(Bloomberg) — Warnings on defaults are starting to pile up in the $1.7 trillion private credit market, prompting at least some analysts to raise concern about underappreciated risks in one of Wall Street’s favorite money spinners.
For years, losses have been contained by the fact that private credit firms have more room than many other investors to be patient with borrowers when times are tough. During the pandemic direct lenders granted companies more time to pay their obligations, often by negotiating behind the scenes with private equity owners.
Most Read from Bloomberg
But a number of analysts this month are holding up a light to underlying stress, including from lenders themselves.
While there is no universal definition of what constitutes default in private credit, default rates for the market are currently in the 2% to 3% range. If so-called non-accrual loans — those on which lenders expect to book losses — are added to the mix, that rate climbs to 5.4%, according to a JPMorgan Chase & Co. report that’s based on data from KBRA DLD. The adjustment puts the default rate for private credit broadly in line with that observed in the broadly syndicated loan market.
Returns above 8% are still luring investment, although private credit funds are not the cash magnet they once were. Fundraising has slowed this year to $70 billion in the period through July 22, accounting for just a tenth of the alternative asset inflows, according to JPMorgan, the smallest share since at least 2015.
“Inflows into the asset class meant too much capital was committed far too quickly,” JPMorgan analysts including Stephen Dulake wrote in a report this month. “Underwriting corners were surely cut; and losses will be outsized come the downturn.”
Private companies and their lenders have been able to keep payment defaults at bay through payment-in-kind arrangements that allow borrowers to defer cash interest payments until debt comes due, leaving them with one big bill at the end. Another way is by setting covenants at “generous” levels that make it hard to act on early signs of weakness, according to S&P Global analyst Zain Bukhari.
“A major selling point of private credit is the low default rates,” Bukhari wrote in a report this month. “This reputation hinges on a narrow definition of default.”
If actions such as maturity extensions and conversions of interest payments from cash to PIK — so-called selective defaults — are added to the calculation, the rate at which borrowers are failing to meet debt obligations is much higher, according to S&P.
Defaults may have been “disguised by significant amendment activity,” as lenders can tweak credit agreements to forestall defaults, according to a report this month by valuation firm Lincoln International.
Lincoln’s “shadow default rate” for the market, which is calculated by looking at “bad” PIK investments as a proportion of total investments, stood at 6% in the second quarter, compared to 2% back in 2021. Officially, the default rate for private credit rose to 3.4% in the second quarter from 2.9% in the prior period, according to the report.
Complicating matters further, the set of borrowers monitored by credit graders and advisory firms can differ widely from shop to shop, making it difficult for any one institution to have visibility on the entire market.
While that creates some dissonance, research from a variety of players seems to chime when it comes to the direction for defaults: Up.
“Higher concentrations of borrowers in weaker credit rating categories and a recent uptick in defaults suggest ongoing headwinds,” said Michael Dimler, an analyst at Morningstar DBRS.
Source: Bloomberg
Nevertheless, some market participants remain upbeat. They say falling interest rates have relieved pressure on companies with heavy debt loads, and that interest coverage ratios in lending portfolios are healthy.
“When interest rates were pointing up our market research suggested there were certain sectors that looked more exposed, but now rates are heading in a downward direction,” said Christopher Bone, head of private credit for Europe and Asia at Partners Group. “A resilient company with strong cash flows can afford interest rates today.”
Deals
Rappi Inc., one of Latin America’s most valuable startups, secured a $100 million loan from Banco Santander and Kirkoswald Capital Partners
Banks and direct lenders are in discussions to refinance the debt of Gridiron Capital-backed Leaf Home as private equity firms hold onto assets for longer
Digital wealth management platform Endowus is partnering with Macquarie Asset Management to introduce private infrastructure investments to eligible investors in Singapore and Hong Kong
The direct lending arms of BlackRock and Morgan Stanley Investment Management are providing a unitranche loan of around €200 million to finance the buyout of French software-as-a-service business Brevo
A group of private credit firms are providing nearly $1.4 billion of loans to support Centerbridge Partners’ acquisition of financial software platform MeridianLink Inc.
Fundraising
Neuberger Berman launched its first interval fund, focused on private asset-based credit, as alternative asset managers look to raise more capital from retail investors
Job Moves
Did You Miss?
US Private Credit Default Rate Fell to 5.2% in July, Fitch Says
Apollo Seeks to Double India Assets to $4 Billion in Credit Boom
How Pimco Outmaneuvered Apollo, KKR to Win $29 Billion Meta Deal
Trez Capital Halts Redemptions Across Five Real Estate Funds
Private Credit-Powered AI Boom at Risk of Overheating, UBS Says
Apollo’s Fox Hedge Is Taking Financial Wizardry to a New Level
Private Credit Is Using Football Transfer Fees as Collateral
Apollo’s Head of European Credit Eyes Deals in Defense, AI
Lure of ‘Free Money’ in Secondaries Nears a Mania: Credit Weekly
–With assistance from Isabella Farr and Rene Ismail.
(Updates with broadly syndicated market comparison in fourth paragraph. A prior version of this story corrected the description of non-accrual loans in the same paragraph.)
