The reflexive nature of the current monetary policy stance versus the resilient economy has forced the Federal Reserve to remain committed, at least for the moment, to its “higher for longer” mantra. The rising interest rates have been a boon for returns in private credit due to the floating nature of the securities, but the longer rates remain persistently high the more they present a potential risk of rising defaults and losses.
"Higher for longer" means borrowers need to carry elevated interest burdens, which broadly speaking, has resulted in a continued deterioration in interest coverage and fixed charge coverage ratios. This elevated credit risk can be observed through an increase in default rates and distressed exchanges as borrower cash flow constraints force decisions from sponsors (such as private equity firms) and lenders (specifically direct lenders) to either support portfolio companies or execute a more lengthy and expensive restructuring / bankruptcy process (Figure 1).
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That said, private credit continues to be an attractive asset class, but credit selection remains the most fundamental element of lending, particularly during periods of uncertainty, as also discussed further in our recent podcast.
Investors can aim to protect their downside by focusing on lending to companies that generate cash flow, are growing, and operate in non-cyclical, recession-resistant or recession-resilient sectors. This includes B2B services, healthcare, and B2B providers of established software and technology.
The prospects for the US middle market
In our opinion the US middle market continues to be fertile ground for such prospects. There are approximately 200,000 middle market companies in the US, the combined revenues of which - if they were an economy - would rank as the third largest in the world, employing approximately 48 million people.1
As these companies are battling continued economic uncertainty lenders are adopting more stringent approaches to risk management. Following the dislocation in credit markets in late 2022, as well as placing greater emphasis on underwriting businesses with strong free cash flow generation, they require greater protections as they consider deploying additional capital. As part of the increased selectiveness, lenders increased the number of covenants and decreased their average hold sizes for new transactions. Increased selectiveness will probably increase the number of distressed borrowers, as the current level of interest rates has begun eliminating the zombie companies who lived on free money for the prior decade. Investors are being forced to reassess the markets discount rate and in turn their required rate of return for taking investment risk, as pressure builds on the highly cyclical, capital intensive, and over-leveraged areas of the economy.
What if it goes wrong?
LCD’s data shows the number of loan issuers conducting distressed exchanges (replacing existing debt with new obligations or securities which have lower face value, longer maturities, or lower interest rates) in 2023 grew 133%, while traditional payment defaults jumped by 200%, albeit from a relatively low watermark. Distressed exchanges are the better alternative for both equity and debt holders as they preserve ownership and control for issuers and sponsors. Lenders also tend to realise higher recovery rates via distressed exchanges rather than via bankruptcy filings.
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In addition, challenging economic environments further the argument for additional operational and financial support provided by sophisticated private equity sponsors. Market activity has shown that it has been a joint effort from both sponsors and lenders to proactively support portfolio companies when necessary. The majority of recent amendment activity has involved pricing adjustments in the form of both cash interest and payment in kind (PIK) interest, sponsor infusions, maturity extensions, and covenant holidays to better assist borrowers through this environment.
Considering the market’s anticipation of interest rate cuts continues to be disappointed, it is imperative that middle market managers address credit risk concerns through credit selection; structuring; being an active, lead lender; and robust portfolio monitoring and management.
With contributions from Andrew Kurtz, portfolio manager at Man Varagon.
1. Sources: Middle Market Indicator Mid-Year 2023 report, National Center for the Middle Market:www.middlemarketcenter.org/Media/Documents/MiddleMarketIndicators/2023-Q4/FullReport/NCMM_MMI_YEAR-END_2023_012524.pdf
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