Private credit has long been an important source of funding for small and middle-market borrowers, alongside the broadly syndicated loan and speculative-grade bond markets. But it wasn’t until recently that the private credit market has seen such explosive growth. This decade-long expansion (against the backdrop of rising credit pressures) has put the focus on the burgeoning risks in an opaque market.

The risk factors associated with private credit are the same as those for mainstream credit—but the emphasis will differ depending on where a borrower is in its life cycle, as well as broader credit conditions. As signs of credit stress emerge and defaults creep up, it remains to be seen whether this “golden age of private credit” can continue.

At S&P Global Ratings, our independent opinions on creditworthiness take a holistic view to provide greater transparency for the totality of private markets participants—from direct lending, business development companies, and middle-market collateralized loan obligations, to private equity, fund financing, and beyond.

Loan Pricing Marches Higher In March

Decreased liquidity and slowing market dynamics have elevated the importance of assessing secondary markets as an indicator of market health, especially when considering the viability of an exit strategy. With liquidity in the public debt markets slowing over the past few years, there's been a shift to more of a buy-and-hold strategy—mirroring private credit markets. Against this backdrop, our proprietary analysis of secondary market pricing for leveraged loans provides transparency on evolving market dynamics.

After leveling out last month, the average bid on all loans in our data set rose to 98.91 as of March 15, marking its highest level since we started sampling in October 2022. The rally includes sponsored and not sponsored loans, with average bids reaching highs of 98.71 and 99.29, respectively, for first liens. Market dynamics continue to improve, and the bid-ask spread for sponsored first liens is now just 5 basis points (bps) wider than not sponsored first liens at 72.5 bps and 67.9 bps, respectively. The distressed ratio for all loans we cover fell to 13.2%—the lowest level in our coverage.

How We Rate Alternative Investment Funds

Alternative investment funds (AIFs) are increasingly turning to credit markets through bond issuance, net asset value facilities, capital call facilities, and subscription lines to diversify and optimize funding, as well as focus on credit investment strategies including private loans.

While uneven liquidity and strained valuations have buoyed this latest burgeoning activity, S&P Global Ratings has provided transparency on this expanding market since 2006—and our coverage and criteria have evolved. We apply our global framework for rating AIFs (updated most recently in 2021) to various funds whose investment strategies span private and public equity, venture capital, and private debt, as well as hedge funds and other investment companies that share key characteristics of AIFs.

Key rating factors include the fund's risk-adjusted leverage, funding, and liquidity. Our analysis calculates the stressed leverage for different types of funds, captures the risks relating to the funding and liquidity of different fund structures, and provides clarity on how we rate instruments issued by AIFs.

Scenario Analysis: Testing Private Debt's Resilience Through The Credit Estimate Lens

In an effort to provide insights on the broader private debt market, we generated a scenario analysis on more than 2,000 credit estimated (CE) issuers with more than $400 billion of aggregate outstanding debt to help assess middle-market issuer durability in the face of rising interest rates and margin erosion. Most borrowers for which we have credit estimates are highly leveraged, and median credit metrics could approach precarious levels under moderate or severe stress scenarios. Some CEs scored predominantly at 'b-' could present characteristics often associated with the 'ccc' category and may be at risk of downgrades under these scenarios, potentially increasing the proportion of 'ccc' assets in middle-market collateralized loan obligations (CLOs). Even though we expect less than half of the issuers would generate positive free operating cash flow (FOCF) in a mild stress scenario, overall liquidity appears supportive for the near term. Like broadly syndicated loans, debt maturities for CEs appear manageable for the next 12-18 months, but a sustained higher interest rate environment would cripple many issuers ahead of a heavier maturity schedule that begins in 2025. Although default rates have remained low, recent downgrade trends point to vulnerabilities in the middle market.

Private Credit Demand Spurs Growth Of Nontraded Business Development Companies

Total assets of business development companies (BDCs) and interval funds rose by near 12% over the past year to $325 billion in third-quarter 2023, and this growth is supporting the availability of funding for private credit borrowers. Nontraded BDCs have led the recent growth, with total assets of nontraded BDCs nearly tripling over the past two years. While private credit borrowers have shown progress reducing near-term maturities over the last year, these recent refinancings are adding to the maturities coming due in 2028. The average yield on a private credit loan fell somewhat in the third quarter of 2023, down 48 basis points (bps) to 10.3% as investors began to look ahead to eventual rate cuts.

ABS Frontiers: The Blurring Of Private Credit Funds And CLOs

We are increasingly seeing private credit fund proposals that include credit tranching of some of their capital structures, which makes them more comparable to collateralized loan obligations (CLOs).

A key differentiator in leverage between CLOs and alternative investment funds (AIFs) has been the presence of any market value or refinancing risk. AIFs that effectively mitigate these risks may have credit risk profiles that bear similarities to middle market CLO transactions.

Our rating analysis of private credit funds assesses the manager's ability and track record to manage risks, including credit, funding and liquidity, legal, operational, and counterparty risks. There may be specific mitigants to these risks in CLO structures, but they may come at the expense of less flexibility for the collateral manager.

We may view the creditworthiness of certain financial obligations issued by AIFs' utilizing securitization technology as less dependent on the overall creditworthiness, or issuer credit rating (ICR), of the AIF.