Interest rates are coming down, but only after one of the most brutal monetary tightening periods in modern history. And they’re probably coming down too late, too little and too slowly for a lot of smaller companies and the investment funds that chucked money at them over the past few years.
Private credit — basically, bilateral corporate loans made by specialist investment funds rather than banks — has been one of the hottest asset classes over the past decade. Possibly the hottest. Depending on who you believe, there’s somewhere between $2tn and $3tn of money in private credit funds.
The problem is that they make floating rate loans — typically priced at 5-10 percentage points above SOFR — and that can be a double-edged sword. Higher rates mean interest income balloons, but at some point it becomes a challenge for even a healthy, growing company to keep servicing its debts. And for many companies the weight of their debt burdens have almost doubled in just a few years.
FT Alphaville has been sceptical over argument that private credit now poses systemic risks, but we’ve long thought that there was probably a lot of dumb stuff happening in the space, given how hot it became. So how is private credit actually faring through the first proper interest rate hiking cycle in its life as a “proper” trillion-dollar-plus asset class?
Well, it’s hard to say for sure, but the IMF sounded a glum note in its latest Global Financial Stability Report:
Even if global interest rates are declining, many firms would find debt servicing a challenge in coming years. Although solid economic activity and healthy corporate balance sheets have kept margins robust for some firms, defaults have steadily risen as weaker firms have struggled. Some midsized companies borrowing at high interest rates in private credit markets are becoming increasingly strained and have resorted to payment-in-kind methods, effectively deferring interest payments and piling on more debt.
. . . Signs are mounting that high interest rates are pressing private credit borrowers, and a severe downturn has not yet tested the many features designed to mitigate credit risks at the private credit industry’s current size and scope. There are signs that the private credit industry’s rapid growth, competition from banks on large deals, and pressure to deploy capital may be leading to a deterioration of underwriting standards and weakened covenants, amid interest rate pressure.
By its nature it will be hard to know exactly how things are going, because private credit is, well, private. Moreover, the locked-up money of private credit funds means that there are a lot of ways for them to keep any distress hidden away. As the old saying goes, a rolling loan gathers no loss.
Even when there are outright defaults it will in many cases be handled discreetly, with no one outside the company and its lender knowing about it. It will therefore probably take many years before we discover the full extent of the pain.
The headline numbers are certainly not very scary. An index of defaulted private credit loans created by the law firm Proskauer increased for three straight quarters to 2.71 per cent at the end of June, but fell back to 1.95 per cent in the third quarter.
This, Proskauer’s Stephen Boyko argues, is because of private credit’s “rigorous underwriting” (no sniggers, please).
We continue to see a relatively stable default rate across our portfolio, in contrast to the rising default rates we see in the syndicated markets. The lower default rates are likely a result of some of the structural differences of private credit: more rigorous underwriting, constant monitoring, greater access to information/management, a small group of lenders, and in some cases, financial maintenance covenants.
Fitch Ratings’ measure of the private credit default rate — which includes outright payment failures and bankruptcies as well as distressed debt exchanges — stood at 5 per cent by the end of September. Significantly higher than Proskauer’s estimate, but again nothing remarkable.
The latest data indicates that private credit funds continue to report impressive returns, boosted by higher interest rates. In fact, MSCI’s data indicates that they notched up another 2.1 per cent gain in the second quarter, putting private equity in the shade.
However, there are other signs of deeper stress if you look closely enough. First and foremost, the growing use of “payment-in-kind” loans — where interest payments are rolled into the principal rather than paid to lenders — is a sign that all is not well in privatecreditland.
PIKs can be a perfectly acceptable tool in fast-growing companies that are better off investing in their core business than spending valuable cash on servicing onerous interest payments. But when a company that previously made interest payments in cash switches to a PIK loan it is not a great sign of health. And that is what appears to be happening a lot in the private credit ecosystem.
Business Development Companies — essentially listed private credit vehicles — are an imperfect but decent way to get some insights into an opaque industry, as their public status means they have to reveal all kinds of information.
The IMF took a look at the sector for its GFSR and found that interest rate coverage ratios have plummeted as interest rates have climbed. Even more alarmingly, it estimated that almost 9 per cent of all BDC income now comes from PIK loans, up from about 4 per cent five years ago.
FTAV spoke with Jeffrey Diehl, head of investments at Adam Street, a large private capital firm, to get a sense check. He said “we’re definitely seeing some warning signs in the private credit industry”, with the rise of PIK income at BDCs being a prime example.
If you’re a BDC you’re charging management fees on the NAV, so you don’t want to take any markdowns. And you definitely don’t want to categorise a loan as non-accrual, which means a company is no longer able to pay any interest on its debt.
The non-accrual rate has remained very low. It’s almost doubled from 1.2 per cent to 2.2 per cent, but it’s still very low as a percentage of the overall BDC assets.
But what has grown is the number of loans that are paying some or all of their interest in kind instead of cash. That is now up to 20 per cent of some BDC portfolios. And most of that growth is from companies that were previously paying cash and has to convert because they were unable to keep doing so in a higher interest rate environment. This is a sign that people are kicking the can down the road on problem loans.
The problem is that PIK income isn’t real money coming into the BDC’s bank account, even if it gets accounted as part of a BDC’s net investment income. It just means that the size of the outstanding loan keeps ticking up. But BDCs are required by law to pay out at least 90 per cent of their income as dividends to investors, so a swelling pile of non-cash generating PIK loans can become . . . problematic.
BDC shares have actually performed pretty strongly in recent years — remember, higher rates lift their interest income — but you can see some concerns starting to creep in since the summer.
The payout issue is unique to BDCs, but the broader credit problems that we can see there will probably be common to most private credit funds.
The problems can be compounded by the fact that private credit loans seem to do a lot worse than commonly thought when they go bad.
Private credit funds often tout how they can get restrictive, bespoke loan agreement clauses to protect themselves, but recoveries have lately actually been worse than for traditional syndicated loans, and only slightly better than from unsecured junk bonds.
As Morgan Stanley noted in the report that this chart is from: “While it is reasonable to expect better recovery outcomes in direct lending loans given their stronger covenants, the data do not confirm this hypothesis.” Quite.
To us, the massive drop in private credit loan prices from just three months before default to default us also noteworthy. It indicates that there is a lot of denial and fantastical marking going on in private credit, even as companies are clearly hurtling towards default.
The locked-up money should mitigate ripple effects from one or several private credit funds going bad, but the IMF still sounds a bit worried — not least by potential blowback into the mainstream banking industry, which has lent plenty to private credit funds.
In a downside scenario, stale and uncertain valuations of private credit could lead to deferred realization of losses followed by a spike in defaults. This possibility makes the private credit industry vulnerable to episodes of crisis of confidence, which may be triggered, for example, by an outsized share of defaults in a group of funds.
An adverse feedback loop could ensue, wherein fundraising for private credit might be temporarily frozen, semiliquid funds might suffer runs, and at the same time, banks or other investors might refuse to continue providing leverage and liquidity to private credit funds. Such a scenario could force the entire network of institutions that participate in the private credit industry to reduce exposures to the sector simultaneously, triggering spillovers to other markets and the broad economy.
This is why interest rates coming would be such a boon to private credit. At this stage the negative impact on interest income would probably be much smaller than the positive impact on credit quality.
At this stage we probably need to stress that this doesn’t look like a disaster. At least not yet. Private credit is inherently risky (leverage-wise its roughly equivalent to the lower reaches of junk) and no investor should be surprised if a lot of the loans sour. Some funds will do badly, and some will do well.
However . . . it’s not great that we’re seeing these issues at a time when the US economy is doing so well. And even lower rates may not come soon enough for parts of the private credit industry, Bank of America warned in a recent report.
Rates may be on their way down, but the lagged nature of the impact means that relief will take time to percolate through the credit ecosystem. Injecting further ambiguity is the strength of recent economic data, which has reignited the reacceleration debate and repriced neutral rates higher. At the same time, the fundamental trajectory is not yet promising enough to offset an extended cashflow drag from high rates.
And if interest rates don’t fall as swiftly and as markedly as some people have assumed — say, if a new president decides to enact extremely inflationary policies that forces the Fed to reverse course — then the pain will become much greater and harder to mask.
As Diehl put it:
If rates don’t move down soon then we are for sure going to see a lot more companies go from cash to PIK, from PIK to non-payment, and from non-payment to handing the keys over to lenders.
https://www.ft.com/content/91f84874-cc05-4937-8878-0f64723879c9
