Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Most companies can’t afford to repay bonds and loans as they fall due. But this is fine. Because it’s not really important whether firms have the cashflow to repay their debts, just as long as they have the cashflow to service them.
And as long as debt service looks sustainable, bond and loan investors almost always just lend firms more money, which is used mostly to repay lenders like themselves. A rolling loan gathers no loss, yada yada.
It’s only when a business appears too shaky to sustain debt service that the music stops. And when it does, default follows. But there are many types of defaults. One type of default — bankruptcy — is pretty public. When it comes to European private credit, a new report from Patrick Badaro and Juliana Hadas at Goldman Sachs estimates another route — debt-for-equity swaps — is more common. Much more common.
Here’s a chart we put together to convey just how much more common the debt-for-equity default route has been, according to the report:
This split represents 150 European companies with c$38bn of LBO financings that have been subject to credit events since 2017.
Wiping out the debt in exchange for some or all of the ownership of highly-levered firms with massive interest drains on their P&L will naturally improve borrower creditmetrics. Of course, creditmetrics become less important once you stop being a creditor.
Still, by opting to take the keys of a company to which you’ve extended a loan rather than seek asset sales or bankruptcy, at least there’s a prospect that the business could survive and maybe even thrive. Moreover, those measures of European private credit defaults that count ‘hard’ defaults will be untroubled by the swaps making the whole thing look nice and safe from a distance.
Everyone’s a winner? Maybe even investors, although the authors only go as far as to say that going down the debt-for-equity swap route “does not necessarily mean a full write-off”.
And how does Goldman see the outlook for European private credit defaults in the future?
While 2023-2025 vintages are not yet seasoned enough for meaningful default events, we expect to eventually see more stress events in these vintages, given the amount of capital managers put to work in this period and a potentially slower path of rate cuts than may have been underwritten in some cases. These deals also featured tighter spreads, providing investors with smaller compensation for credit risk.
👀
Read the full article here