Banks extending more credit to PE. Will they regret it?

More banks are getting comfortable with a source of loan growth that — for now — has shown little risk and good returns: private equity.

And they’re eager to do more.

Private-equity managers have been stockpiling massive funds to buy stakes in promising companies then offloading them at a profit for their investors, which are often major institutions, pension funds and university endowments. But more of these funds have been tapping lines of credit offered by banks to either help pay for businesses they are investing in, or to improve a key accounting metric used to show the rate at which they are returning profits to their clients.

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“It's a business we like, and we definitely are going to continue to grow,” Silicon Valley Bank President Michael Descheneaux said about lending to private-equity firms on an Oct. 24 call with analysts. “That's a very sizable market and a big opportunity for us.”

Private-equity lending makes up more than half of the $68.2 billion-asset Silicon Valley Bank’s loan portfolio.

It is one thing for the bank, situated in Santa Clara, Calif., with its own private investment and venture capital arm, to be heavily involved in the business. But more regional and midsize banks have been seen pushing into the space, too, as they seek new avenues for loan growth without taking on too much risk given the uncertain economy ahead, according to analysts and academics.

For instance, the $49 billion-asset Signature Bank in New York recently hired a team from Silicon Valley Bank to offer lines of credit to private-equity funds. The team has already closed $900 million in these loans during the third quarter alone, CEO Joseph DePaolo said in a recent interview.

“Banks' confidence in the robustness of fund finance as a business line is arguably backed by the relative rarity of default,” Florin Vasvari, a professor at the London Business School and an expert in private-equity financing, said in a study published in August.

The $71.7 billion-asset Comerica Bank in Dallas, known for its energy and national auto-dealer-financing business, has seen its book of loans to private-equity firms and venture capital funds more than double from four years ago to above $2.5 billion at Sept. 30, according to its third-quarter earnings presentation.

Comerica CEO Curt Farmer touted the potential of the business during a presentation at the Barclays Global Financial Services Conference in New York in September.

“Our pipeline remains robust, and we expect to continue to deliver growth,” Farmer said at the time. “Credit quality is excellent and no criticized loans since inception. We have not taken a charge-off in this business since inception.”

Private-equity managers had typically used lines of credit from banks to bridge funding gaps for particular deals, but they are now more often using this financing to boost their internal rate of return, which is how these funds are graded for investors, who expect a certain profit within a certain time. By using bank financing in lieu of drawing committed capital from their investors, fund managers can shorten the timeline for doling out a cut of the profits to investors and essentially increase their IRR.

The market for this kind of lending sits on the edge of the so-called shadow banking system, so its exact size is hard to pin down.

However, data provided by the Federal Deposit Insurance Corp. shows the amount of lending from banks above $10 billion in assets to nonbanks — which include mortgage lenders and real estate investment trusts along with private-equity funds — passed $403 billion in the first quarter of 2019. That was up nearly 18% year over year and more than double the amount five years ago.

There are no official numbers breaking out loans to private-equity firms specifically, but the New York law firm Cadwalader, which handles a substantial amount of this business, estimates the global market for subscription lines of credit to private-equity firms has hit $550 billion year to date, a more than 20% increase from last year.

Most of this financing comes from banks, and more appears to be on the way. There is some unpredictability for when cash-rich investment funds will decide to pay them down; earlier-than-expected payments can put a pinch on interest income.

“Volatility lies … in timelines of credit for venture capital and private-equity funds,” First Republic Bank CEO James Herbert said on an Oct. 15 earnings call.

The $111 billion-asset bank in San Francisco reported a 4-basis-point dip during the third quarter in the percentage of its lines of credit extended to these funds that are being used.

East West Bancorp in Pasadena, Calif., which has $43.2 billion in assets, reported a slight drop in private-equity loans outstanding for the quarter, but overall executives are optimistic about growth.

“It's really hard to predict when they need to draw down, when they need to pay down, because oftentimes, it depends on the investment that they make,” East West Chairman and CEO Dominic Ng said on an Oct. 17 call with analysts. “And so the [private-equity] funds have always been harder to predict, but we continue to bring in more [private-equity] clients throughout the year.”

While private-equity funds have clearly shown an increased appetite for these lines of credit while the economy has expanded, it remains to be seen whether demand — and the low default rates demonstrated so far — would hold during an economic slowdown.

Meghan Neenan, North American head of nonbank financial institutions at Fitch Ratings, wrote in a study published by the private-equity industry tracker Preqin in June that more data was needed on this corner of the market.

“The widespread adoption of subscription facilities post-crisis confirms many of their perceived benefits, but Fitch expects that through a full market cycle, some of the accompanying risks may come to the forefront,” Neenan wrote.

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