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As investors bask in what Blackstone has called private credit's "golden moment," some investors are watching for signs of stress in loan portfolios.
But what will the signs be?
In recent years, private credit providers have stepped up to finance deals that may have been done in the syndicated loan market or the bond market in the past. The trend has accelerated in the wake of the pandemic.
Now, these borrower companies of private credit loans are feeling the increasing strain of higher interest costs. Loans placed in 2018-19, in particular, are being watched, as credit market conditions were strong at the time, market professionals say.
For syndicated loans, ratings downgrades would often document a borrower's decline. Private credit loans are typically unrated, however.
Another difference between the two markets is the number of lenders. Most private credit loans are held by only a few lenders, while a syndicated loan could be held by dozens of lenders, or as many as 200. Information about increasing stress often surfaces from a large lender group. 'Notable and worrying' One focus in recent quarters has been on fixed-charge coverage ratios, an indicator of a company's ability to service interest and debt amortization from free cash flow. Some borrowers have turned to mezzanine financing to alleviate stress in an environment where it's difficult to raise new debt, or place new loans without resetting existing loan terms.
Earlier this month, advisory firm Lincoln International said its proprietary private market database shows that 45% of companies could register "notable and worrying" declines in fixed charge coverage ratios as of the first quarter, pro forma for a 5.5% base rate. Lincoln's database includes over 4,750 portfolio companies held by more than 145 sponsors.
In anticipation of a turn in the credit cycle, HPS and Barings have reportedly been hiring to bulk up their in-house workout teams, while Blackstone and Bain Capital have been recruiting restructuring specialists in the last year, according to a Bloomberg news report.
"Spreads are higher, but, equally, increases in presumptive default rates will likely reduce some of the benefit," said Michael Haynes, head of private credit at Beach Point Capital Management.
One indication of stress is non-accrual loans in investment portfolios of business development companies, which indicates doubt over whether principal or interest will be collected in full. In many instances, this is the first public acknowledgment of stress in directly originated loans.
Another sign of strain may be increased PIK interest on existing loans. A lender at times may allow a switch of cash interest on a loan to paying interest in-kind, a trend that has emerged in some public filings of BDCs, which are the listed entities of private credit providers that have reporting requirements.
The default rate of the Morningstar LSTA US Leveraged Loan Index rose to 1.60% at the end of May, a two-year high, by issuer count, after three bankruptcy filings were recorded on a single business day.
Some say defaults of the syndicated loan market could be a proxy for private credit defaults. The trends are moving in tandem, at least so far. Beneath the surface In another measure of defaults, specifically of private credit loans, the Proskauer Private Credit Default Index—which tracks defaults for senior secured and unitranche loans—has risen for four consecutive quarters, to 2.15% in Q1, according to law firm Proskauer Rose.
The Cliffwater Direct Lending Index, a proxy for directly originated middle-market loans, returned 2.69% in the first quarter, weighed down by 0.25% in realized losses—the highest in over two years.
Behind the scenes, there is likely even more stress in private credit loans that likely never surfaces to investors.
In private credit, a single or a handful of lenders have a toolbox of instruments that could ease the stress on a borrower company facing challenges. A recent survey from investment bank Carl Marks Advisors found 22% of alternative lenders are "more flexible and supportive" when working with a challenged borrower, versus 15% of respondents who believe that alternative lenders are more aggressive.
This has long been one position private credit providers use when arguing the virtues of the asset class. Since a single private credit lender may have several loans to a given private equity firm, both the lender and the private equity sponsor have incentives to find solutions. It's possible that some struggling borrowers are granted a wide latitude from lenders to cope with challenges. 'Less than adequate' CIBT Global is an example of a loan issuer whose problems were visible since its debt was rated. The company is a provider of travel visa and passport services, a business that crumbled under pandemic-era travel restrictions. Despite efforts, CIBT fell deeper into distress.
Kohlberg & Company had acquired the company in 2017 via debt financing provided by Antares, Goldman Sachs, Jefferies and Owl Rock.
In the second half of 2020, Owl Rock moved its piece of the borrower's second-lien loan to non-accrual, indicating the loan was no longer paying cash interest. The company continued to struggle. The second-lien loan was cut to D by S&P Global Ratings in August of that year.
The ratings move was due to distressed-motivated actions that were tantamount to a default, including PIK interest on the second-lien debt, partial PIK interest on a bond, relaxed covenants and extended maturity on a revolver.
Despite this, in 2022, S&P Global Ratings said the company's leverage exceeded 30x, a level that had been helped by the 2021 amendment to the credit agreement that shifted most quarterly first-lien interest payments to PIK. Moreover, private equity sponsors provided equity support in 2020 and 2021, according to S&P Global Ratings.
Nevertheless, liquidity was "less than adequate," according to S&P. At that time, the company said revenue in its travel service segment, which accounted for 80% of the company's total revenue, recovered to only roughly 37% of 2019 levels.
The efforts were insufficient in the face of negative industry trends. In early June, S&P Global Ratings downgraded the company again to Selective Default (SD), and first-lien and second-lien credit facilities to D—following an amendment transaction that extended maturities and PIK payments of first- and second-lien loans. Winners and losers Many investors and lenders acknowledge anticipated elevated defaults and credit impairments in the coming quarters as impacts of macroeconomic pressures build.
"The back half of this year is when we will likely see a particularly pronounced increase in defaults in the middle market," Haynes said.
Often, it takes some time for economic pressures to pass through companies' income statements and balance sheets, and most businesses are able to navigate the trough in a relatively short period. But when these adverse conditions persist for more than a year, it becomes a concerning issue and could lead to more serious problems, he added.
Jason Friedman, global head of business development at Marathon Asset Management, said he expects the default rate in the private credit market to pick up as we get later in the cycle, ultimately catching up with the leveraged loan market.
Lenders with strong loan workouts and restructuring capabilities have more capacity to reap the best possible recoveries. Many private credit providers have been preparing for years for a turn in the credit cycle, building workout teams even when there has not been a lot of distressed activity. But some firms have done little to nothing to prepare for a coming storm.
"I think investment managers in middle-market lending do not have a uniform skill set [in loan workouts]," Haynes said. "There will be winners and losers."