Hide the Umbrellas The following was excerpted from Third Eye Capital Management Inc.'s Q4 2013 Annual Investor Letter.

Regulatory pressures are reshaping the banking industry, with higher compliance and capital costs pushing banks to reevaluate the markets they serve. Amid the prospect of stricter regulatory oversight, banks are not only increasing capital levels (consistent with Basel III capital requirements) but reducing and sometimes eliminating assets that are considered risky, noncore, or yield low returns on capital.

Under the Basel III framework drawn up by the Bank of International Settlements’ Basel Committee on Banking Supervision, minimum capital requirements for banks is 8% of risk-weighted assets (as it was under Basel II), but 4.5% must be common equity Tier 1, the highest quality capital (compared to just 2% under Basel II). Private-sector loans have a 100% risk weighting among assets, and can increase up to 150% for the riskiest borrowers, making it more difficult for banks to generate returns on such loans on a risk-adjusted basis. In addition, there are several add-ons to Tier 1 capital, such as capital conservation and countercyclical buffers that at the highest rate would increase the minimum capital for banks to 13% of risk-weighted assets. Bank will also have to comply with liquidity coverage requirements and restrict asset-liability mismatches, which will further discourage growth in business loans. Overall, requirements under Basel III will penalize commercial credit through higher costs for banks and decreased availability for their borrowers. If Mark Twain was alive, he would have summed up the impact of Basel III this way: bankers will be reluctant to lend you their umbrella even when the sun is shining.

In Canada, implementation of Basel III began in 2013 with a quicker phase-in of requirements than recommended under the rules. The U.S. and European Union begin implementation this year. In the U.S., the Dodd-Frank Act, leverage lending guidance from the Federal Reserve, Office of the Comptroller of Currency, and Federal Deposit Insurance Corporation (“FDIC”), and reform of the Chapter 11 bankruptcy code will also have profound impact on banks’ ability and willingness to provide business loans. For instance, asset-based loans, which have traditionally been considered the least risky form of commercial lending assets due to their tie to asset values rather than cash flow, will now be included in the definition of “leveraged finance” that regulators will use to calculate leverage ratios. Definitional changes could result in higher reported leverage and therefore larger capital reserves as a buffer against potential losses. Another example is the FDIC’s shift in insurance assessments from deposits to loans, with higher assessments placed on commercial loans regarded as “higher risk”. Generally, higher risk includes any loan greater than 20% of the total funded debt of a borrower and that has a senior debt leverage multiple of greater than 3X. ABL invariably falls in this category because asset-based borrowers tend to be highly-levered when analyzed on a cash flow-basis. The lending business is becoming more expensive for banks in the U.S., and will only be compounded once the Basel III rules start to get implemented. The good news is that alternative lenders, like our funds, will be able to reap significant profits through regulatory arbitrage because they will not be subject to the same costs and oversight as banks. The challenge for investors desirous of benefiting from this opportunity is selecting the alternative lender with the best risk management capabilities. Most lenders, including banks, fail not because they have insufficient capital reserves but because they suffer unbearable losses.

Regulatory constraints notwithstanding, bank shareholders want to see their investment strongly capitalized to avoid the government bail-out and dilution risks that occurred during the financial crisis. Banks are increasing shareholder value, not through loan growth, but by limiting expenses and growing non-interest income. According to a 2013 study on the banking industry by Deloitte LLP, banks are reshuffling their product mix to generate increased revenue, particularly from fee-based businesses such as foreign exchange, cash management, and wealth advisory. Bank earnings in the U.S. posted eighteen consecutive quarters of year-over-year growth through 2013, yet ROE for banks at 10.6% is still below the 1993-2006 average of 14.4%. This makes capital allocation a bigger priority for bank management, and reducing risk exposures that force higher risk weightings to capital, such as loans to small, unrated borrowers, is an imperative toward increasing profitability in a more regulated banking environment. Previously, banks might have kept certain business lines as part of their core even if they did not meet return hurdles but they are now more ruthless about eliminating laggard activities, especially if they impact capital. Banks everywhere are motivated to shift to businesses that use less capital, are more fee-based, and attract lower costs and risk weights. Private credit is not such a business.

The retreat by banks from business lending is ongoing and is creating a growing gap that needs to be filled. Alternative lending funds are being formed at a frenetic pace to replace the supply of credit to the middle-market and meet higher demand expectations from an improving economy and more optimistic borrowers. Private debt funds raised over $322 Billion over the past five years, according to data compiled by Private Debt Investor Magazine, and there are currently more than 200 funds targeting combined capital commitments of $114 Billion. While other alternative asset classes are undergoing consolidation, private debt is growing and institutional investors are building internal teams and carving out portfolio allocations dedicated to private debt funds.  However, the boon to private debt funds means lower quality borrowers will receive financing even if they should not, and better quality borrowers will benefit from intense competition for their financing requirements. Not all of the managers of private debt funds will possess the specialized skills and experience necessary to properly assess credit quality. The dispersion in returns among funds will be large and manager selection will be challenging yet critical for investors. Given the tectonic shifts taking place in the lending landscape, the challenge will be extremely worthwhile.

Third Eye Capital Management Inc.