Just kidding! While that note on defaults is true, the report also included figures that show how these companies are doing in more granularity than whether they’ve missed a payment or not.

Borrowers aren’t defaulting much, but they sure are succumbing to some of the pressures of higher rates as downward credit migration picked up momentum in the latest quarter: Some 21% of reviewed credit assessments migrated to a lower ratings category, compared to 13% in Q4. For clarity, these credit assessments include both the unpublished and confidential credit estimates that KBRA holds on private borrowers, along with the KBRA credit assessments that are requested by lenders or managers for the purpose of modeling portfolios or checking compliance to transaction tests and concentration limitations.

Furthermore, the ratio of upgrades to downgrades fell sharply to .46, the lowest point in over a year and a steep drop from previous quarters.

Source: KBRA

“For some companies interest costs are growing faster than revenues and faster than EBITDA, so you’re seeing a credit erosion there,” Bill Cox, global head of corporate, financial and government Ratings at KBRA, told 9fin. He also noted that more borrowers in the sample reviewed by KBRA are now rated at B- or triple C, and fewer are rated above a B-, even though the average portfolio grade remained stable at B-. Cox said that he expects this credit deterioration and downward migration in ratings to continue.

There was a sectoral skew to these downgrades as well, as 23 out of 95 lowered assessments in Q1 2024 came from the healthcare services and technologies sector, and particularly from borrowers that were involved in roll-up strategies.

As we’ve covered before, the No Surprises Act meaningfully impaired PE’s playbook in certain sub-sectors of the healthcare space. Furthermore, the FTC has been vocal about its scrutiny of PE healthcare roll-ups, both of which have cooled some enthusiasm for the space.

Cox said that all of these factors are playing some role in the underperformance of the sector. He also added that high debt levels, particularly in roll-up strategies, add to the woes.

“There’s even more leverage than usual in that space, and with very aggressive growth targets, so anything that caused a hiccup in the acquisitions of new providers obviously caused the leverage to be very acutely felt by the pre-existing portfolio company,” said Cox.

Before we move on, there’s one last point on the default figures — the authors said that defaults are too low to be significant, and that these defaults appear to be idiosyncratic and not related to company size (a continuous private credit debate,) but they do note that nearly half of the defaults recorded in the past two quarters were in the healthcare services and technologies sector.

Considering the skewing of that sector in both defaults and downgrades, we asked what the latest data points in the charts above would look like excluding the healthcare services and technology sector and found that the picture doesn’t change very much: they came out to .55 for figure 9 and 19% for figure 10.

While excluding healthcare slightly improves the picture, the difference is small enough to suggest that this deterioration is less sector-specific than lenders might hope.

Recent ratings moves suggest that these downgrades indeed aren’t happening in a vacuum — just a few weeks ago we saw Moody’s downgrade its outlook for three BDCs managed by big credit names: BlackRock, Oaktree, and KKR.

Who needs enemies

Private credit financed the $7.3bn take-private of Inovalon in 2021 (Blackstone Credit provided $1.7bn of the $3.3bn debt package), in what was one of the larger deals in the asset class’s history at the time. The memory of the deal has been marred by court disputes however. Its saga took a turn this month when Delaware courts agreed with an appeal made by multiple pension funds that held Inovalon stock, alleging that the advisors hired for the transaction did not adequately disclose material conflicts of interest.

Once private equity sponsors expressed interest in purchasing Inovalon, the company hired JP Morgan and Evercore as financial advisors. As is standard, these advisors disclosed their material relationships with potential counterparties, in order to highlight possible conflicts of interest. The issue, according to Justice Karen Valihura, was that these disclosures omitted material details about those relationships.

The most striking detail of the ruling involves the undercounting of the fees that JP Morgan received from counterparties. While the ruling stipulates that “there is no hard and fast rule that requires financial advisors to always disclose the specific amount of their fees from a counterparty in a transaction,” it later states that JP Morgan’s disclosure “created a misleading impression as to the ‘rough scale’ of the omitted fees.”

The undisclosed fees in question turned out to be approximately 25 times higher than the amount disclosed ($15.2m vs nearly $400m), interpreted by the court to mean that “stockholders could be misled into thinking that the undisclosed fees earned in the concurrent representations were of a similar magnitude.”

The outcome of this case is TBD, as it is now going back to lower courts for further proceedings. In the lower court’s initial ruling, “the court recognized the business reality ‘that most financial advisors have relationships with major private equity firms,’” and dismissed the complaint. And that interpretation seems understandable — at the upper end of the market in particular, many of the top sponsors are fishing from the same pond of top advisors, inevitably creating potential conflicts of interest.

But this change of heart could impact the way deal parties, and advisors, approach their disclosures moving forward.

One direct lending lawyer described the Inovalon situation as a massive conflict of interest but added that even if the actual borrower (in this case Inovalon) is ultimately liable for any penalties, the creditors would most likely have grounds for some sort of lawsuit against whoever is ultimately at fault — in this case, the advisors who failed to adequately disclose concurrent conflicts. They suggested that sponsors, who would likely see their equity value in the company even more impacted by any ruling against the portfolio company, would have similar recourse.

While that may be reassuring for potentially impacted lenders and sponsors who likely want protection against cash being siphoned out of their portfolio companies, one can imagine that such lawsuits could complicate business relationships with oft-encountered partners. We’ll keep an eye on how this one develops, and any implications for dealmaking.

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