The rise and evolution of private capital in the lower and lower-middle market since the Great Recession in 2008 has had a profound impact on how many smaller businesses operate and grow.
Jeff Schwartz, the chief executive officer of Corbel Capital, an investment firm that specializes in those markets, was one of the earliest investors to identify the market inefficiencies that existed after the regulatory changes enacted post-financial crisis. This has allowed Schwartz and Corbel to have a more nuanced understanding of that market and, as a consequence, have a great deal of success with their capital deployment.
Schwartz spent 10 years in investment banking and then another 10 in private equity. He started Corbel in 2013 to serve the lower-middle market, getting out of the large-cap game after seeing the inefficiencies in the former.
Financial Crises and the Great Recession
Changes in market behavior, either by lenders or borrowers, are often brought about by changing conditions. Interest rates, significant social or political events and global market meltdowns would all qualify. The financial crisis in 2007 that created the Great Recession in 2008 and 2009 was one of the more impactful events to facilitate such change.
The “official” beginning of the Great Recession was marked in December of 2007, according to the United States National Bureau of Economic Research, and ended roughly June of 2009, or about 18 months.
While a number of factors, the U.S. housing bubble were correlative to the massive collapse of banks and markets, overreach by banks and the lack of an enforceable and adequate regulatory environment were seen as culprits.
Derivatives, such as credit default swaps, were essentially unregulated and allowed banks to invest massive amounts of money on mortgages, essentially betting that the booming U.S. housing market would continue to grow. And it did, until it didn’t.
Once the teaser rates that many homeowners had taken to get into their house in the first place were up, defaults started to skyrocket. The banks that held the notes on those were left with worthless assets.
Lehman Brothers went bankrupt. Bear Stearns and Merril Lynch were sold to other banks in what was basically a fire sale.
As global economies turned around, in the case of the U.S. officially in June of 2009, new regulations were in place to curb bank lending practices.
In the case of middle market investment, that meant a much more cautious approach by institutional lenders due to regulatory changes enacted with the idea of stopping such a global catastrophe in the future.
“There was significant bank consolidation, and the regulatory and reserve requirements placed upon traditional lenders increased significantly,” Schwartz said in an interview. “Banks were less inclined to aggressively lend to small businesses.”
But Schwartz said that created an opening. Those small businesses still needed capital to grow or recapitalize, and the creation of more private lending institutions was facilitated.
“The evolution of the private credit market has really filled that void and allowed institutional investors to back firms who are able to price risk in a different way,” Schwartz said.
For Schwartz, that meant opening the doors up for structured investment products, ones that had great flexibility for small businesses where they could secure capital without necessarily giving up complete control of their company.
“There were many, many small businesses looking for what we at the time called structured equity,” Schwartz said. “Now, it’s turned into more structured debt, a structured investment that provided them with capital to either or recapitalize their businesses and also have a level of private equity support and sponsorship that certainly doesn’t exist from a normal lending institution.”
Emergence of a Market
Those structures have fueled growth, both by the lenders, such as Corbel, and the businesses they invest in.
“It’s created a dynamic and more efficient marketplace for small businesses to raise capital and allowed these businesses to grow without necessarily selling control for their business to more traditional private equity buyers,” Schwartz said. “It’s also keeping our banking system safe and more secure because there is more inherent risk in small businesses that are probably not appropriately taken by banks that have deposits and regulatory requirements.”
But, Schwartz said those same risks are exactly the type of investments the private market can handle.
“They are more appropriate for private funds or debt institutions that are targeting a certain yield in return for their investors,” Schwartz said. “And those investors are making that investment recognizing that risk and pricing that return appropriately.”
Schwartz said the needs of smaller businesses, which often have fewer resources and more liquidity demands because of that, can be more adequately met by private investors. And that those private investors, many of whom are also smaller entities, can benefit from the dynamic as well.
“This is a great asset class for a family office, smaller institutions, endowments and for high-net-worth individuals,” Schwartz said. “Whether it’s a high-net-worth individual or an endowment who has expenditure requirements, having a current yield and a cash-yielding asset for them in their portfolio is very valuable.”
Valuable indeed. According to a report by Morgan Stanley in late September of this year, the private credit market at the start of the year was about $1.4 trillion. It was at $500 million in 2015, $875 billion in 2020 and the bank estimates it will hit $2.3 trillion by 2027.
What was once viewed as “shadow banking” and somewhat looked down upon by institutional investors is now a major component for business growth.
Interest rates continue to stay at a level that is somewhat prohibitive for major banks to issue, as Schwartz said, what they see as high-risk loans to smaller businesses. Those rates will, at some point, creep back down. But the consensus is that even as the institutional lenders re-enter the playing field, private credit has landed a permanent place as a viable option, especially for smaller entities, for capital.
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