Tom Speller, a Managing Director within the Funds Rating Group at global, full-service rating agency KBRA, chats to Private Equity Wire about the current state of the private credit market and some of the challenges and opportunities facing private credit funds and their managers…
PEW: How are current economic conditions affecting the private credit market
We understand the current rate environment has increased the appeal of private credit as an investment. Volume continues to increase despite higher borrowing costs, in part driven by a reduction of lending volume in liquid markets and the continued demand for debt capital from private equity sponsors. We’ve heard managers have seen some improvement in pricing which, coupled with the increase in interest rates, has resulted in strong returns for private credit managers. In addition, we’ve heard managers have seen improvements in terms, such as stronger covenants or lower loan-to-values (LTV), given the potential for increased volatility. Conversely, we understand there is increasing portfolio stress and or heightened vigilance in some sectors, which we expect will increase into 2024 as the impact of monetary policy and higher interest costs impact liquidity in portfolio companies. Likewise, we expect there will be greater differential in default experiences and returns across private credit managers in 2024 and beyond.
PEW: What are some of the biggest challenges being faced by private credit funds currently?
We understand that the private capital fund raising environment continues to be challenging given a slowdown in distributions and exits from private equity funds, coupled with declining valuations and volatile public markets which has left investors over-allocated to private capital. We’ve had a number of enquiries from managers, who are considering using ratings to assist in the fundraising process for certain types of investors, who would find a rated product beneficial. The observed decline in marks and delays in realisations are expected to also strain some existing portfolios of lending exposures.
PEW: What opportunities do you see emerging for private credit firms in the near future?We expect a continued expansion of the private credit market as companies and sponsors will increasingly turn to the private market for ease of execution and the growing capacity to hold loans that are significant in size. This is especially true in some regions, where banks have reduced capacity to lend or where high-yield markets remain less attractive. We released research earlier this year that discusses the marked growth in European private credit, and we expect further growth opportunities for asset managers in the region.
PEW: Is default risk on the rise due to inflation and recessionary pressures?
Yes, higher rates are impacting liquidity of portfolio companies and defaults have risen since 2022, although, to date, the volume of defaults is still relatively benign in comparison to previous periods of financial stress and when compared to the historical track record of public high-yield markets. We expect, however, that default risk will increase. We have published several papers on this topic including a stress test that examined interest coverage across a portfolio of over 2,400 private middle market companies in the event “all-in” interest costs rise to 12%-13% (terminal reference rates of 5.5%-6%). The outcome of this analysis resulted in approximately 16% of KBRA’s credit assessment portfolio suffering a material decline in credit quality or mounting liquidity pressures that in time could result in companies becoming unable to service interest payments from current cash flow – forcing greater reliance on balance sheet resources and or equity infusions. We expect this to lead to greater levels of differentiation across managers, with larger platforms that have remained very disciplined in the last several years positioned well to manage increased levels of market stress. Smaller, newer, and or less disciplined platforms will have more difficulty.
PEW: If yes, what steps are firms taking to mitigate these risks
The underwriting process serves as the most important first line of defence. Disciplined private credit managers have tightened leverage and covenant requirements and most have remained focused on sectors and companies that will be more resilient to economic headwinds. In addition, for preexisting loans, many managers have expanded their monitoring lists, and are enforcing structural protections. Most importantly, we understand in certain situations that sponsors have held the line and forced equity infusions, cost reductions, or other steps necessary to move companies into compliance with covenants. The ability to work closely and constructively with sponsors is among the reasons private credit loan performance may prove to be more resilient in this economic cycle than bank or public market loans.
Thomas Speller, CFA, Managing Director, Funds, KBRA – Tom is a Managing Director within the Funds Rating Group at KBRA UK. He joined KBRA in 2021 and focuses on the rating of Fund Finance transactions including subscription lines and NAV loans. Prior to joining KBRA, Tom was an executive director at Goldman Sachs International, where from 2006 he worked as a credit risk analyst covering a variety of industries and products, with a particular focus on the funds industry, including private equity funds and hedge funds, as well as structured lending. Tom received a BSc. in mathematics and statistics from the University of Edinburgh and is currently a CFA Charterholder.
