New Shadow Banks Run Into Old-School Credit Issue of Ratings

(Bloomberg) -- Lenders trying to break into the booming private debt markets by wooing insurance companies may face an unexpected barrier to entry: credit ratings.

Insurance companies have become bigger buyers of loans to America’s middle market companies as they seek out higher yielding assets. Yet unlike most other buyers of these loans, they typically require ratings.

“There’s a lot of new entrants in direct lending wanting to manage money for insurance companies,” said John Simone, head of Voya Investment Management’s insurance solutions group. “Some of them who aren’t aware you have to go through this extra step are going to get a rude awakening.”

Getting a credit rating is a costly and time-consuming process for any lender. It is even more unwieldy for newcomers with limited track records in a competitive market. Some lenders may not even be aware ratings are needed by would-be insurance buyers, who face punitive capital charges without them.

Growing Interest

There are 116 U.S. insurance companies with $7.7 billion in assets under management now active in private credit, according to research firm Preqin. In 2015, there were just 75 with $5.4 billion of assets.

That growth has made them attractive targets for all private lenders looking to beef up business and source new buyers beyond pension funds and foundations. In a February global private debt report, Preqin said insurance companies were one of the three largest investor groups that intend to make future investments in private debt.

DBRS rated about 30 middle market loans in the year ended June, and expects to rate a total of 60 in 2019.

This year alone Fitch Ratings has rated about 216 middle market loans, which are typically $250 million or smaller and often arranged by non-bank lenders. That’s about double the rate last year.

“The growth has been very strong and we’ve seen the demand across sectors,” said Sarah Jamieson, a director in leveraged finance at Fitch Ratings.

Both DBRS and Fitch Ratings attribute increased demand for middle market loan ratings to greater participation by insurance companies.

“As spreads in the market have tightened, investors are looking to asset classes where there might be a pickup in illiquidity premium, such as middle market corporate loans,” said Jerry van Koolbergen, managing director responsible for structured credit at DBRS.

Different Times

Yet acquiring ratings may be a bigger hurdle for new lenders, who are already forced to carve out niches due to stiff competition for deals and investor cash. Market participants say there is a danger they may become too reliant on ratings to win business, rather than carry out their own due diligence.

There are challenges for the ratings agencies as well. They have to dig through financials of small companies that may have changed hands multiple times, while audited financials can be hard to come by. Both make analysis difficult.

Christian Stracke, global head of credit research at Pacific Investment Management Company LLC, said ratings could be a good thing for the industry as long as methodologies take into account differences from prior cycles.

It’s more common today to see asset-lite borrowers with covenant-lite loans. In prior cycles loans had more investor protections and better claim on assets in times of financial troubles, he said. There’s also been an uptick in loan-only capital structures with no unsecured debt to help absorb losses for senior lenders. They all impact debt recoveries.

“If you’re getting aggressive methodology or methodology using stale historical data for an asset class, then you’re setting up some surprises in what is already a pretty crowded market with a fair amount of leverage.” Stracke said.

To contact the reporter on this story: Kelsey Butler in New York at kbutler55@bloomberg.net

To contact the editors responsible for this story: Natalie Harrison at nharrison73@bloomberg.net, Adam Cataldo

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