SINGAPORE (June 18): Raghuram Rajan, the famous economist and former governor of the Reserve Bank of India, outlined with great insight the reasons banks need to be regulated when he spoke at the 2018 MAS Lecture earlier this month. For me, his presentation was a timely reminder of how things can quickly go wrong in the finance sector. And, it was especially relevant as we approach the 10th anniversary of the collapse of Lehman Brothers, amid a heightened degree of risk taking in the market.

Some of the key reasons for bank regulation that Rajan cited are widely acknowledged in the finance sector. He pointed out that banks operate with highly levered balance sheets, and bank failures have huge negative externalities for the rest of the economy. Moreover, central banks have the power to create liquidity when it is needed. And, because there is broad expectation that the authorities will act to save the banking system, the authorities have to intervene even more, setting rules and regulations to keep everyone in line.

However, the most interesting reason for regulation cited by Rajan has to do with what he calls “perverse incentives” in the finance sector. Notably, banks often continue fighting to maintain market share in a particular business even as the risks rise and returns fall. To make the point, Rajan brought up an infamous statement by Charles “Chuck” Prince, who was chairman and CEO of Citigroup when the global financial crisis began unfolding.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” Prince said, in an interview with the Financial Times in July 2007. Prince was referring to concerns that cheap credit fuelling leveraged buyouts would be disrupted by turmoil in the US subprime mortgage market, and was stating that Citigroup, which was one of the biggest providers of financing for private equity deals, was not going to pull back. Prince retired as chairman and CEO of Citigroup in November 2007.

Rajan said that Prince had subsequently told him that he was concerned at the time about losing his staff at Citigroup. Relating what Prince had told him, Rajan said: “My people were being hired away all over the place, and I could not tell them that I do not want to make these loans, because essentially I would be telling them that I want to end the franchise. So, to keep the franchise, I had to keep making the loans.” Rajan went on to wryly observe that competition in most industries results in a general improvement in quality, but competition in the finance sector seems to result in reduced credit quality.

A new kind of bond

On the same week that Rajan delivered the MAS Lecture, the local market was abuzz with talk of a new bond for retail investors, backed by a portfolio of private equity investments. The bonds are being issued by an entity called Astrea IV, a vehicle managed by Azalea Investment Management, which is a unit of Temasek Holdings. A total of $242 million worth of Class A-1 bonds are being issued, half of which are being sold through a public offering with a minimum subscription of $2,000. Nearly $890 million in valid acceptances were received, which represented a subscription rate of 7.4 times.

The rest of the Class A-1 bonds as well as US$210 million ($280 million) of Class A-2 and US$110 million of Class B bonds are being sold to institutions and accredited investors, and are also said to have seen strong demand. The Class A-1 bonds offer a yield of 4.35%. The Class A-2 and Class B bonds offer yields of 5.50% and 6.75% respectively. The Class A-1 and A-2 bonds are callable in five years. If they are not redeemed at that time, the interest they offer will be stepped up by one percentage point. The final maturity is in 10 years.

See: All valid applicants of Astrea IV PE bonds to receive some allocation, say issuers

All in, some US$501 million will be raised from the issue of three classes of bonds. These bonds are supported by cash flows from a US$1.1 billion portfolio of 36 private equity funds, managed by 27 managers. These investments are spread across about 600 portfolio companies, of which 62% are in the US and the rest in Europe and Asia. Pre-sale rating reports by Fitch and S&P refer to Astrea IV as a collateralised fund obligation transaction. Both agencies accorded preliminary ratings of Asf to the Class A-1 bonds. Fitch also has ratings of Asf and BBBsf on the Class A-2 and Class B bonds. (The sf suffix denotes a structured finance instrument.)

Azalea has stated that it wants to develop the co-investor base for products based on private equity funds, and suggests that other products besides bonds might be rolled out in the future. Prior to Astrea IV, similar structured fund obligation transactions were organised under Astrea I in 2006, Astrea II in 2014 and Astrea III in 2016.

Big private market boom

The launch of the Azalea IV bonds comes in the wake of a sustained boom in private markets since the global financial crisis. Despite public markets performing strongly in 2016 and 2017, capital has continued to pour into private markets. Last year, private asset managers raised a record US$750 billion globally, according to a report by McKinsey & Company. Much of this growth was fuelled by what McKinsey calls “mega funds” of more than US$5 billion. “Mega funds now account for 15% of total fundraising, up from 7% in 2016, having exceeded their previous peak of 14% in 2007,” the report states.

One reason for this consolidation is that mega funds are viewed as a safe choice. After all, being able to raise more than US$5 billion is often the result of the general partner having delivered outperformance with smaller funds in the past. Mega funds are also useful to institutional investors who need to quickly put a lot of money to work. And, there is little evidence at the moment of mega funds being unable to match the performance of smaller funds. “The data suggests that since 2008, the average mega fund has outperformed other fund sizes — and also outgunned public market equivalents,” the McKinsey report says.

Interestingly, some of the growth in the private markets is being fuelled in part by demand for credit that is not being met by regulated banks and established bond markets. According to the McKinsey report, funds raised to invest in private debt grew by 10% last year, to more than US$100 billion, reaching a peak last seen in 2008. Most of that growth happened in Europe (up 26%) and in Asia (up 200%, off a low base). Funds created to lend directly (as opposed to investing in distressed or special situations, or mezzanine) raised 51% of all private debt capital in 2017, a sharp increase from 25% the previous year.

“The takeoff in debt indicates that private markets are increasingly seen as a good alternative to banks, particularly in India and China, where banks have been overwhelmed with non-performing loans. Similarly, public debt markets are not deep in many parts of the world,” the McKinsey report notes. “As access to bank loans and high-yield issuance diminishes, private debt investors step in to fill the void.”

Should we keep dancing?

Yet, some signs of strain in putting all that money to work are emerging. Last year, in the private equity space, global deal volume was up 14% to more than US$1.2 trillion, but the deal count was down 8% to about 8,000. “With deal volume increasing and deal count dropping, average deal size has risen — by 25% this year. About two-thirds of this increase is due to growing multiples; the remaining third might be said to be organic, as it is explained by acquisitions of larger targets that generate higher Ebitda (earnings before interest, taxes, depreciation and amortisation),” according to McKinsey.

The higher private equity deal valuations are probably a reflection of higher valuations in the public markets, low interest rates as well as generally benign economic conditions. Yet, at some point, higher valuations could begin translating to lower returns for investors. The instruments created to provide investors with exposure to the private markets will likely evolve, to match their shifting needs and concerns. But investors should keep an eye on the bigger picture. If underlying returns begin deteriorating, it is likely to be only a matter of time before the financial structures built on them begin to crack.

Meanwhile, for players like Azalea, the challenge will be to overcome the “perverse incentives” that blinded some top Wall Street firms to the emerging risks of the US subprime mortgage crisis a decade ago. The private markets might well be making capital available where it is needed and delivering good returns for investors for now, but it’s worth remembering that the time to get off the dance floor is well before the music stops.

This article appeared in Issue 835 (June 18) of The Edge Singapore, which is available at newsstands now.

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