Downturn dread

It was as long ago as 2017 — an age, in market years — that talk of recession was as widespread in private credit as it is today. Credit cycles lasted eight years, and the global financial crisis was about that long ago. The moment was upon us.

Except, of course, it wasn’t. Coupled with new banking regulations, the ultra-low interest rates that were set in the wake of the GFC created fertile ground for direct lending to grow. Notwithstanding a once-in-a-hundred-years pandemic in 2020, credit markets have only expanded for far longer than a typical cycle.

Perhaps our assumptions around the timing of these cycles need rethinking? 

Still, even amid this long bull-run, private credit managers claim to have been bearing an eventual recession in mind when underwriting loans: modeling out worst-case scenarios, stress-testing their portfolios, and gravitating towards sectors that have historically performed better in a downturn.

Many market participants and observers believe The Big Test has now arrived. It might be taking its time, but by nearly all accounts a recession is on its way. We won’t repeat Warren Buffett’s overused metaphor about tides and swimming naked; suffice to say that when the cycle does turn, it is expected to divide private credit firms between those doing the good loans and those doing the not-so-good loans.

Here’s David Golub, of the credit firm that bears his name, on the most recent earnings call for its BDC vehicle:

A more challenging environment typically leads to greater dispersion in borrower performance. And that typically leads to greater dispersion in lender performance. And that in turn leads to different outcomes for investors based on which managers they're invested in.

A rise in defaults is now widely expected. Whether they’ve borrowed in the high yield bond market or the broadly syndicated loan space, it seems inevitable that more companies will fail to keep up with their interest payments and potentially struggle to refinance their debt.

In the words of Joe Taylor, head of capital markets at PineBridge Investments, liquidity constraints are going to fuel an increase in defaults. 

“The backdrop of a slowing economy, continuing inflationary pressure, and high relative leverage levels are stressing operating cash flows,” he said in an emailed statement to 9fin.

This has been the talk for sometime, but now the data is confirming these expectations. As we recently reported, defaults are a growing problem for direct lenders: Lincoln International is reporting headline defaults at 4.5% in the first quarter, up from 2.5% in the first quarter of 2022.

Proskauer’s default measure, meanwhile, is at 2% — almost twice what it was in the first quarter of last year. The methodology differs between both firms, but the conclusion is the same: defaults are going up, and quite dramatically too.

Model management

We’ve been here before. At the peak of the Covid-19 pandemic (the second quarter of 2020) the private credit default rate reached 9.4% according to Lincoln data, and 8.1% according to Proskauer’s figures. 

This was an exceptionally sudden spike. Covid took most people by surprise, and companies were suddenly selling into an economy that was locked down with no clear line of sight to an eventual reopening. 

In response, lenders agreed to amend credit agreements in exchange for higher spreads. Loan facilities were converted to non-cash paying instruments, and in some cases, sponsors replenished their portfolio companies with fresh capital.

For most observers, the Covid test showed that the private credit model worked not just in theory but in practice. The idea that small groups of lenders are better able to hash out deals with borrowers seemed to bear itself out: lenders were able to support companies at a challenging time and avoid a death-spiral of defaults and bankruptcies.

The recession we are now facing is not a surprise, so theoretically, lenders should be even better prepared. Taylor at PineBridge argues that they will also be better funding partners than traditional bank lenders:

“In this evolving environment, private lenders may be found to be more proactive and effective in maintaining the long-term viability of a borrower through bespoke restructurings and principal protections, than would otherwise be expected from a traditional banking relationship,” he said.

Everything, everywhere, all at once

This argument rests on the assumption that private credit funds have strong portfolio managers and robust risk mitigation practices. For that reason, management teams may come under increased scrutiny in the months to come. 

Indeed, some already are. Venture lender TriplePoint has found itself under the microscope after problems at two of its portfolio companies, which were accused of fraud and/or mismanagement. 

According to a critical report from investment newsletter The Bear Cave, the lender’s BDC vehicle is sitting on a “weaker loan book saddled by portfolio company bankruptcies and upside-down startups.”

TriplePoint is relatively small compared to the giants of private credit. For bigger lenders, which are managing larger portfolios, troubles may arise thick and fast. With that in mind, some firms are looking to staff up now to build a deeper bench of restructuring experts. 

As Tim Lyne, the CEO of Antares Capital, said on a recent episode of Cloud 9fin: 

It’s not like it’s going to happen one one week and then another a month later. A lot of this is going to happen at the same time, so you really need to have a lot of people with a lot of restructuring experience to jump on these challenging situations at the same time.

So far, the reality of a recession has lagged market predictions. But if the data continues trending as it is, the time of reckoning is drawing near. Covid gave private credit a quick taste of distress; are the right people at the table for when the full meal is served?