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David Brooke

The Unicrunch is our US private credit newsletter, in which we break down everything from unitranches to ABL lending. Sign up for the inside track on this fast-growing market.

The critical question, perhaps fundamentally the only question, for credit investors is — how do I get my money back? The business model at its heart is to give some out to get back more. And in that process secure as many certainties as possible that it will happen, through both tight covenants and robust due diligence.

The ability of borrowers to make good on their loans has been in focus as rates have risen. Interest coverage ratios, a simple calculation of dividing a company’s EBIT by the total interest expense (2x has usually been considered a healthy level), are slowly coming down as we outlined a couple months ago.

Coverage ratios averaged about 1.59x, according to a report from Benefit Street Partners from May (2x is firmly in the rearview mirror). Meanwhile, S&P produced its own stress test results last week for companies financed by private credit. The ratings agency outlined three scenarios where average EBITDA decreases 30% and SOFR increases by 1.5%.

In the most severe scenario the median interest coverage ratio fell to 1.1x. In such a case a typical borrower does not need to dip into its own liquidity pools to pay back the debt, but instead pulls from cash flow to service the loan. While that is much below 2x, perhaps it is reassuring the figure is above the 1x marker in the most extreme situation, which the ratings agency in the report admits such drops in EBITDA and SOFR increases are an “unlikely phenomenon”.

Of course that is the median, and there are many lenders that will be managing borrowers that fall below that level. One lender in better shape is Sixth Street, which in its BDC reported an average interest coverage at 2x, slightly dipping from 2.1x in Q2 2023. Ares’ BDC reported its own at the 1.6x mark for the third quarter, compared to 2x at the same time last year. BDCs don’t contain every loan made by a manager but their health is largely in lockstep with the wider funds they manage.

But as Sixth Street’s Bo Stanley attested to in a recent earnings call, earnings and revenue growth have largely been strong over the last few quarters. “The fundamentals continue to be okay to good although coverages are declining,” he said.

It’s a sentiment echoed in Golub Capital’s mid-market report, released last month. Earnings grew 13.3% and revenue increased 7.6% in the third quarter compared with the third quarter in 2022 — and the highest year-over-year earnings growth since 2021.

“Growth exceeded our expectations,” proclaimed Laurence Golub CEO of Golub in a release issued by the lender, with growth reported across all industries tracked — including the healthcare, industrials, tech and consumer sectors. As the old saying goes, never underestimate the power of the American consumer!

Returning to the S&P report, one alarming tidbit is how quickly the median leverage level rises. Today the base case is as high as 7.1x, the ratings agency notes, but rises to 7.9x in the mild stress scenario (10% drop in EBITDA; 0.5% increase in SOFR).

Indeed, it’s much higher than the 6x marker laid down by regulators as a limit for bank loans in the aftermath of the global financial crisis. Of course, we all know the story of private credit — it very much waded into the space beyond the 6x marker to provide the leverage desired by private equity borrowers.

Maybe this was sustainable in the ZIRP era, but in the “higher for longer” stage there may be some tough questions to answer coming up. 

Yet the data is not bearing this out. Investment bank Lincoln International found default rates in the private credit market dropped to 3.9% in 3Q from 4.2% in the previous quarter. 

Lincoln’s focus is on dollar losses for lenders, instead of the technical defaults tracked by the Proskauer default index — yet in the latter defaults are also coming down. It goes to the heart of the model of private credit, that having close relationships and agreeing to amendments on existing loans or waivers keeps everyone out of the courtroom (and off the graphs!).

However, that lack of transparency only invites further questions about the condition of the asset and what terms are private credit mangers ultimately agreeing to keep the show going on. And if the show keeps going on, it can potentially harm the recovery of the debt. Calling the default now might hurt your relationship, but it is the LPs lenders must worry about.

Nevertheless, lenders are making the right noises. My colleague Peter Benson reported from SuperReturn North America this week that lenders are focused on the issue. “The second act of the play hasn’t played out in private credit,” said Grady Frank, head of private credit origination at GoldenTree Asset Management.

Waiting for Godot is often jokingly referred to as the play where nothing happens twice. Perhaps in the first act private credit lenders have been able to swerve any widespread issues in the economy filtering into private credit in the free money era, but if the current rate environment is the new normal, then there will be no more waiting and plenty of action.

The Unicrunch — Repressing the stress

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