BDC Credit

Week 21

Introduction

This week, we’d like to use the occasion of the publication of an article about recent corporate bankruptcies to provide our latest “big picture” thoughts about credit conditions.

Corporate Bankrupcies

This week saw another worrying headline about conditions in the non-investment grade company universe, which the BDC sector and many other groups finance. The venerable FT led with this headline: ” US credit squeeze triggers rise in corporate bankruptcies”. The article contained interesting recent data about the rise in U.S. corporate bankruptcies.

Eight companies with more than $500mn in liabilities have filed for Chapter 11 bankruptcy this month, including five in a single 24-hour stretch last week. In 2022 the monthly average was just over three filings.  Twenty-seven large debtors have filed for bankruptcy so far in 2023 compared to 40 for all of 2022, according to figures compiled by bankruptcydata.com.

Sujeet Indap in the FT – May 25, 2023

More Of The Same

Of course, this increase in bankruptcies is nothing new, but the continuation of a trend that has been going on all year and which we most recently discussed in the BDC Credit Recap for the week ending March 31, 2023.

Not So Bad

We were interested to see the FT quoting S&P Global predicting the “12-month trailing default rate for speculative-grade securities “will increase from 2.5% at the moment to 4.5% by early 2024.” That sounds dramatic but if true would – ironically – be a great relief to leveraged lenders. The default rate peaked at 6.9% in 2020 and 13.4% in 2009. (That’s using Moody’s data).

Finger Pointing

We differ, though, with FT in blaming the raft of bankruptcies on a “credit squeeze”, which presumably ties the bankruptcy phenomenon to the fall of Silicon Valley Bank (SVB) and the solvency challenges of the regional banks. As we’ve seen, bankruptcies and restructurings have been on the rise all year, long before SVB became a national story.

Shifting Sands

The problem for some leveraged companies is that interest rates increased very quickly making it very difficult for underperforming businesses to replace debt coming due this year or next at the same level as before. For some time the managers and owners of these sorts of companies had been able to keep carrying on thanks to the very low cost of capital out there. Now that capital has become much more expensive, hard decisions had to be made about the real value – if any – of these businesses. There is no real “credit squeeze” but a rational re-pricing of capital due to its higher cost. As we’ve seen all year in the BDC space – and on these pages – new loans are being booked all the time as companies are bought and sold, but not on the same terms as previously.

Unaffected

Companies performing well – those who have managed to increase their EBITDA – have not been caught up in the bankruptcy net, even if their current debt was coming due. As a result, we are seeing a normal “winnowing” process – which had been put on hold since the pandemic – of weaker companies getting restructured, both inside and outside the bankruptcy process. Even if rates had not shot up, many of the companies that have failed would have done so anyway because i) their capital structures were over-extended and ii) their business models could not handle changing conditions.

Name Dropping

Think of Jenny Craig (drugs replacing dieting), David’s Bridal (brides not needing so many locations post-Covid), Heritage Power (power plant using coal); Vice Media (competing in a sharply shifting news landscape that’s engulfing CNN and Fox, and many others). Then there’s the change going into how we shop brought on by the internet and its impact on retail such as Bed Bath & Beyond; Serta Simmons, Nielsen & Bainbridge, and so on. Looking through the BDC Credit Reporter’s database of restructured and bankrupt companies one cannot help but feel that most of the corporate victims of 2023 to date were due either a re-sizing or a liquidation.

Unhealthy

There is one industry, though, that is causing us some above-average concern: healthcare. Clearly, that’s a catch-all category for all sorts of businesses. We’re seeing, though, repeated troubles at healthcare-related businesses with a proportionately large number of employees. Wage inflation and just finding appropriate staff – two interrelated phenomena – are grinding away at solvency in a number of instances. So far, most of these companies have been holding on but high debt service costs and no end to inflation in sight might bring about the need for restructurings and bankruptcies later in the year and beyond. Of the 397 underperforming companies, the BDC Credit Reporter has identified in the 4,000 company plus BDC universe, 43 – or more than 10% – are in the Healthcare sector. We’d suggest that wage pressures are the greatest challenge these troubled companies face.

CONCLUSION

A Warning

You’re going to see many more worrying headlines about bankruptcy and restructurings in the financial and mainstream press.

That attracts “eyeballs” as they like to say.

Undoubtedly, this increase in credit stress is notable and newsworthy.

There’s a danger, though, that the headlines could be misleading, suggesting a much worse state of affairs than yet exists.

Natural

Look behind the headlines – we would argue – and you’ll find more of a reversion to the mean than the early stages of the next Great Recession and cataclysmic losses for BDC lenders and shareholders.

The great bulk of BDC-financed companies – despite higher interest rates – are performing in line with their lender and manager expectations.

However, the Fed’s rate pivot has accelerated the day of reckoning for a small minority of companies – probably no more than 5%-10% of the total – already in trouble.

It’s Been A While

What we’ve not experienced – even if 5 companies did file for bankruptcy on a single day – is the sort of credit dam breaking one gets in a real economic downturn.

Those sorts of events – blessedly rare – usually affect a far broader swathe of companies and result in worse ultimate outcomes for those businesses that succumb.

None of the metrics in the non-investment grade company universe or among the portfolios of the public-BDCs we follow are even at the beginning of such a credit slump.

Door Open

It’s possible that will yet come to pass but the current spate of bankruptcies and restructurings is not actuated by the same factors that might happen down the road if the economy contracts.

A 4.5% default rate is “manageable” for the BDC sector but 14.5% would not be.

We’ll continue to follow credit trends closely and let you know if we detect a worrisome change in conditions.