Credit Estimates Provide Insight On Private Debt

The private debt market has more than doubled in growth over the last five years. Based on data from PitchBook, the global private debt market was estimated to be at $1.75 trillion by the end of the first half of 2023 (including private credit funds, business development companies, interval funds, and middle-market CLOs) and comparable to the U.S. Broadly Syndicated Loan (BSL) and the High Yield (HY) markets. While direct lending is the most common strategy among private lenders, other purposes for which funds are raised include special or credit opportunity funds, distressed debt lending, infrastructure, and real estate funds. These funds are managed by asset managers (general partners) while investors in this asset class are mostly pension funds, insurance companies, and sovereign wealth funds (all limited partners). Many of the loans in direct lending funds and other strategies are also allocated to middle-market CLOs.

S&P Global Ratings provides credit estimates (a point-in-time confidential indication of the likely long-term credit rating) to the CLO managers for the entities whose loans are held in the middle-market CLOs. Therefore, this scenario analysis on our CEs, which we believe to represent a sizeable portion of capital deployed in private credit, helps provide transparency in this increasingly important asset class.

Stress Scenarios And Implications On Credit Quality

In conducting the scenario analysis, we reviewed credit estimates completed between August 2022 and August 2023, noting that prior to any application of stress, 78% of the CEs had a 'b-' score, along with 13% in the 'ccc' category. Our three scenarios assume a mild, moderate, and severe stress case with S&P Global Ratings-adjusted EBITDA (at the time the CE was last reviewed) declining 10%-30% combined with SOFR increases of 0.5%-1.5% from our base case--which recasts the issuer's last 12 months (LTM) interest expense to reflect our current base-rate expectations of around 5% in 2023.

We believe that a dual combination of rising interest rates and a widespread decline in earnings is an unlikely phenomenon, with the Federal Reserve likely to hold rates steady (or cut them) if there are pervasive economic issues and a sustained deterioration of earnings across U.S. corporates. However, we still sought to assess how credit estimated issuers in the middle market universe would be affected by the stresses, and the extent to which they are positioned to withstand a combination of higher funding costs coupled with deep pressure on their margins.

On the earnings front, we have already seen cost inflation, supply issues, and labor constraints that have led to margin compression. Although inflation has moderated since the beginning of this year, the latest Consumer Price Index (CPI) reading of 3.7% remains above the Federal Reserve's 2% target, signifying uncertainty around whether the Fed will continue to push beyond its current overnight rate target of 5.25%-5.50%. Thus, increasing rates remain a critical consideration for middle-market issuers whose capital structures are typically composed entirely of floating rate debt. Furthermore, we are seeing an increasing number of cases in recent transactions where investors command a higher premium with credit spreads above SOFR pushing beyond 7%, compared to around 6% or less on earlier deals.

Specifically, we sought to measure the impact of our hypothetical stresses on key credit metrics including leverage (debt to EBITDA) and interest coverage (EBITDA to interest) ratios, cash flow, liquidity, and covenant headroom. Based on that information, we also inferred that a portion of CEs with predominantly 'b-' scores would be highly vulnerable and reflect risk profiles more consistent with those of 'ccc' category credits.

Leverage

Median leverage ratios could rise to double digits in a severe stress scenario, and would remain elevated in all stress scenarios.   Based on our three stress scenarios, median debt to EBITDA (S&P adjusted) ratios ranged from 7.9x-10.1x, suggesting leverage that already stands at 7.1x in our base case will remain elevated under all of the stress scenarios and would reach double digits in our most punitive scenario.

Chart 1

Interest coverage

Concurrently, in all stress scenarios, the median interest coverage ratio falls below 1.5x, with a range of 1.1x-1.4x, implying that many issuers would experience challenges servicing debts solely from the cash flows they generate. Under our base case, about 20% of our sample (approximately 425 issuers) have interest coverage ratios below 1.0x, which would increase to 26%-44% of the portfolio (approximately 550-920 issuers), depending on the level of stress.

Chart 2

A combination of elevated leverage and weaker interest coverage ratios would have adverse implications for issuers already feeling pressure from higher interest costs that have yet to be fully realized in their financial statements, but which have already been factored into our base case. Hence, more borrowers could face higher borrowing costs, difficulty remaining compliant with covenants, and could require liquidity drawn from supplemental sources of cash like revolvers and delayed draw facilities.

Cash flows

Less than half of the issuers could generate positive free cash flows even under our least punitive stress scenario.   While 55% of issuers have positive free cash flow under our base case, that percentage drops to 46% in a mild stress scenario, 35% in moderate stress, and 25% in severe stress. We recognize most companies would likely cut growth capital expenditures, address working capital issues, and introduce other cost rationalization measures to help offset cash flow weakness. However, delaying growth investments could hurt revenues in the medium to long run.

Chart 3

Liquidity

Liquidity appears sufficient in the near-term, but covenant relief may be required as headroom tightens.   Base case liquidity ratios (sources to uses over a prospective 12-month horizon) appear strong with a median of 2.4x. This metric remains at or above 1.5x even in a severe stress scenario, suggesting that most borrowers have enough in the way of cash on hand, revolver or delayed draw term loan capacity, and other sources to navigate a rough patch over the next year or so. However, their ability to meet financial obligations beyond that timeframe if rates remain high remains uncertain.

Chart 4

Unlike loans in the BSL market, the vast majority of issuers for whom we provide credit estimates have loans with financial maintenance covenants. Based on a subset of portfolio issuers who are currently subject to specific financial covenants--including a maximum total leverage test or a minimum fixed charge coverage ratio (which constitute about two-thirds of the CE portfolio)--we estimate that roughly 70% of them would be able to maintain headroom above 15% in a mild stress scenario, decreasing to below 40% of the subset in a severe case. We believe issuers who fall below the 15% headroom threshold are much more sensitive to unforeseen risks. Therefore, if stressed, an increasing number of borrowers would need to seek covenant relief from lenders; though lenders have generally been amendable, they often grant such relief in return for higher margins, fees, or general tightening of documentation.

For calculating covenant headroom, we used reported EBITDA from recent covenant compliance certificates, which we believe is more representative for the exercise. We acknowledge this calculation does not account for nuances across different credit agreements, but we believe it is a reasonable approach for estimating the impact of our stress scenarios on covenant headroom across the issuer subset.

Staggered Maturity Schedule Provides Only Temporary Reprieve For Borrowers

The debt maturity schedule for credit-estimated issuers is mostly staggered, with the bulk of loan principal maturing over the next several years coming due in 2026 and 2027. However, with debt maturities ramping up in less than two years, a potential higher-for-longer interest rate environment could be problematic for borrowers contending with cash flow deficits for an extended period. We also note that among the three most represented sectors in the CE subset, Business Services companies have significantly more debt principal maturing in the near term than both Healthcare Services and Technology Software and Services companies.

Chart 5

Technology Software And Services Credit Estimates Show Fissures In Our Stress Scenarios

Roughly 55% of the CE issuers are categorized into one of three sectors--Business and Consumer Services, Technology Software and Services, and Healthcare Services. These three sectors are popular with investors in the private markets given their growth prospects. Furthermore, they are widely viewed to be relatively resilient in tougher economic conditions due to various characteristics including their noncyclical nature, recurring cash flow streams, high customer switch costs, low capital intensity, and recent demographic and technological trends.

Out of these three sectors, the Technology Software and Services space appears to be the most vulnerable in our stress scenarios. Although its leverage metrics are comparable to those of Healthcare, CEs in the Technology sector had a materially weaker median interest coverage ratio and covenant headroom. In a moderate stress scenario, we expect median leverage for tech issuers would exceed 10x, along with interest coverage below 1x and covenant headroom of less than 10%.

Conversely, the Business Services sector seems to be on firmer footing with a turn less of leverage and significantly more covenant headroom than the other two sectors. Notwithstanding the discussion of the three sectors, we also note that the Telecom and Cable sector, which has much less representation in our CE dataset, also exhibited very weak credit measures and interest coverage ratios at or below 1x in any stress scenario.

With Limited Capacity To Absorb Stress, More 'b-' Issuers Are Falling Into The 'ccc' Category

We continue to see an increasing trend of downgrades into 'ccc' territory, with 87 issuers falling into the category from the beginning of 2023 though the end of August. Over the last year and a half, reference rates for loan issuers have jumped by more than 400 basis points and driven up debt servicing costs significantly. The downgraded companies often had capital structures that we viewed as unsustainable absent favorable economic and financial conditions, or upcoming loan maturities without a definite plan to extend, refinance, or redeem the debt. We expect this downward trend to accelerate when applying our stress scenarios. This could increase middle-market CLO 'ccc' baskets, which currently average about 12.3% versus the typical threshold of 17.5%; beyond which, CLOs would have to take a haircut on excess 'ccc' assets when calculating their overcollateralization (OC) ratios.

In attempting to assess the impact of stress on credit quality, we identified credits in the single 'b' category that might reflect certain credit attributes often associated with CE scores in the 'ccc' category: a significant portion of debt maturing within 12-18 months, leverage exceeding 14x, or interest coverage below 1x with less-than-adequate liquidity.

As seen in the table below, 5% (90 companies) of these issuers have a substantial debt maturity before mid-2024, which indicates a significant level of refinancing risk. If we take the analysis a step further to include companies without a substantial near-term maturity, but who would have a debt-to-EBITDA ratio exceeding 14x or an EBITDA-to-interest ratio below 1.0x with less-than-adequate liquidity in a stress scenario, the potential downgrade exposure to 'ccc' category scores could grow to a range of 21%-33% (291-508 companies). We note that leverage ratios approaching the mid-teens are generally viewed as excessive for most issuers, and interest coverage below 1x with less-than-adequate liquidity is often indicative of a future payment default barring any sponsor or lender intervention.

Table 3

Issuers With Specific Features In Their Credit Agreements Are More Exposed To Stress

Specifically, we view some credits, including those with annualized recurring revenue (ARR) covenants and options to pay-in-kind (PIK) interest as more susceptible to stress.

Issuers with ARR covenants, which are initially based on recurring revenues rather than the more traditional EBITDA metric, are primarily present in the technology space and comprise 78 names (less than 4% of the portfolio). More than 70% of those entities are already estimated at the 'ccc' category since these are typically early-growth stage companies with very low EBITDA and cash flow, in addition to high leverage. Accordingly, they are more dependent on revenue growth and retention, as well as relatively higher sponsor equity contributions. Many of these issuers also take advantage of accommodative terms such as nonamortizing principal balances and the ability to PIK interest. For more information on ARR loans, readers can reference our recent article "Rocky Road Ahead For Recurring-Revenue Loans," on Ratings Direct.

There are three types of PIK instruments in the companies we review. The first category includes instruments paying mostly cash interest along with a smaller PIK component that serves as additional appeal for lenders. The second category of PIK instruments are structured to toggle by allowing the issuer to choose whether to PIK or pay cash, a form more commonly seen in recurring revenue deals and early-stage tech companies where growth is predicated on upfront investments in infrastructure or customer acquisition and retention. The third category poses the greatest risk--these are loans where the issuer has executed an amendment to defer interest payments because of the company's inability to disburse cash interest payments mostly due to performance issues. We have seen around two dozen instances of such amendments this year and will likely see more as the full impact of higher rates flows through issuers' financial statements.

A small portion of the CE portfolio has covenant-lite term loans with covenants that are not tested until revolver utilization exceeds a predetermined threshold. Such loans are an exception rather than the norm for middle-market deals; however, the absence of a financial maintenance covenant limits the lender's ability to implement countermeasures as credit performance deteriorates. Given that virtually all these credits are currently scored at 'b-' or higher, any material deterioration in financial performance can quickly translate to a downgrade given the limited avenues for lender intervention.

CE Defaults Remain Muted, But Accelerating Transitions To 'ccc' Reveal Vulnerabilities In The Wider Market

Credit estimated companies that we track exhibited a default rate just below 3% in the second quarter of 2023 (including selective defaults [SD]) and around 0.3% excluding SDs, confirming that sponsors and lenders prefer out-of-court resolutions rather than allowing a full payment default that may lead to bankruptcy.

We note that out of all the CEs we reviewed from August 2022 to August 2023, 79 companies (approximately 4%) were determined to have experienced a recent selective default. In addition to deferral of interest, another major driver of selective default is the extension of debt maturities (without adequate compensation) to buy time for a full-scale refinancing or sale of the business at desirable terms.

As the full weight of higher interest charges flows through borrower financials during the latter part of 2023 and early 2024, an increasing number of middle-market companies could become distressed due to deteriorating cash flows, lower coverage ratios, and tighter liquidity. Thus, sponsors' willingness to inject additional equity into underperforming portfolio companies may be tested along with lenders' flexibility on covenants and debt maturities.

In the next 6-12 months, we believe there will be an increase in specified amendments, and the lenders' playbook for navigating the current higher-rate environment could resemble actions taken during 2020--including conversion to PIK interest, pushing out loan maturities, covenant waivers or suspensions, and rolling amortization payments into bullet maturities. However, the viability of such solutions hasn't been tested in prolonged stress, and we would expect to see a material pickup in defaults if interest rates remain high for a longer period.

Methodology And Assumptions

• For this analysis, we incorporated all unique credit estimates assigned between August 2022 and August 2023.
• Credit estimates are a confidential indication of the long-term credit rating on an unrated entity. This point-in-time analysis may not reflect significant developments since the issuer was last reviewed. Nevertheless, we find that our estimates are often less than six months old given ongoing manager requests and annual assessments across multiple CLOs.
• Debt and EBITDA figures referenced in this study are generally based on S&P Ratings-adjusted numbers. For more details, please see our Ratios and Adjustments criteria.
• The analysis does not account for tax shields or interest rate hedges. We note that middle-market issuers typically maintain little or no interest rate hedges and are usually structured as LLCs that tax the company at the shareholder level.
• In selecting our range of base rate increases for the various stress scenarios, we considered current macroeconomic conditions and recent public comments from Federal Reserve officials.