NEWS

“Defaults in private credit are nearing 3-5%, partly due to covenant breaches and modifications and “kicking the can down the road between borrower and lender,” Co-Deputy Managing Partner of Davidson Kempner Capital Management Patrick Dennis said at the Milken Institute Asia Summit on Thursday.

Defaults are kicking up in all three areas” the company is working on, said Dennis

“From a severity perspective, I think this is the biggest risk in the market that we’re trying to evaluate,” he added”

Bloomberg. – September 18, 2024

“The private credit market is set to face a “reckoning moment” and a period of difficulty it hasn’t seen since 2008 amid risks of inflation and recession, according to Jae Yoon, chief investment officer of New York Life Investment Management.

Yoon, who is also responsible for developing the $727 billion money manager’s operations in Asia, made the comments on a panel at the SuperReturn Asia conference in Singapore on Tuesday.

While fiscal stimulus and booming markets had protected players who would’ve been otherwise wiped out, Yoon warned time was potentially running out. “The last time you had a major dispersion between well-managed versus unnecessary risk-takers was 2008,” he said. “We’re about to come to a reckoning moment.”

“The recovery rate is coming down, there are too many players and too much money chasing deals and covenants are getting lighter and lighter,” Yoon said, referring to a loosening of restrictions placed on borrowers. “The last 15 years should not be repeated in the next five to 10 years.”

While Yoon emphasized that the risk was not of an “Armageddon” level meltdown, he said the flood of capital had led to too much debt concentration.

“In private credit you have to be extremely careful how you segregate, diversify,” he said, adding that even allocating separate pools of funding to two different players may not give real diversification”.

Bloomberg – September 24, 2024

“S&P Global Ratings’ Private Markets Analytics and Credit Research & Insights expect the U.S. leveraged loan default rate to remain near 1.5% through June 2025.  This would reflect a very modest decline from the 1.55% default rate in June 2024.

Leveraged loan issuers have been benefiting from tailwinds including the buildup to interest rate cuts, strong financing conditions, and a flurry of refinancings that have reduced near-term maturities. While these factors already contributed to a 0.5-percentage-point decline in the default rate from February to June, further declines could be hard to come by.

…

In our pessimistic scenario, we forecast the leveraged loan default rate could rise to 3.25%.  In this scenario, economic growth would decrease more than expected, possibly turning negative. Meanwhile, rate cuts would take time to flow through and reduce firms’ costs of funding, and bankruptcies would account for a growing share of defaults as some companies would struggle to meet cash flow demands amid an economic downturn.

In our optimistic scenario, we forecast the default rate could fall to 1%.  In this scenario, economic growth would be slow yet steady, alongside faster-than-expected interest rate cuts. Demand would remain resilient, supporting borrowers’ cash flow until their costs of funding ease.

…Distressed exchanges, which are excluded from the leveraged loan default rate, are the leading cause of speculative-grade defaults more broadly. Distressed exchanges are at their highest since 2009 and accounted for almost 60% of the speculative-grade defaults over the 12 months through June.”

S&P Global – September 25, 2024

ANALYSIS

Relevant

This is only slightly off topic for the BDC Reporter.

None of the commentators quoted above are directly referencing the public BDC sector.

However, there is no doubt that public BDCs are a significant sub-set of the “private credit”, “private markets” and “leveraged loan” universe.

Scary

So should BDC investors be worried that a “reckoning moment” will shortly be upon us and conditions worse than any we’ve known since 2008-2009?

Alarmist statements – especially those like the one by the CIO of New York Life Investment Management are easy to make – but we like to look at the data, even if that’s more complex and the conclusions more ambiguous.

Point Counter Point

As shown above, we’ve very recently heard from S&P Global Ratings that both the actual and projected “leveraged loan default rate” are very modest at 1.55% and 1.50% respectively.

Current macro conditions are seen as favorable:

Leveraged loan issuers have been benefiting from tailwinds including the buildup to interest rate cuts, strong financing conditions, and a flurry of refinancings that have reduced near-term maturities.

S&P Global

New York Life may be worried about “too many players” in the market but the result has been “refinancing activity [that] was robust through the first half of the year, following significant growth of both loan and bond issuance that has continued well into the third quarter…Near-term refinancing pressure has therefore eased for most”.

Right Direction

Moreover, rather than getting worse, the recent trend in loan defaults is improving, if S&P is to be believed:

With macroeconomic conditions and financing conditions improving, the leveraged loan default rate was 1.55% at the end of June 2024, with 18 issuer defaults in the index over the prior 12 months, down from 22 during the same period one year prior. This is also a swift fall from as recently as February, when the leveraged loan default rate was over 2%

Even the broader “U.S. speculative-grade” market – which includes borrowers with bonds as well as loans – is getting better where default metrics are concerned, expected fall to 3.75% in June 2025 from 4.57% in June 2024.

Not Bothered

We’ve heard multiple commentators and analysts wring their hands about perceived lower recoveries on debt that goes bad but S&P data shows that this does not seem to have affected the “average bid” on loans, as this chart shows:

Omitted

With all that said, S&P does point out that “distressed exchanges” – such as debt-for-equity swaps negotiated outside of bankruptcy court – are not included in their default data.

There has been plenty of “action” in that arena:

Distressed exchanges, which are excluded from the leveraged loan default rate, are the leading cause of speculative-grade defaults more broadly. Distressed exchanges are at their highest since 2009 and accounted for almost 60% of the speculative-grade defaults over the 12 months through June.

Ditto

Over at our sister publication – the BDC Credit Reporter – we’ve noticed a similar phenomenon.

There are a number of companies getting into trouble – up and down the size spectrum – but very, very few are ending up in front a bankruptcy judge, with the exception of “prepackaged” bankruptcies which are just restructurings within a legal wrapper.

Instead, the BDCs – and other lenders – are almost always agreeing to a debt-for-equity swap. (There are a few debt-for-debt swaps as well).

A Small Selection

The most famous example is Pluralsight, here over $800mn of BDC debt was converted into equity and control ownership, but also Benefytt Technologies – now split into two entities one of which is owned by the lenders and named Daylight Beta Parent LLC. Then there was Arcstor Midco, now known as Arcserve Cayman. What was once $39mn in BDC debt is now $34mn in equity and $5mn in debt. Down in the lower middle market, Saratoga Investment (SAR) took control of two portfolio companies:

We have taken decisive action with respect to Pepper Palace and Zollege, assuming full control over both investments through consensual restructurings with the prior sponsors and establishing a combined remaining fair value of $4.4 million. The Zollege restructuring was completed during the first quarter, and the Pepper Palace restructuring is imminent.

Saratoga Investment – Earnings Conference Call – July 10, 2024

We could go on and on but you’ll have to take our word that virtually all we’re seeing at the BDC Credit Reporter when realization events occur are variations on the debt-for-equity story.

Weighing

This is a good news – bad news phenomenon. Starting with the latter, the lenders involved typically have to book significant realized losses for forgiving debt and – sometimes – need to ante up more monies to help with liquidity at the business – opening up the classic “good money after bad” risk that private equity groups have to face. Moreover, there’s no guarantee that – say – David’s Bridal – is going to succeed under the aegis of CION Investment. (However, after one year, the BDC’s equity stake is valued – by CION – 50% higher than its cost). F

Finally – as the saying goes – “these things take time”. Previously a BDC had a clear cut loan maturity to look forward to. (In real life the average loan stays only 3 years on the books). When you become an owner, the timeline lengthens and becomes unknowable. There are BDC-owned companies that have been around for a decade or more.

Second Act

The good news is that the BDCs – and their shareholders – get another bite at the apple when portfolio companies fail. The lenders are in a good position – given their long standing relationships with the borrower and their teams of turnaround specialists at the ready – to properly assess whether switching from lender to owner (or owner-lender) makes economic sense. If they “get it right”, the potential ultimate proceeds can exceed all losses booked along the way and any interest income forgone.

Furthermore, the BDCs have the financial resources to support their now controlled companies. Controversially, Prospect Capital (PSEC) has turned this into an art – continuously advancing more funds to portfolio businesses that otherwise might have failed and been liquidated.

All of this makes evaluating the impact of loan defaults much more complicated than in the past. Today’s credit loser may turn out to be the day after tomorrow’s shining success and anything in-between.

VIEWS

Soap Box

We’ve got two points to make.

First, we have some doubt that the direst prognostications made about the outlook for the “private credit” market are based on recent hard data.

We’ve only quoted S&P Global here but our own readings take us far and wide where credit is concerned and what we hear from KBRA; Fitch; Moody’s and the Fed do not suggest that credit is crumbling, or is expected to, by most of the analysts devoted to this subject.

Furthermore, we read the quarterly revelations of 40 public BDCs, which are themselves controlled by asset managers with even larger investment franchises and – with only a few exceptions – have not heard the bell toll on credit.

Mostly, BDC managers report that the revenues and EBITDA of their thousands of portfolio companies – on average – continue to grow; debt service multiples are holding up and should quickly improve further with lower rates and that economic conditions are generally favorable.

Admittedly, there have been a few darker prognostications about credit. Most notable was Oaktree Specialty Lending (OCSL).

Always Looking

Most importantly of all – at the BDC Credit Reporter – we’ve been going through recent credit performance and the portfolios of each BDC with a fine tooth comb every day.

Our research is not yet complete but – generally speaking – we’ve been surprised and impressed how resilient most BDCs have been where credit losses are concerned in 2024, as well as over the longer term.

After all, this is a risky business where a lot can go wrong and some amount of losses “comes with the territory”.

Nonetheless, the majority of BDCs have impressive credit metrics – including over a multi-year period that included a recession.

For example, Ares Capital (ARCC) has booked net realized losses of only ($52mn) since 2019 while generating 100x more in Net Investment Income.

Unequal

On the other hand, we agree with the New York Life CIO that there is – and will continue to be – “a major dispersion between well-managed versus unnecessary risk-takers” within the BDC community.

The BDCs that have fallen and may or may not get up of late include the afore mentioned OCSL, as well as BlackRock TCP (TCPC); Goldman Sachs BDC (GSBD); Golub Capital (GBDC); OFS Capital (OFS) and a couple of venture debt BDCs, facing the worst conditions for that sector in two decades.

Rebounding

At the same time, some BDCs burdened with an earlier surfeit of bad loans are making a credit comeback, including FS-KKR Capital (FSK) and Monroe Capital (MRCC).

Overly Simplistic

Our second point is that just pointing at default rates – up “bad”, down “good” – does not tell us much.

With BDCs increasingly willing to take control of troubled companies a much more nuanced – and long term – analysis is necessary to determine the ultimate impact on BDC net book value and earnings power.

Furthermore one cannot paint with a broad brush given the very different risk dynamics in the different segments of the “private credit” market.

There are huge differences in every area when comparing lower middle market companies to upper middle market companies or to venture companies – to choose but 3 of the multiple segments in which leveraged finance operates.

There is no typical BDC any more. Almost every player is snowflake-like in their risk make-up and how their performance will play out.

That’s good for the BDC Reporter which spends most of its time spelling ouyt those differences and also for BDC investors looking for a safe place to place their money – if they do their homework.