by Bryan Perry
May 16, 2023
The failure of three large regional banks and the challenges facing the entire sector remained in high focus this past week after it was disclosed that PacWest Bank (PACW) saw another round of deposit flight. Despite some banks showing a pause in withdrawals, sentiment remains largely bearish as the rising risk of a credit crunch for community and regional banks looms large in the minds of investors.
As with each past banking crisis, the FDIC stepped in to help put out the fires and then, together with Congress, enacted a slew of new regulations designed to target the few bad apples operating in the sector, but the ripple effects spread through the entire sector. The Fed had been shrinking its balance sheet for the past year (see M-2 money supply, below), decreasing available capital to banks to slow the economy well before the demise of the three big failures (Silicon Valley Bank, Signature Bank, and First Republic Bank).
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
With PacWest Bank and perhaps others on the ropes, any large-scale rescue effort by the FDIC, the Fed, Treasury, and Congress will very likely bring with it a whole set of tighter lending standards that result in making it more difficult for borrowers to obtain financing. The blame falls on the risk managers at banks over-investing in low-yield, long-dated Treasuries and jumbo mortgages, not the borrowers. But as this scenario unfolds, it will likely lead to tighter lending standards and less capital available to credit markets.
In a recent interview with Bloomberg, JPMorgan Chase CEO Jamie Dimon said it’s time for regulators to help put an end to turmoil in the banking industry; but he also predicts that policymakers will take away the wrong lessons: “I think it’s going to get worse for banks — more regulations, more rules and more requirements,’’ Dimon said in Paris. “If you overdo certain rules, requirements, regulations — there are some of these community banks that tell me they have more compliance people than loan officers.’’
Warren Buffett echoed this sentiment at the annual Berkshire Hathaway shareholder meeting, where he said, “If a CEO gets a bank in trouble, the CEO and directors should suffer.” When that doesn’t happen, he says, it “teaches the lesson that if you run a bank and screw it up, you are still a rich guy… that is not a good lesson to teach the people who are holding the economy of the world in their hands.” For instance, he said, “That is what First Republic was doing… in plain sight. The world ignored it until it blew up.”
Buffett has been reducing his bank holdings. He also made it clear that he is ready for a worst-case scenario in the banking crisis, citing a cash hoard approaching $130 billion. “We want to be there if the banking system temporarily even gets stalled,” he said. “It shouldn’t. I don’t think it will. But it could.”
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Navellier & Associates Inc. does not own PacWest Bancorp (PACW), Ally Financial, Berkshire Hathaway, Bank of America, BNY Mellon, Citigroup, Goldman Sachs, Jefferies, JPMorgan Chase, M&T Bank, Nubank, PNC , US Bancorp, and Wells Fargo in managed accounts. Bryan Perry does not own PacWest Bancorp (PACW), Ally Financial, Berkshire Hathaway, Bank of America, BNY Mellon, Citigroup, Goldman Sachs, Jefferies, JPMorgan Chase, M&T Bank, Nubank, PNC , US Bancorp, and Wells Fargo personally.
Two Sectors That Stand to Benefit from a Credit Squeeze
Under the premise of a forthcoming squeeze on bank credit, two sectors that stand to benefit from filling the void are private credit and business development companies, or BDCs, as they are known. Private credit pools have been around for a while, but they gained popularity per the regional bank crisis. These pools of money are formed by private equity, institutions, family offices, foundations, endowments, etc. These BDCs provide mostly floating-rate loans that generally pay 5%-7% over the Secured Overnight Financing Rate (SOFR), currently quoted at around 5%, thereby generating yields of 10%-12%.
These private transactions are negotiated directly between the lender and sponsor/borrower, with a focus on extensive due diligence and downside protection. Private lenders seek to negotiate strong structural protections, including covenants and higher call premiums. Borrowers seek certainty of terms, flexible structures, and a more efficient process than the public market.
The cost of this loan has recently soared amid higher interest rates. A $1 billion loan from a private equity firm for a company rated non-investment grade, or junk, now averages an interest rate of up to 12%, up from about 7.5% in 2021, according to an executive interviewed by Reuters.
There are two ways to get in on this private credit action – either buying shares of stock in publicly-traded private equity firms – with all the exposure to the troubled commercial real estate – or buying shares in carefully-researched business development companies (BDCs) that use public markets to sell shares.
BDCs are regulated investment companies, similar to REITs, in that they are required to pay out 90% of net investment income. They can use leverage and derivatives to hedge as well, making them a uniquely attractive asset class that pays out yields comparable to private credit pools. A well-run BDC is lending to small-to-medium-sized private businesses operating in defensive industries, structuring loans that are also floating rate with similar terms, many of which include equity kickers if the borrower is a company that eventually goes public or is privately acquired.
Key target areas of lending include:
- Industrial manufacturing and services
- Insurance
- Value-added distribution
- Healthcare products and services
- Consumer products
- Aerospace and defense
- Business services
- Tech-enabled services and SaaS models
- Food and beverage
A well-run BDC’s portfolio will have the majority of loans structured as senior secured debt. There are 57 such publicly traded companies to choose from. Many are invested in areas of the economy that are much more vulnerable to an economic downturn than others. It’s vital to go through the portfolios of each BDC of interest to see their loan mix. For the most part, the companies and industries they are lending to are all listed on their websites.
What makes BDCs so compelling from an investment standpoint is the dividend payouts that are now averaging between 10% and 13%, matching yields to that of private credit pools.
Compare these double-digit yields to the S&P 500. According to Investopedia, the S&P indexes date back to the 1920s, becoming a composite index tracking 90 stocks in 1926. The average annualized return since its inception in 1928 through Dec. 31, 2022, is 9.82%. The average annualized return since adopting 500 stocks into the index in 1957 through Dec. 31, 2022, is 10.15%.
The question posed here is, if the S&P’s historical return is roughly 10%, then in this current investing environment, it might prove worthy to have some assets where the dividend income matches the historical performance of the S&P. If sticky inflation, an ever-rising debt ceiling (what ceiling?), a bungled Fed policy, and a regional bank sector mired in disarray got you down, spend some time researching the BDC sector and see how America’s businesses are accessing the capital they need expeditiously to maintain and grow the top and bottom line. I see it as the old story of turning lemons into lemonade.
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
Also In This Issue
A Look Ahead by Louis Navellier
Countdown to the Debt Ceiling Deadline
Income Mail by Bryan Perry
Business Development Companies to Benefit from a Credit Crunch
Growth Mail by Gary Alexander
On James Madison’s Birthday, Let’s Review His Rule Book
Global Mail by Ivan Martchev
Real-Time Inflation Indicators are Quite Weak
Sector Spotlight by Jason Bodner
To Find Big Treasures, You May Need Ballast
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Bryan Perry
SENIOR DIRECTOR
Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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