(Bloomberg) — The continued competition between banks and direct lenders to win deals could compromise underwriting standards in transactions, researchers at the Federal Reserve wrote in a note Friday.
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The growth of dry powder — which has quadrupled relative to 2014, according to the note — and managers’ need to deliver returns to their limited partners could lead them to choose riskier deals and offer looser documents as a slowing economy leads to fewer opportunities, Fang Cai and Sharjil Haque wrote.
“Combined with high concentration of dry powder within a few funds, fund managers run the risk of structuring deals poorly going forward in order to boost internal rate of return,” they wrote. “Deterioration in deal quality can raise future defaults, hurting fund performance and investors’ returns, given relatively low recovery.”
The central bank researchers are the latest to warn about the possibility of lower dealmaking standards across the industry. Analysts at Moody’s Investors Service wrote last year that any “race to the bottom” in leveraged buyout terms and pricing between banks and direct lenders could have systemic risk implications.
The researchers also mentioned that partnerships between banks and direct lenders, although limited at the moment, could have implications for financial stability. Synthetic risk transfers, which move risk from banks to private fund managers for regulatory capital purposes, “pose hidden risks to the financial system, especially as the industry has yet to endure a prolonged recession.”
Among other concerns for financial stability, the researchers highlighted spillover to nonbank institutions like property and casualty insurers who invest in private debt and may face a spike in short-term claims, potentially exacerbating liquidity problems.
See also: Ardonagh’s $2.3 Billion Bond Deal a Bank Win Over Private Credit
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