Financial intermediation: what are the new rules?
The gap in the capital market, created by the withdrawal of banks from markets with high credit risks, is increasingly being filled by private venture capital companies. The assets managed by these parties have more than doubled over the last five years. This has changed the fundamental rules of the game for financial intermediation and raises a number of important issues.
Regulation of the banking sector
As a result of the regulation of the banking sector in response to the credit crisis between 2007 and 2011, banks that underwent stress tests changed their strategies. In order to improve their resilience to macroeconomic shocks, they are shifting their credit to more secure markets and changing their business models from 'spend to hold' to 'spend to distribute'. In doing so, they are reducing their direct exposure to credit risk and distributing the loans they issue. This diversification of liquidity and credit risks increases their own assets and contributes to the growth of the shadow banking system. As a result, the leverage ratio between the risk-weighted assets of the banking sector and the total market value of their shares has decreased significantly. This is true for banks in many Western European countries. For Belgium, for example, the leverage ratio has fallen from 24.99% in 2008 to 12.75% in 2020.
The need for alternative financing models
Due to the regulation of the banking sector and the subsequent avoidance of high credit risks, there is an increased need for alternative financing models. As a result, households, companies and authorities are making less and less use of financial intermediation offered by banks. Instead, they are turning directly to the capital market and private lenders. Parties such as Apollo, Ares, Blackstone, Carlyle and KKR are therefore given space to make significant growth. Simply by capitalizing on the sell-off that took place at the start of the coronavirus pandemic, these companies have more than tripled in value. They have reached valuation levels that seem difficult to sustain based on the valuation of their future cash flows. Yet investors' capital is gradually being channeled into private venture capital companies or private equity funds. These are relatively young intermediaries that are not hindered by regulation.
Innovation in corporate finance
The development that has taken place as a result of the regulation of the banking sector can be considered an innovation in how companies are financed. Private venture capital companies have partly taken on the role of banks. Consider capital provision in complex financing transactions for companies with a high credit risk, for example. The large-scale privately financed takeovers, LBOs, capital restructurings and delisting transactions that are currently taking place are another unmistakable sign that as financial intermediaries in the capital market, these parties are here to stay.
More and more assets from institutional investors
Institutional investors are prepared to pay high fees to private venture capital companies, and they are also entrusting more and more assets to them. Today, the capital managed in the private market amounts to more than eight trillion US dollars. That is more than six times the total outstanding volume of leveraged loans in the US: around 1.3 trillion US dollars according to the S&P/LSTA Leveraged Loan Index. The total amount accounts for 10% of global interest-bearing loans of non-financial companies in 2020 (according to statista.com).
Immense shift towards private capital
The growth of the assets managed by private venture capital companies is expected to remain stable or even increase in the near future. This immense flow of capital is stimulated by interesting returns of private equity or private loans, for which an average actuarial return of more than 15% and 9% respectively is expected. After years of ample profits and fear of inflation, investors are now pursuing a new model. They are increasingly shifting their assets towards private capital. In this matter, investors are following the example of the investment strategy used by Yale University, which has so far been able to achieve an annual return of over 12%.
Private venture capital companies: what do we actually know about them?
In short, private venture capital companies have now become an essential financial intermediary. This observation makes us wonder: What do we actually know about these new financial intermediaries and what more do we need to know about them? What more do we need to know or be reminded of when it comes to traditional intermediaries (the banks)? Should we measure the essential role of banks as financial intermediaries in units of distributed assets rather than in total credit on their balance sheets? How does the 'spend to distribute' model affect banks' motivation to monitor credit? The key now is to look for answers to these important questions.
This article originally appeared as a column by Prof. Pascal Böni in CFO Magazine Belgium, November 2021.
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