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Private Credit 

Shubham Saharan

Rachel Butt

After SmileDirectClub filed for Chapter 11 bankruptcy last September, it had about two months to find a buyer.

Its billionaire founders had already provided $20m to fund the search and made a Hail Mary attempt to buy the dental aligner company out of bankruptcy. SmileDirectClub struggled to turn a profit since it went public in 2019, and its sales were hit hard by the double whammy of the pandemic and inflationary pressures.

To create breathing room last year, SmileDirectClub mortgaged its receivables and intellectual property to raise $255m in financing from HPS. But the company is now heading towards a liquidation — the worst-case scenario — as it couldn’t get its lenders on board with the founder-led bid.

That company is one illustration of what’s been happening in private credit portfolios. Direct lending-backed companies have undertaken a number of restructurings since the tail end of last year, but those workouts are now becoming more frequent, according to the over half a dozen lawyers and direct lenders 9fin spoke to for this article, as interest rates remain higher for longer and companies attempt to navigate upcoming debt maturities and a cash crunch.

Sponsors and lenders are increasingly turning to amendments, recapitalizations, and cash infusions in an attempt to stave off company liquidations and bankruptcies, sources told 9fin.

“We’re going to see more workouts within existing books and a dispersion in private credit managers’ performance based on their ability to fix mistakes,” Rick Miller, CIO of TCW’s private credit group, told 9fin.

The picture from the outside is a bit more muddled: private credit defaults seem to be going down, but professionals claim that the number of workouts have increased.

For example, the latest data from Lincoln International puts the default rate at 3.4% as of Q4 23. This has decreased from previous quarters, down from a two-year peak of 4.5% at the end of Q1 23. Lincoln’s index measures the dollar amount lost on loans.

Meanwhile, Proskauer’s private credit default index, which measures the rate of loans that have a payment, financial covenant, or bankruptcy default, also has defaults remaining low. For Q4 23  defaults were at 1.6%, up incrementally from the 1.4% reported in Q3.

This is despite growing distress in US leveraged credit markets, where the default rate sits at 3.35%, according to Fitch.

That discrepancy between low default rates, but a greater number of workouts could be because the workouts happen before any event of default actually occurs, according to one private credit lawyer.

“In how many of those deals did you get a consent signed up before a default?” they noted. “It’s not a default if you change the covenant before the default hit. The more of those types of deals hit, the more it’s going to reduce the default rate.”

Some stress is also starting to pop up in BDC portfolios. FSK reported that non-accruals more than doubled to 5.5% of its total investment portfolio at fair value by the end of last year, while Blue Owl Capital Corporation listed four investments on non-accrual in Q4, up from three in the prior quarter. For Oaktree Specialty Lending Corporation, the non-accrual number jumped to 4.2% from the 1.8% reported in the prior quarter.

Jason Friedman, a partner at Mayer Brown focused on leveraged finance and private credit transactions, said some of that increase in non-accruals can be attributed to sponsors and lenders preemptively trying to fix operational or cash flow issues.

“Sponsors have exhibited a tendency to be more proactive in coming to private credit providers in the early innings of a developing issue to say, ‘Look, there is an issue blossoming here, or we see one coming up on the horizon, and we need to work in tandem to help the company solve for it,’” Friedman told 9fin.

Lenders have typically been the ones eager to initiate balance sheet talks with companies and their owners. But these days, it’s the private equity firms that are increasingly starting those conversations, sources told 9fin. Especially if they’re looking for ways to part with problem assets.

"In what feels like the first time in a long time, private equity sponsors have begun approaching their private credit lenders to say look, we're ready to exit stage left. We don't want to continue to fund the business. So would you like us to hand you the keys or throw you the keys?" said Vincent Indelicato, global co-chair of Proskauer’s restructuring group.

The last BDC earnings season gave several examples of private credit funds taking businesses over from private equity owners:

Cerberus-backed facilities services provider KBS was put on non-accrual status by lenders, including FSK, in the fourth quarter last year. The company is now going through a restructuring which involves the BDC’s $366m dollar first-lien loan exposure being split into a $166m first-lien loan and a $200m second-lien term loan.

Executives noted on the BDC’s earnings call that a full restructuring is expected to occur in the near term, which will likely result in the lenders equitizing a portion of the second-out and taking control of the company.

That’s also what happened in the case of Dermatology Associates, a Carlyle Secured Lending portfolio company, which the BDC’s executives said “was successfully recapitalized in early February with the lenders taking equity control.”

And, in another more active situation is airport concession business OTG Management. In their Q1 earnings call in early February, Oaktree BDC executives noted that the company had “announced a series of initiatives to position the business for long-term growth and stability,” part of which included the lender and other investors acquiring the company.

New money injections are of course an option for sponsors or third parties that are willing to support a struggling business. But those cash infusions are increasingly coming in the form of preferred equity.

That trend has gained steam in the last year with investors willing to take on more risk to get higher returns, and there are plenty of struggling companies that can make use of this capital to right-size their capital structures or boost liquidity.

For example, Blackstone-backed event services company Encore is reportedly looking to raise at least $500m in preferred equity to reckon with upcoming loan maturities.

And in a recent example of a private equity firm propping up one of its own companies, Warburg Pincus-owned street sweeping provider, Sweeping Corp of America is actively negotiating with lenders such as FSK for a restructuring that will result in the sponsor investing more equity into the company and the majority of its debt returning to interest accrual status, FSK executives said on that BDC’s recent earnings call.

Another option is for sponsors to also become lenders within a capital structure. But that may not go over well with existing lenders, because it could potentially impede the ability of the incumbents to take control or steer restructuring talks.

"For those sponsors that have demonstrated a willingness to put more dollars at risk, they generally want to enter the capital structure through pari or last out debt, which prolongs their equity option,” Indelicato said.

“But [that] also introduces an entirely new set of considerations for the lenders, who have to balance the attractiveness of a capital infusion against the fear of letting the proverbial fox into the hen house.”

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