The US Federal Reserve’s
leveraged lending guidelines have raised concern that
liquidity could be stretched making it difficult for mid-market
firms to find financing. But partnerships between banks and
business development companies (BDC) are offering a way to
fill that gap.
BDCs are not entirely new. Banks have arranged and partnered
with other banks and shadow banks to issues multi-tranche loans
However, the increasing amount of leverage in the market and
the idea that banks are skirting the guidelines through these
partnerships has raised the eyebrows of market participants and
regulators. Until regulators form a clear opinion on the issue
or market conditions change, the trend seems set to
"I expect that as more regulators give feedback to banks
about their portfolios and the structures being used, banks
will have a better sense of what they can do," said Geoffrey
Peck a partner at Morrison & Foerster. "Depending on that
review, there may be banks looking to fashion creative
structures around that review."
- Banks and business development companies are
partnering up to offer leveraged loans to mid-market
- It’s unclear whether regulators will
step in to prevent the progress of these deals;
- Business development companies and mid-market
firms are benefiting due to the higher interest rates placed
on the unsubordinated section of the loans.
That concern has led to mixed reaction from
regulators, with figures from the Office of the Comptroller of
Currency (OCC) informally saying that it was concerned about
these partnerships. Banks have noted that the OCC is the
regulator who most
strictly enforces the guidelines.
" It is highly likely BDCs
will become a larger part of the financing spectrum
However, no official ruling has been made about them.
Some regulators are also expressing concern about the amount
of leverage in the financial system. With banks being the main
target of regulation and little consensus on how to bring the
overall amount of leverage down, few expect changes in the
BDC- bank partnerships will therefore likely continue to add
leverage to the system without exceeding the leverage
regulators allow banks to hold.
Most of the loans being issued rely on a unitranche
structure where the banks hold the senior loan and the BDC
issues the subordinated section. Apart from allowing banks to
hold less leverage, this structure has benefits for the BDCs
For borrowers, particularly in the
mid-market, access to capital can be limited as banks
become more cautious about what they put on their books, or
more expensive if it comes from shadow lenders looking for high
returns. These partnerships create a cost balance.
Likewise for BDCs, which have higher capital costs than
banks, the subordinated loans come with higher interest rates
to help increase investor yield.
BDCs are a product of the 1980s economic downturn. Created
as an amendment to the 1940 Investment Act, they are closed-end
funds, similar to hedge or private equity funds, but without
the requirement that investors be accredited. Their goal was to
help drive funding to small businesses that were not receiving
it from banks.
"The resurgence of BDCs is likely
due to the cyclical nature of the economy and we are seeing
similar stages in that cycle to the ones in which BDC were
originally legislated," said Rossie Turman, a pattern at
Banks too are not acting far from their traditional
role in these deals. Most of the banks generate revenue from
activities other than traditional lending, including loan
"I think it is highly likely BDCs
will become a larger part of the financing spectrum," said
Turman. "BDCs are another provider of capital in leveraged
lending that are able to fill the gap created as banks are
forced to reduce the amount of liquidity they can place in the
With the market expected to stay in this condition and
regulators yet to make their position clear, this trend seems
likely to flourish. A harsh reaction from regulators could even
see a drop in liquidity for the mid-market.
"Regulators are reviewing banks’ leverage
guidelines and portfolios to see how well the
banks’ portfolios match the guidelines," said
He added: "If BDCs and other non-banks feel they need bank
partnerships to do their business and the regulators come down
on banks, this could affect the ability of mid-market companies
to leverage their businesses in an appropriate way."
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