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Direct lenders start to sweat as rate hikes hit interest coverage
Shubham Saharan
•4 min read
Persistent inflation and a 500bps rise in the Fed funds rate in just over a year: how are borrowers supposed to cope?
As an era of cheap borrowing draws to a close, companies which flourished in the era of low rates are feeling the stress. Analysts are projecting lower earnings, companies are cutting pandemic-era perks — and direct lenders are recording a decline in interest coverage.
Private credit spreads remain stubbornly above 600bps (Baxter’s biopharma spin-out and OneOncology are two recent examples) and all SOFR tenors are in excess of 4%. As such, many borrowers are contending with double-digit percentage coupons on unitranche loans.
This is putting pressure on interest coverage ratios, a credit metric that took a back seat in the low-rate era but has recently come back into fashion.
MidCap Financial, the business development company managed by Apollo, revealed last week that interest coverage across its portfolio slipped to 1.7x in the first quarter; FS KKR Capital said the same in its own first quarter earnings presentation.
Meanwhile, Goldman Sachs BDC reported a weighted average interest coverage of 1.6x in its first quarter earnings call — although it noted that this was in line with the previous quarter.
Interest coverage of around 2x is generally seen as a healthy measure. It’s not just these leading BDCs that are recording figures below that level: the entire market is suffering. In 2021, private credit deals averaged a coverage ratio of 2.56x, but as base rates rose through 2022 and early 2023, that’s shrunk to 1.59x, according to a recent report by Benefit Street Partners.
"We are seeing balance sheets and financials tightening up for portfolio companies of lenders across the board … and signs of decline in credit strength and financial robustness,” Ruth Yang, a managing director at S&P focusing on credit research and insights, told 9fin.
“I think there's no doubt that pressures are on due to higher cost of debt servicing.”
Feeling the heat
This is new terrain for private credit, given that many lenders in the market set up shop after the 2008 financial crisis. As the industry swelled in size, lenders were quick to put cash to work — but some are now beginning to look inwards.
“We're focused on current and future interest-coverage and fixed-charge-coverage ratios across the portfolio as a component of an active risk management process,” said Ted McNulty, CIO of MidCap Financial, during its first quarter earnings call.
The pressure may mount further in the coming months. Because base rates are set at either three-month or six-month SOFR for the majority of private credit deals, coupon costs are set to pile up into the summer and beyond, as the lagging impact of recent rate hikes filters into company earnings.
Another point of potential concern is fixed-charge coverage ratios, which indicate a firm’s ability to meet mandatory expenses (EBITDA relative to fixed charges such as leasing costs and debt interest and principal payments).
Fixed-charge coverage ratios fell to an average of 1.19x in the first three months of this year, compared to 1.4x in the same period last year, according to data from Lincoln International.
via Lincoln International
Ron Kahn, a managing director at Lincoln who focuses on debt advisory and valuation services, said he anticipates that 35% of private credit borrowers will have less than 1x fixed charge ratio on a dollar-weighted basis within the next few months.
“There’s no question it's coming down,” he told 9fin. “It's happening, and it is a little disconcerting.”
No money, mo’ problems
The relationship between borrower and lender is often pitched as more intimate in private credit than it is in the syndicated markets. Closer ties between direct lenders and the companies they finance can provide flexibility in troubled times.
In the current market environment, for example, many borrowers facing debt maturities may request to extend the life of their loans, as opposed to fully refinancing; others may try to raise additional funds through add-on loans.
All of this can reduce the amount of dry powder that lenders have on their books. Extending the life of loans means less cash in the door from redemptions, while providing incremental debt means cash going out the door.
On top of this, borrowers are reducing principal prepayments on private credit facilities, according to the Benefit Street Partners report we cited earlier. That leaves lenders with even less cash coming in.
Add to that the already tricky fundraising environment, and some lenders are starting to worry. One direct lending fund manager said many private credit firms are proactively building up liquidity buffers.
“Lenders are being really careful to hoard cash right now, just in case they have liquidity problems,” the fund manager said. “So the refinancing of problem loans — boy, that's going to be hard.”
“If rates just stay roughly where they are now, even if they're a little lower, it's terrible. Everything has to be recalibrated.”
