Moody’s touch

One of the reasons these concerns are surfacing now is because private credit coupons are generally tied to three-month or six-month SOFR, so the full force of 5%-plus base rates is only just starting to show up in borrowers’ finances.

Moody’s is the latest to raise the alarm about private credit performance: 

The stage is set for the first test of private credit, with factors underlying the market’s exceptional growth and strong performance having changed dramatically in recent quarters. Now rates are rising, economic growth is stalling and there is less capital flowing into risk assets.

We’re likely to see higher defaults, a trend that has already been highlighted in reports from Proskauer and Lincoln (9fin clients can see our coverage here). Moody’s also points to the likelihood of weaker recoveries, particularly for deals made in 2021. 

In a few weeks, business development companies will be publishing their quarterly reports. A separate Moody’s report looking ahead to those earnings anticipates slightly higher non-accruals (rough translation: more defaults) and an uptick in realized losses. 

Many BDCs are also expected to be at the higher end of their leverage targets. BDCs define this as a debt-to-equity ratio (this is a regulatory measure — here’s an explainer) and typically target a figure of 1x-1.25x.

Basically, several indicators of portfolio performance are heading the wrong direction, and the outlook for origination isn’t great either. For many years, lenders countered concerns about where they were going to deploy their cash by pointing to record dry powder in private equity; now, higher rates are stressing traditional buyout models, and thus restricting new deal flow for lenders.

LPs are under pressure too. While many are still excited about the asset class, they are also being hurt by the denominator effect, forcing many to rethink allocations to alternatives in general. 

None of this seems to have stopped people from declaring a ‘golden age’ for private credit. Advent chairman Marc Lasry said it, Blackstone president Jon Gray said it, Marathon chief executive Bruce Richards chimed in, and so have panelists at multiple conferences. 

In many ways, they’re right. It is an undeniable fact that individual loans are generating higher yields in this rising rate environment, which is boosting returns for many funds. The converse is that these higher debt costs are a burden for borrowers — so if this dynamic persists for too long, the scales could tip the other way. 

Dicey docs

Documentation is increasingly important in these times, and the word on the street is that those supposedly watertight J.Crew blockers may have a leak. 

As we reported earlier this week, lenders are becoming wary of a potential new method for stripping collateral from existing debt: the sometimes overlooked securitization basket, which in some cases could be applied not just to standard securitization assets like accounts receivable, but also to other potentially valuable assets like intellectual property.

In such a scenario, existing lenders could lose valuable collateral and potentially find themselves subordinate to new lenders.

The specter of J.Crew has been hanging over the broadly syndicated loan market for some time, and recent events at KKR and Platinum portfolio companies have put lenders on edge. Private credit docs, by comparison, have generally been stronger — with the majority at least including the kind of maintenance covenants that are often absent in the BSL market.

So it’s concerning for direct lenders that this vulnerability could open the door for opportunistic funds, which have been growing at a tremendous rate, to insert themselves into capital structures. Disputes over things like MFN protection are not new to private credit, but they might soon get nastier. 

For years the trend was simply that docs were getting weaker as sponsors had the upper hand. That changed last year, when Russia’s invasion of Ukraine and the Fed’s decision to aggressively hike rates upended markets; the pendulum swung in the favor of lenders, and ever since they’ve been able to secure protections unseen in previous years.

But the pendulum may be swinging back again, at least in the larger reaches of the private credit market. Leverage limits, amortization terms, prepayment premiums and incurrence tests are among the areas where lenders may be willing to bend, according to our reporting. 

Could collateral leakage be next? Many lenders talk tough on this front. Perhaps only time will tell whether or not they can back that up. 

“We simply do not allow for assets to get stripped out,” Craig Packer, co-founder of Blue Owl, told us in a recent episode of our Cloud 9fin podcast. “We can’t afford to live with that risk, and we don’t.

The Unicrunch will be off next week. Stay tuned for the next edition on 19 July.