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Private Credit 

Shubham Saharan

Private credit defaults are ticking up as companies begin to buckle under the weight of higher interest rate payments and compressing margins, new data shows.

Lincoln International’s Senior Debt Index which measures how many private credit-backed companies default on covenants and payments on a size-weighted basis, saw an increase to 4.5% in Q1 23 from 2.5% from the same time last year. That’s higher than the 3.3% trailing two-year default average, the investment bank said.

Meanwhile, Proskauer’s Private Credit Default Index, which tracks default rates across almost 1,000 loans, inched up to 2.15% from 1.12% in the year-ago quarter. Still, both firms’ default rates have remained under the pandemic-driven high of 9.4% for Lincoln and the 8.1% for Proskauer, both in 2Q 20.

Results between the two indices vary for Lincoln’s focus is on the dollar-amount weighted, meaning that defaults on larger loans carry a higher weight than defaults on smaller loans. Proskauer, meanwhile, equally weighs any loan which trips a payment or financial covenant or enters bankruptcy. Both reports were published earlier this month.

Liquidity pressure on borrowers is a major driver of the default increase, thanks in large part to the Federal Reserve hiking the federal funds rate by 500bps in just over a year. Borrowers are now faced with double-digit percentage loan costs compared to the single-digit ones they signed on for just two years prior.

"The defining characteristic of those companies that are stressed or in default is a lack of liquidity," David Hillman, co-head of the private credit restructuring group at Proskauer, said to 9fin. Also contributing to borrower and lender woes, he said, is a softer economy which "makes it more difficult for lenders to exit their investment with a refinancing or through a sale of the business.”

Middle-market companies continue to feel the pinch. Earnings growth continues to trail revenue expansion suggesting that companies are struggling to pass on increased costs from a mixture of persistently high inflation and a widespread labor shortage.

"It's been seven quarters now where revenue is growing faster than earnings, that means margins are contracting,” said Ron Kahn, a managing director at Lincoln who focuses on debt advisory and valuation services, in an interview with 9fin.

"You have not seen the full effect [of the rise in base rates],” he said. “People lock in SOFR for 90 days very often, so you're not going to see it until sometime in August, September.”

And it’s not just Kahn warning of the upcoming increase in default rates, over 75% of Proskauer -surveyed private credit executives said they expected defaults in their portfolio to increase in the next year. 

But those defaults aren’t hitting all sectors the same, the Lincoln data shows. Two of the most impaired sectors are the ones private credit firms have an affinity for: healthcare and technology.

Defaults in healthcare jumped to 4.1% in the first quarter of this year while technology came in at 4%. That’s compared to the 1% and 0.9%, respectively, reported at the end of 2021, Lincoln said. Consumer services, meanwhile, continues to be the hardest hit sector at a 6.4% default rate.

Before these companies get to a default, there are a few options they can try. Sometimes that looks like an amend and extend, other times that's additional capital provided by the sponsor. 

And even if default is imminent, the path to a solution can be smoother when the core issue is debt-driven as opposed to operational. 

"When the source of distress is a bloated balance sheet as opposed to a broken business, it will be far easier for private credit borrowers to get on a Zoom call [or] to get in a conference room [and] find a path with the sponsor to stabilize the business," Hillman said.

Defaults are no abstract issue for today’s sponsors. In the past couple of quarters there has been an uptick in restructuring, amendments, and payment-in-kind (PIK) activity, as borrowers and lenders get together to find a solution as liquidity challenges continue to pile up.

Still, these may just be early days as the full weight of rising interest rates makes its impact, according to Bill Cox, global head of corporate, finance and government ratings at KBRA.

"There are already more loans being added to monitoring lists across the direct lending landscape; Later in the summer, you'll start to see uptick in defaults, restructurings, and recapitalizations,” Cox told 9fin.

Amendments often come at a hefty price for borrowers.

Of all the amendments seen in the first quarter of 2023, nearly one-third of them had sponsor infusions associated with them, according to data from Lincoln. Within those amendments, almost 41% also included pricing increases, with the median increase in spread being 125bps. 

Such price increases may be difficult to absorb as the higher cost of debt financing has already begun hampering companies’ ability to pay off their fixed costs.

In some cases, as interest-related expenses balloon for borrowers and lenders face a tricky fundraising environment, private credit firms have to pick and choose where they spend their energy. Sponsors are already starting to have conversations about whether to walk away from an asset and deploy dry powder elsewhere, Cox said.

Large direct lenders have also begun bracing themselves for the impending storm in other ways. Firms like Barings, Blackstone and Bain are among those beefing up their restructuring teams as dark clouds gather. Those additions may be a direct result of what’s to come in the future, Cox said, adding that difficult conversations between lenders and borrowers have already begun.

“We have heard directly from some lenders that the number of and the intensity of these ‘strategic’ conversations among lenders, sponsors, and portfolio companies has increased in recent weeks, and will continue to increase in months to come,” Cox said.

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