By Chiara Elisei
LONDON (Reuters) – Stellar growth in private debt markets over the past decade looks set to face a reality check as a looming recession and higher interest rates squeeze companies’ earnings and their ability to service borrowing costs.
An era of ultra-easy cash from central banks lured investors into private credit, attracted by juicy returns in the high-single to low-double-digits.
Regulation in the wake of the global financial crisis forced banks to dial back on lending to corporates — particularly riskier ones. This opened the way for investment funds, such as Blackstone, to fill the gap and lend money to companies, which are often owned by private equity firms.
But the private debt market — the fastest-growing in the credit sector since the financial crisis — is about to hit a speed bump as investor appetite for risky assets is tested by aggressive monetary tightening and recession.
The private debt market has expanded to $1.4 trillion, up from $250 billion in 2010, according to data provider Preqin, with funds including Ares, Blackstone and KKR holding big positions.
“Some of those companies – particularly in the mid-market space – will face real difficulty, especially if it’s not, as the market is anticipating, a shallow recession,” said Jason Friedman, global head of business development at Marathon Asset Management.
The jury is out on how private lenders will react if the downturn might be more prolonged rather than “six months and I’m through it”, said Friedman, with the threat of a lengthy decline in earnings and potentially higher defaults looming large.
Major central banks have ramped up rates at breakneck speed, the European Central Bank is delivering its fastest tightening cycle ever. Meanwhile, the global economy is expected to tip into recession as high rates and inflation take their toll, which makes for a much tougher environment for corporate borrowers.
WARNING SIGNS
As central banks drain trillions of dollars of extra cash they pumped into the economy over the past decade, warning signs are already flashing, such as a surge in redemption requests at an unlisted Blackstone real estate income trust.
Corporate default risks are rising, making investors think twice about holding riskier private debt.
A Private Credit Default Index by law firm Proskauer showed a default rate of 1.56% on U.S. dollar-denominated deals in the third quarter, the first notable increase over the past 18 months.
This is similar to a 1.6% default rate in the public debt markets for speculative-grade corporates in the United States, based on data as of September 2022 from S&P Rating.
The agency expects the speculative-grade default rate to hit 3.75% by September 2023.
“The (private credit deals) default rate was extraordinarily low during the past 18 months so it’s not surprising to see it rise, particularly when the market is generally under pressure,” said Peter J. Antoszyk, Co-Head of the Private Credit Restructuring Group at law firm Proskauer.
“While the default rate is likely to go up, I wouldn’t expect to see a significant spike in 2023,” he added.
After the COVID-19 pandemic, support from private equity owners and private creditors helped to keep payment defaults to a minimum, according to S&P Global Ratings.
Whether that happens in the coming year depends on the severity of any recession.
“In the worst-case scenario of a protracted recession, some of these businesses will need to restructure their debt in a higher rates environment and perhaps raise the cost of funding to 10% interest plus – I am not sure how they will all be able to come out of it,” said Ruth Yang, Global Head of Thought Leadership at S&P Global Ratings.
PROS AND CONS
The private, largely bilateral nature of the market could prove to be a saving grace.
Yannick Le Serviget, Global Head of Leveraged Loans and Private Debt at 184 billion euro asset manager AXA IM Alts, said one advantage was companies have to deal with only a handful of lenders rather than a large pool of creditors, making it easier to extend maturities and survive a downturn.
But a big challenge will be cash management with companies often not having a variety of financing lines to access regularly.
“If they need cash, the capacity of the shareholders to put additional money in the business will be critical,” Le Serviget said.
A number of debt funds are looking at strategies such as bringing restructuring and legal experts in house to tackle potential problems at companies in their portfolio in advance.
But it is not all doom and gloom.
“There will be very interesting (prospects for) rescue financing and opportunistic lending, where if you can see through the problem twelve months from now, you can finance your way through it,” Friedman said.
(This story has been corrected to change spelling in text paragraph 5 and graphic to Preqin, not Prequin)
(Reporting by Chiara Elisei, editing by Dhara Ranasinghe, Karin Strohecker and Jane Merriman)