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The “golden age” of private credit may not have lasted long*.
Activity in private credit heated up a lot in mid-2022, but this year some juice is back in the market for leveraged loans, also called broadly syndicated loans (BSL). There are some uh noteworthy trends driving this reversal but first we have to give some background information.
These two markets – private credit and BSL – are seen as close competitors, if not substitutes. This is because they both offer variable interest rate loans (mostly) to junk-rated companies that are not large enough to easily tap bond markets. Historically, BSL deals have been larger, because they are marketed to a broader group of investors, almost like a bond offering. On the other hand, borrowers in private credit markets have a direct relationship with a smaller group of lenders.
In any case, the market for large-scale syndicated loans dried up for a while, as Barclays noted in a recent note:
However, lending was still occurring in volume. Trades have just been redirected to private credit markets. In 2022, direct lenders saw a significant rise in “jumbo tranche” deals.
While the term sounds like something out of a Pacific Rim-style summer blockbuster, it actually describes a private credit deal worth more than $1 billion:
As shown above, this shift did not last. From Barclays:
It appears that there are fewer opportunities for private credit to distribute capital towards loans similar to secured credit loans in terms of volume. The recent strength of the BSL market has reduced some of the advantages that private credit previously had over public markets. Meanwhile, private credit dry funding has risen to record levels, with dry funding reaching more than $430 billion globally as a result of several consecutive years of strong fundraising activity (Figure 11 and Figure 12). This raises the question of whether the “golden age” of private credit capital allocation is behind us.
Now the “end of the era” claim has become a bit sensational, because it is not clear that anyone ever expected private credit to replace the syndicated loan market. Much of the demand for syndicated loans is driven by collateralized loan obligations, which comprise large portfolios of loans whose diversification is intended to protect against losses. Perhaps relatedly, syndicated loan markets also became known for aggressive manipulation of borrowers at times when demand was high.
They also support this with a relatively specialized argument: the number of private credit loans that are refinanced in BSL markets versus BSL loans that are refinanced in private credit markets:
At first glance, at least, the private credit boom of 2022-2023 appears to have gone well for investors. In the longer term, stressed borrowers could move to private credit markets to refinance if BSL markets close to them.
Defaults have been relatively low in private credit compared to widely securitized loan markets. From Barclays:
But this is where things start to get a little difficult.
The problem is that companies – especially low-rated ones that borrow in private credit markets – have less ability to cover interest payments as interest rates rise. From Barclays:
So why isn't the default rate higher?
Well, direct lenders can easily offer borrowers the option to switch to payment in kind (paying interest on additional debt instead of cash). In contrast, the CLO securitization machine in the BSL market typically places a 5 percent limit on loans that allow borrowers to switch to PIK payments, according to Barclays.
Oh, and private credit lenders have been offering these types of deals more to borrowers. Last year, more than 9 percent of new private credit deals contained PIK options, more than in 2020:
In other words, borrowers certainly feel the pinch of higher interest rates, and deal with them by paying interest in kind (i.e., with additional debt).
Their lenders may be approaching the maximum period for which they can defer the account. North American private credit funds have generally called in more capital from investors than they have deployed for several years now. The bank indicates that private credit funds are on track to completely reduce total capital distributions for the first time since 2020:
As Barclays says:
In our view, the decline in private credit default rates in recent quarters is largely attributable to the PIK switch. PIK has been a great tool for issuers seeking to maintain margins and cash balances during this period of high base rates, but we believe the private credit structural advantage of including PIK may be at its inflection point. Given negative net capital distributions over the past several years, lenders with skewed cash/PIK ratios may feel greater pressure from LPs to sell portfolios in order to manufacture distributions.
For those who don't speak in euphemisms about the marketing side, the “inflection point” often means that the game of musical chairs is coming to an end.
*Credit to Robin for using the phrase “golden moment,” as moments by definition don’t last long
