Attention in private credit is on loans that mature in the next three to five years, with more defaults inevitable, according to a panel at the Milken Institute Global Conference entitled “Private Credit in the Institutional Portfolio.”
Weakness in the private credit market remains difficult to detect, but can be seen through amendments, maturity extensions and increased PIK (payment-in-kind) interest, attendees of the panel heard.
Private credit has reverted to a much more “normal” environment than the one that prevailed in the past decade, which was defined by a flood of investor capital, cheap borrowing costs, and elevated asset prices. Higher defaults will inevitably be part of it.
Megan Neuburger, regional group head of Fitch’s US and Canada Corporate Ratings, said the rating agency’s portfolio of lower-rated credits of 300-350 companies showed more deterioration in private loans than in other categories of credit, as EBITDA growth has slowed over the past 12-18 months.
Fitch said its calculation of defaults last year on private credit was about 9%, roughly double its default rate on broadly syndicated loans, at 4.5%. The relationship-driven nature of private credit and private equity means the parties are working together, essentially agreeing on defaults.
“The nature of defaults in private credit is nuanced. About three-quarters of the defaults we see come through that portfolio are PIK interest, are extensions of maturities, so there’s sort of these ‘collaborative’ defaults that ultimately have been constructive for lender recoveries,” Neuburger said.
AI-driven disruption of software businesses was a recurrent theme this week at the Milken Institute’s flagship conference in Beverly Hills, where leaders in leveraged finance convene annually to exchange ideas on business, technology and philanthropy.
Jeff Levin, head of credit at software-focused PE firm Thoma Bravo, echoed other investors in software, noting a discrepancy between the performance of the businesses and the sentiment of retail investors with regard to the sector. But AI will undoubtedly accelerate changes for the sector, he said.
“The businesses across our portfolio are performing really well,” said Levin, who joined the firm roughly six months ago from Morgan Stanley.
“AI will accelerate the demise of certain software businesses that were already laggards, and will accelerate the profitability and growth of a certain cohort of the market,” said Levin, adding that the strongest software companies included ones that had domain expertise and operated in highly-regulated environments.
“The cohort of deals from the 2021 vintage that were levered extremely high, with modest LTVs (loan-to-value) at the time — that’s a different story today,” Levin said. He said the next six to nine months will tell about the direction of the market.
Investors are preparing for the new environment and the potential for a significant return of distressed investment opportunities, which have been lacking for more than a decade.
“All is not well in private credit. You’re seeing cracks in the ice,” said Rick Miller, Chief Investment Officer of TCW Private Credit Group, which invests in several credit strategies, including new issues, specialty lending and rescue finance.
“The US economy remains very resilient. If anything, we’re seeing challenges in companies that go onto our ‘watch list’ or go on to underperform. They’re having a harder time coming out of that,” Miller said.
Also top of mind for investors is the possibility of a new capital influx into private credit from retail retirement funds at a time of slow M&A and buyout activity. Investors in direct lending to private equity-backed middle market companies — a popular strategy in private credit — rely on robust deal flow.
Most asset managers favor 401(k) funds investing in private credit as a way to boost assets under management (AUM) and fees, but Ted Koenig, founder and CEO of Monroe Capital, said he maintains a contrarian view.
“I’m concerned about it. I don’t know if it’s the right thing to do,” Koenig said.
“What happens with all that money?... You can be the best underwriter in the world, but if you’re told you’re going to do 4x the volume in your portfolio than you have today, something’s going to give,” Koenig said.
Many institutional investors agree that increased retail participation could erode returns, Koenig said.
“They do not want to see retail money invested side-by-side with institutional accounts because they’re concerned about deterioration,” Koenig said.
For our recently released “Peek under the Hood” report and more BDC analysis, see the PitchBook website under Private Credit: PitchBook Credit Research.
Featured image by LPETTET/Getty Images/iStockphoto
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