Private credit is closely tied to central bank decisions. Because the loans these firms make are floating-rate instruments tied to the SOFR benchmark, the Fed funds rate effectively determines the range of the cost of capital for borrowers. Higher rates put more cash in lenders’ pockets, but are a burden on sponsors.

A reduction in rates, especially if it happens at the same pace as they rose, could have cascading effects. Some of them are good: for existing borrowers, the cuts will help to ease interest costs and expand free cash flow. As we’ve covered previously, interest coverage ratios have fallen this year, below the 2x level that is generally considered healthy. 

Lower rates should also help to get the M&A engine moving, partly by reducing borrowing costs but also potentially by boosting valuations. This may bridge the valuation gap that has plagued sale processes this year, and it could also make buyers less reliant on expensive PIK instruments.

For lenders in private credit, the rate reduction could be a different story. 

All of the trends we’ve just described have played into the hands of direct lenders this year, and helped the industry shape a narrative about outperforming private equity; since the Fed pivoted last week, the Cotiviti situation (which we covered here) has shown how quickly BSL markets can become competitive again.

Now that inflation is moving closer towards the Fed’s target, interest rates can also come down, bolstering the “soft landing” narrative that predicated the recent US stock market rally. This could give bankers a lot more certainty around the trajectory of public markets, helping ensure smooth syndications and encouraging them to be more competitive in new underwrites.

Falling rates could also create a problem for BDCs, which fund themselves in the fixed rate bond market and are facing a wall of fixed-rate maturities. 

If they borrow at peak rates and then rates fall, they could be caught offside — paying high interest on their own debt, and collecting lower coupons on the fixed rate loans they make to borrowers. Some BDCs, like Ares and Oaktree, have recently swapped their fixed coupons to floating in anticipation of this problem. 

(A quick note here: private credit is a broad and increasingly self-referential church, and plenty of non-bank lenders, many of them with their own BDCs, invest in the fixed-rate debt of other BDCs.) 

On a broader level, lower interest rates will probably help a lot of direct lenders’ portfolio companies avoid default. That can’t be a bad thing. But for that to happen, the Fed needs to stick the landing, and there are plenty of obstacles along the way.

Inflation could remain stubbornly high; consumer spending could fade; the employment market might not play ball; and on top of all that, there’s plenty of scope for geopolitics to upset the apple cart. 

In short, lots of lenders will be hoping for a soft landing, but fastening their seatbelts just in case.