Red flags are emerging in parts of the $1.7 trillion private credit market with an expectation for more private fund and business development companies to face increasing performance challenges, while the investment banks that had ceded market share to private funds want back in, Moody’s Ratings said in its latest report.
Warning signals are emerging as borrowers contend with the realities of potentially higher-for-longer interest rates, the ratings agency said Tuesday. Moody’s cited an increasing number of payment-in-kind loans.
“The increasing number of PIK [payment in kind] loans and nonaccruals is a red flag because it suggests that LBO [leveraged buyout] borrowers are experiencing weakening cash flows,” Christina Padgett, an associate managing director with Moody’s private credit team and an author of the report, said in a statement.
“We are seeing this trend toward greater use of PIK loans and nonaccruals to an even greater extent in the BSL [broadly syndicated loan] market. With higher rates eroding LBO performance, investment exits have slowed considerably, and new LBOs are coming at a snail’s pace,” Padgett said.
Data for PIK loans and nonaccruals was not immediately available.
The agency also expects to see more LBO defaults in the coming months, with high leverage, longer-lasting higher interest rates, rising operating costs and weaker performance hitting home, the report said.
Although Moody’s expects asset-quality erosion to grow, that “deterioration will not be uniform. For one thing, lending yields have improved as interest rates have increased, given that loans are floating-rate. Most BDCs are reporting average portfolio EBITDA growth, and credit spreads have narrowed in recent quarters, which has helped stem deterioration in investment valuations,” the report said.
Moody’s also reported that banks are “angling for [a] bigger share of private credit business” and that, although bank exposures to the market are opaque and difficult to quantify, they look moderate in aggregate. U.S. private markets represented 32% of total U.S. banking system assets as of September, Moody’s said, vs. 16% a decade ago.
Banks had been ceding ground on private debt due to regulatory restrictions, making them less likely to make and hold risky loans. While they remain critical to the credit ecosystem as providers of liquidity and financing for private credit lenders and alternative money managers, they’re still looking for more ways in. Moody’s cited increased partnerships with private credit lenders as well as global investment banks — including Goldman Sachs and Morgan Stanley — “making it a strategic priority to scale up the private credit investment platforms within their asset management businesses.”
Banks are focusing on two areas of lending: leveraged lending to corporate borrowers and asset-based finance. Examples of such partnerships include the AGL Private Credit platform and Barclays, and Societe Generale and Brookfield Asset Management, the report said.
Another area of development in private credit is asset-based finance — “the new frontier,” the report said. Large alternative money managers are “rapidly expanding their lending activities beyond corporate borrowers into the much larger and more diverse ABF [asset-based finance] market. In addition, the volume of private credit/middle-market collateralized loan obligations continues to grow.”
The report added that while structural features of private debt vehicles protect investors from asset-quality deterioration, “as ABF becomes central to asset managers’ growth ambitions, leverage will rise, as will questions about who is holding the riskiest part of the structure.”
The full report is available on the Moody's Ratings website via registration and may require a subscription.