takeovers, load companies up with debt, extract onerous fees or cut jobs or quality of care, they face big payouts when things go well, but generally suffer no legal consequences when they go poorly.

It’s a “heads I win, tails you lose” sort of arrangement — one that’s been enormously profitable.”

Don’t worry, it gets worse. 

Thanks to the endless revolving door between Washington and PE – including cabinet members, speakers of the House, generals, a C.I.A. director, a vice president and a smattering of senators – the industry has a rockstar list of Insiders lobbying on their behalf (and not yours).

According to money-in-politics watchdog, OpenSecrets, the private equity industry spent $16.5 million lobbying Congress last year; all told, 415 of 435 members of the House and nearly every senator took money from the industry during the runup to the last election.

Today, PE titans are invested in almost everything you do in your daily life; Newspapers, fast food, retail shops, sports teams, energy assets, higher education, dentists, call centers, nursing homes, and prisons are among the list of industries dominated by PE firms.

That’s not to say that all PE firms are evil corporate raiders who are plundering America for their own personal gain…

However, as more assets continue to flow to non-bank lenders (like PE), it’s not a stretch to imagine the increasing amounts of risk these entities impose on the stability of our financial markets.

What’s your take?

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Our Favorite Comments From Last Weekend's Polls

Last week, we launched our first Weekend Edition, and had some excellent participation from our members in the polls. Here are the poll results along with some of my favorite comments.

Split Decision on Fintech

Bear Case

“Fintechs to fold but legacy banking sector put on notice they need to modernise and digitalise to compete in the next loose money cycle. Fintech equity holders are the losers in this cycle.”

Bull Case

“The smart minds behind Fintech will figure out the efficiency they need via blockchain so they don’t have to rely on legacy banks. Smart contracts will develop further and offer mechanisms to fulfill regulatory reporting requirements that bank charters impose. I don’t see Fintech going away completely, but rather many of the smart minds will find a path to flourish or get acquired because incumbents don’t have the technology prowess of the neobanks.”

Something Else

“As in most markets that are supposedly getting disrupted, there will be 2 - 5 winners who survive and thrive. They will advance, get charters, and become dominant in their niche. The rest will die with quick or slow death from lack of capital and be gone. A few will get acquired if you are lucky. ”

BREIT: The “Little Known” Blackstone Product

Yes

​​“Great management, decent returns, and no fire sale risk like public REITs since there are redemption limits. THe concept of mark to market for commercial RE is ludicrous. Much longer time horizons are relevant.”

“I also withdrew my funds last week.”

No

“Won’t invest in an ESG company that wants to use my money for their social agenda”

“seems it’s on the downhill slide in my opinion .”

First time

“Haven't been paying attention to the "big boys" thinking that will have to change”

Pretty Much Everyone Hates Gary Gensler

This one wasn’t even close. Here are some of my favorite comments (of which there were many).

“I’m racking my brain trying to come up with anything positive he has overseen since being in his position. ”

“Gensler was an abject failure at CFTC at preventing manipulation of markets, particularly gold and silver, when evidence of same was handed to him on a "silver" platter.”

“His attacks on crypto companies is ridiculous. It's obvious he's working with the administration to clear the playing field for their rollout of a CBDC. It's all about protecting his cronies in big finance and enriching himself along the way”