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Although private credit remains all the rage with investors (and asset managers thirsty for fee-rich, flow-strong businesses), there is chatter that there’s a decent amount of quiet extending-and-pretending now going on.
One important difference between private credit and the public high-yield bond universe is that the latter pays fixed coupons, while the former is floating rate debt, with the interest payments ebbing and flowing with interest rates.
Rising rates help private loan returns — up to a point. Paying out SOFR/LIBOR plus, say, 500 basis points is a lot easier when rates were floored, and many more leveraged companies are now probably struggling to service their debts. Some investors say that private credit firms are therefore amending and extending some dicier loans, hoping for some respite in 2024.
The problem is that private credit is, well, private, so it’s hard to know just how bad things are (or aren’t). But Bank of America’s credit strategist Oleg Melentyev has a good idea:
While we cannot directly observe valuations and credit loss experience in private credit space, we can look at proxy issuers and make a reasonable inferential judgement. We have previously determined that implied leverage in the whole US private credit space is likely to be at 6x . . . This is broadly consistent with the single-Bs/CCCs segment in the US HY market, where the blend average leverage currently stands at 5.8x. We also know that private credit is dominated by smaller issuers and secured debt.
All these attributes are identifiable and measurable within the HY market: a segment of privately-owned single-B/CCC rated issuers, which represents $350bn of total HY face value. For valuation measurements, we further restrict this sample to smaller issuers (under $500mn in bond face) and their secured bonds.
So what is the current default rate for private single-B/CCC bonds? About 7.7 per cent, compared to 2.5 per cent for the broader high-yield bond market . ..
Interestingly, this segment actually had a lower default rate in 2020 as private equity firms — which are the dominant owners of companies that tap private credit funds and the high-yield market — stepped in to support stricken companies in their portfolio. However, since 2022 things have clearly changed radically.
Melentyev notes some caveats to using the 7.7 per cent private high yield default number as a proxy for the private credit universe.
Our standard default calculation includes distressed exchanges, and those are technically unlikely to be identified as such in the context of private credit, since by definition they require discounted dollar price which is not observable. In other words, what is labelled as a distressed exchange in the context of public credit would likely be viewed as an amend & extend transaction in private credit.
As a result, this would not be counted as a default there, regardless of whether or not it is economically defensible. Just for perspective on sensitivities, if we were to narrow our default definition only to missed payments and bankruptcies, the 2023 private proxy defaults come in at 4.5%, and the overall HY market at 1.4%. Therefore, the delta in hard defaults in private credit narrows to 3.1% vs 5.2% for all forms defaults, soft restructurings included.
Presumably, the fixed rate nature of private Bs/CCCs also means that the pain of higher rates is less here than it is for actual private credit loans. Regardless, it’s probably safe to assume that there are some stresses in parts of the burgeoning private credit complex.
Further reading:
— Private debt is out of control (FTAV)
— Is private credit a systemic risk? (FTAV)
Read the full article here