Private credit’s “ golden age ” might’ve not lasted very long*.
Activity in private credit heated up a lot in mid-2022, but this year some juice has returned to the market for leveraged loans, also called broadly syndicated loans (BSL). There are some, uh, noteworthy trends driving this reversal. But first we should give some background.
Those two markets — private credit and BSL — are seen as near competitors, if not substitutes. That’s because both make floating-rate loans to (mostly) junk-rated companies that aren’t quite big enough to easily tap bond markets. Historically BSL deals have been bigger, because they’re marketed to a wide array of investors, almost like a bond offering. Borrowers in private-credit markets, on the other hand, have a direct relationship with a smaller group of lenders.
Anyway, for a while the market for Broadly Syndicated Loan deals dried up, as Barclays pointed out in a recent note:
Lending was still happening in size, however. The deals just got redirected to private-credit markets. In 2022, direct lenders saw a noticeable uptick in “Mega Tranche” deals.
While the term sounds like something from a Pacific-Rim-style summer blockbuster, it actually describes a private-credit deal of more than $1bn:
As shown above, this shift did not persist. From Barclays:
There appear to be fewer opportunities for private credit to deploy capital toward BSL-style loans in size. The recent strength of the BSL market has reduced some of the advantage that private credit previously held over public markets. Meanwhile, private credit’s dry powder has climbed to record levels, with over $430bn of dry powder globally due to several consecutive years of robust fundraising activity ( Figure 11 and Figure 12 ). This prompts the question of whether the ‘golden age’ of private credit’s capital deployment is behind us.
Now, the “end of an era” claim is a bit spicy, because it’s not clear that anyone ever expected private credit to replace the syndicated loan market. A large part of syndicated-loan demand is driven by collateralised loan obligations , which have big portfolios of loans whose diversification is meant to protect against losses. Perhaps relatedly, syndicated loan markets also became known for aggressive borrower gamesmanship in times when demand was high.
They’re also backing this up with a relatively niche argument: The number of private-credit loans being refinanced in BSL markets vs BSL loans being refinanced in private credit markets:
At first glance, at least, it looks like the 2022-2023 private credit boom has gone pretty well for investors. Over the long term, it’s possible that stressed borrowers could move to private credit markets to refinance if BSL markets shut down for them.
And defaults have been relatively low in private credit compared to broadly securitised loan markets. From Barclays:
But this is where things start to get a little bit tricky.
The catch is that companies — especially lower-rated ones borrowing in private credit markets — have less ability to cover interest payments as rates climb. From Barclays:
So why isn’t the default rate higher?
Welllllll, direct lenders can easily offer borrowers the option to switch to Payment-In-Kind (paying interest in additional debt instead of cash). The BSL market’s CLO securitisation machine, in contrast, typically puts a 5-per-cent limit on loans that allow borrowers to toggle to PIK payments, according to Barclays.
Oh, and private-credit lenders have been offering those types of deals more to borrowers. Last year more than 9 per cent of new private credit deals had PIK options, more than in 2020:
In other words, borrowers are definitely feeling the pinch of higher interest rates, and have been dealing with it by paying interest in kind (ie with additional debt).
And their lenders may be approaching a limit to how long they can put off a reckoning. North American private-credit funds have on aggregate called more capital from investors than they’ve distributed for several years now. Private-credit funds are on track for their outright decline in gross capital distributions for the first time since 2020, the bank points out:
As Barclays puts it:
In our view, the suppression in private credit default rates in recent quarters is largely attributable to PIK toggles. PIK has been a great tool for issuers seeking to preserve margins and cash balances during this period of elevated base rates, but we believe that private credit’s structural advantage of PIK inclusion may be at its inflection point. Given negative net capital distributions for the past several years, lenders with skewed cash-pay/PIK proportions may feel greater pressure from LPs to sell down portfolios in order to manufacture distributions.
For those who don’t speak in sellside euphemisms, “inflection point” often means that a game of musical chairs is nearing its end.
*Credit to Robin for using the phrase “golden moment” , as moments by definition don’t last very long