(Editor's Note: Market participants' need for transparency on the full scope of credit risk will expand as the financial system innovates—with increasing interplay and interconnection between public and private markets. Systemic Risk is a new commentary series from S&P Global Ratings, providing perspective on private credit's characteristics, the dynamics of U.S. banks' loans to nonbank financial institutions, and the global state of play for this bank-nonbank nexus.)

Private Credit Is Here To Stay, But Will Follow Its Own Path

The headwinds that will shape 2025—including uncertainties around future interest-rate cuts, broader financial market volatility, and concerns over the new U.S. administration's tariff and tax policies—could have an outsized impact on smaller and riskier companies. The unique structural factors of private credit could elevate risks, or potentially act as mitigants.

Private credit demonstrated its resilience last year during the first true test of its durability and competitiveness in relatively normalized credit markets. In many ways, private and public markets performed similarly in 2024, with booming issuance and tightening spreads as demand outstripped supply. Both sides of the credit spectrum appear to have transitioned to a higher cost of funding without experiencing substantive default rates.

As interest rates declined and the likelihood of a global recession faded, the BSL and bond markets both reopened with a vengeance to post record new issuance in 2024. Both aggressively flexed refinancing debt back into public markets against the backdrop of spreads tightening across the board—falling roughly 90 basis points (bps) to around 304 bps at the start of 2025, from nearly 395 bps at the end of 2023, according to LevFin Insights data. The drop was spurred by investors' appetite for blockbuster BSL CLO issuance.

Private credit spreads also compressed, albeit not as aggressively. For deals that recently refinanced from private credit to the syndicated market, spreads narrowing by a median of 250 bps indicate significant savings for borrowers qualified to make the leap. The continued growth of private credit can be best demonstrated by the expansion of middle market CLOs in 2024, based on their growing appeal to institutional investors.

But there are fundamental structural differences between public and private credit, and those differences create both challenges and opportunities for private credit market participants. The ability to maintain documentation quality, the utilization of PIK features to manage cash, and the challenge of valuations in a highly illiquid market will require participants' clear understanding of the nature of private versus public.

Systemic transparency provides a clear line of sight on changing market dynamics and performance.

Credit Estimates Shine Spotlight On Private Credit's Performance Under Duress

S&P Global Ratings' credit estimate universe—representing nearly $800 billion of total debt in 2024 from roughly 3,000 borrowers—provides unique insights into the performance and structures within the direct lending market. Credit estimate scores serve as an indication of credit quality for unrated entities whose loans are held in middle market CLOs.

The majority of borrowers are the small and midsize enterprises (SMEs) with median EBITDA of approximately $30 million that are the foundation of private credit. Ultimately, this credit estimates portfolio provides a unique perspective into how private credit is performing and how its structures will evolve as private and public markets compete for paper.

Borrower performance at large improved throughout last year on the back of resilient economic growth, solid corporate earnings, repricing activity, and the U.S. Federal Reserve's 100 bps reduction to benchmark interest rates providing incremental relief for highly leveraged companies. For private credit in particular, the softening in the cost of funding helped reduce pressure on liquidity and cash flows as the median EBITDA cash interest coverage ratio for credit estimates crept up over the course of the year to 1.6x (from 1.5x in 2023).

Default rates also declined as credit quality strengthened, as seen in the improvement in credit estimates' downgrade-to-upgrade ratio. This ratio has steadily declined from 4.8 in the third quarter of 2023 to nearly equalize at one-to-one by the fourth quarter of 2024. Looking ahead, we expect downgrades to continuing to moderate, with the likelihood that they could still exceed upgrades early in 2025.

Because of private credit's fundamental nature as the primary source of funding for SMEs and private markets' overall capacity to carry riskier credits, credit estimated borrowers are skewed towards the lower end of the score spectrum. Approximately 84% of our credit estimates are scored at 'b-' or higher. The remaining 16% are in the 'ccc' category, which is characterized by capital structure unsustainability, liquidity concerns, and higher vulnerability to non-payment. This is higher than the 14% of 'CCC' or lower rating category currently in the S&P UBS Leveraged Loan Index on an issuer count basis.

Rate cuts, however, remain in flight. Given our expectations of an additional interest rate cut in 2025 and more to follow from the Fed next year, we analyzed EBITDA-to-cash interest coverage capacity across our entire portfolio of credit estimate borrowers at various SOFR levels. As our policy rate forecast declines to 3.6% by the end of 2026, an additional 1% of our credit estimates (approximately 30 companies based on the 2024 portfolio construct) could see their annualized cash interest coverage capacity move above the 1x mark with all other factors held constant.

However, our analysis shows that the transition to a structurally higher cost of funding is wearing on the smaller, riskier credits. Our longer-term benchmark projections bottom out near a 3% neutral rate, hinting that there may be limited supplementary relief for debt-laden entities.

Even with more favorable rates, many weaker credits in the 'ccc' category will remain vulnerable to elevated borrowing costs, cash outflows, and other stresses including margin pressure from residual inflation. As we expected, the 'ccc' population has less capacity to cover interest rate charges at our baseline 4.1% policy rate assumption for 2025 versus the 'b-' and higher population. Likewise, they are more likely to underperform if the descent in rates does not materialize as expected.

Distress is also more prevalent in some industries than others—including those with compelling growth prospects like software and health care services, which together represent more than a fifth of our credit estimate universe. The year-end 'ccc' score distributions for those industries were roughly 27% and 20%, respectively, compared to 16% across the entire credit estimate portfolio. We have observed shrinking liquidity for 'ccc' category software and health care credits, whose median sources-to-uses ratios indicate a median liquidity runway of a year and a half or less.

Ultimately, moderating interest rates should continue to open the offramp of exits for private equity. We also expect the rise in mergers and acquisitions (M&A) and leveraged buyouts (LBOs) that gained momentum in 2024 to continue this year, opening more exit opportunities for sponsors and driving redemptions or refinancing for some of the unresolved near-term debt maturities weighing on certain borrowers in the 'ccc' camp. An increase in activity should also translate to fewer maturity extensions, which often produce selective defaults for riskier credits.

This year could see roughly $45 billion of debt at credit estimated entities come due—followed by a mostly staggered schedule through the end of the decade and the largest concentration in 2028 at around $190 billion, according to our latest analysis.

Private Credit Offers Unique Features Compared To Traditional Debt Markets

Beyond public and private credit's numerous similarities, private credit provides several advantages that borrowers seek particularly in world with a higher cost of funding. Key differentiators include structural flexibility from payment-in-kind (PIK) and delayed draws, recurring revenue loans, and certainty of closing. As a result, capital flows to private markets have continued to grow. Although more than $65 billion in private credit flexed back to BSL in 2024, that represents less than 5% of BSL's total volume. At the same time, private credit also grew in 2024 by a record $39 billion of middle-market CLOs printed (totaling 77 transactions).

Nonetheless, there's no doubt that the upper end of private credit has become intensely competitive with BSL as investors on both sides pursuing the same paper. Spreads over SOFR have narrowed to 500 bps or less for many middle-market loans. Under this dynamic, documentation and covenant quality will likely continue to weaken in the upper middle-market.

Additionally, we've seen many cases of financial maintenance covenants being amended away in parts of the upper and core middle-market. Anecdotally, we've also noticed some "covenant-loose" deals that make it very unlikely for a borrower to trip the covenant barring very substantial deterioration in operating performance—which can constrain lender opportunities for early intervention when borrowers run into trouble and impede eventual recoveries.

Even though the presence and quality of upper middle-market covenants have weakened, our analysis of 300 borrowers with private credit agreements executed in 2024 demonstrated that approximately 80% still had at least one maintenance covenant in place. Notably, such covenants were not as prevalent for larger debt structures of more than $750 million, where over 60% of the transactions reviewed do not have a financial maintenance covenant. This is slowly starting to resemble the BSL market, where about 90% of the loan structures are covenant-lite.

To be sure, there is some level of conservatism and credit protection in the other parts of the loan documentation. For 22 companies that had refinanced from the BSL market into private credit, those documents were generally tighter with regard to capping EBITDA addbacks and putting guardrails on asset transfers that have led to contentious liability management transactions in the syndicated world.

Given the relative strength of documentation and relationship-based lending, we have yet to see lender-on-lender violence in any of our credit estimates. We note that the private debt-financed online learning platform Pluralsight made news headlines last year after it raised new preferred equity through a drop-down of intellectual property (IP) to a non-guarantor restricted subsidiary and used the proceeds to pay its interest before subsequently restructuring via a debt-to-equity conversion.

One of the key structural differentiators between public and private is the relative frequency of PIK features in private credit. PIK interest has long been a hot topic for investors as some view it as a key tool for borrowers to maintain financial flexibility, whereas others see it as nothing more than a way for over-levered companies to "kick the can down the road" as their debt continues to grow and accumulate interest.

PIK features have increased in popularity as borrowers and their financial sponsors continue to seek optionality in an accommodative market. However, PIK comes in many flavors and isn't solely used as a way for struggling borrowers to defer payments in order to preserve liquidity. As a barometer of PIK-for-distress, 70% of 104 selective defaults (SD) in 2024 were a result of borrowers amending their credit agreements to defer interest, compared to 52% of 121 SDs in 2023.

Analyzing business development company (BDC) holdings shows the prevalence of private credit's PIK usage. Based on our analysis of filings for more than 165 BDCs, approximately 11.7% of private and syndicated loans ($39 billion at fair value) held in these vehicles were making PIK payments in the second quarter of 2024—versus less than 10% (around $25 billion fair value) in the second quarter of 2023. Similarly, the average proportion of PIK interest income as a percentage of total interest income for 14 publicly rated BDCs increased to 9.5% in the second quarter of last year, up from 8.5% for the same period year-over-year.

However, most PIK interest and dividends were from performing credit originated with PIK components—rather than borrowers executing an amendment due to liquidity constraints and switching from cash-pay. PIK toggle options are more common in larger debt stacks, pointing to the flexibility sought by (and granted to) borrowers at the upper end of the direct lending market.

Across our credit estimate portfolio, a vast majority of borrowers stood on solid footing in 2024 regarding liquidity, which should curb wider necessity for cash-to-PIK amendments. There is also strength in earnings based on the growth rates materializing for revenue and EBITDA in key sectors. Last year's median sources-to-uses ratio for credit estimates was around 3.6, and only 11% of borrowers (or 294 companies) had a liquidity ratio below 1.2—which would usually be assessed as "less than adequate" and infer a need for near-term support.

Credit Estimate Defaults Are Trending Lower, Even As Some Larger Companies Are Failing To Meet Their Debt Obligations

The implications of tightening benchmark rates and spreads have already begun affecting borrower risk profiles—with a reprieve that should continue to flow through companies' financial reports in the coming months and ease pressure on interest coverage ratios, cash flow, and liquidity. That view is supported by the declining rate of private debt defaults, assessed through the credit estimates lens. The last 12 months' total default rate for credit estimates, which has historically been higher than the BSL default rate, has now declined below its syndicated counterpart to 4.4% (from 5.7% at the end of 2023).

We also expect the issuer-level U.S. speculative-grade default rate will fall to 3.25% by September, which is a positive sign for private credit. The BSL default rate at the end of 2024 was 4.7%.

Although the 23 instances of credit estimate payment defaults in 2024—based on missed interest or principal payments—surpassed the 19 we were notified of in 2023, the payment default rate has remained relatively stable around 1% or less since mid-2021 due to the significant growth in credit estimate volumes. (Excluding SDs, the default rate marks just under 1% for credit estimates.)

While credit estimate payment defaults remain low, sponsors are choosing to walk away if the economics no longer justify further support from a valuation standpoint in instances where borrowers are extensively stressed. In our view, this trend is likely to continue if interest rates remain elevated.

Nonetheless, a greater portion of 2024's payment defaults were attributed to larger borrowers. Roughly 35% of our credit estimate universe with a general default (or 8 of the 23 entities) had more than $500 million of committed debt. This was a significant increase from prior years, as only 6% (or 4 of 62) of aggregate payment defaults from the beginning of 2020 through the end of 2023 were on debt structures exceeding the $500 million threshold. From both the standpoint of potential losses and the number of investment vehicles affected, such activity has negative implications for lender exposure to defaults.

Among the 85 private credit/credit estimate traditional defaults we've been notified of since 2020, we also identified at least 20 instances where these borrowers were subsequently restructured by converting a majority of their debt to equity—whereby lenders effectively take over control of a company. Aside from the media buzz they tend to generate, these situations can create friction between direct lenders and sponsors, who are generally much more closely aligned in the private market than in the BSL space.

Illiquidity And Lack Of Clarity On Valuations Could Hinder Private Credit

It is no secret that private credit generally lacks the level of loan pricing transparency present in the actively traded syndicated market. Just as bonds and BSL are different, the differences between private credit and BSL can result in diminishing clarity on both valuations and implied credit risk.

Bonds are, of course, securities with a wide array of pricing services anchored against dealers' marks based upon their books, alongside the depth and breadth of the market's readily available trade data. Meanwhile, BSL is a hybrid of private placement with an established secondary market structure, due to the banking framework and the need for secondary trading to facilitate syndications—that results in mark-to-market pricing based on indicative bids from dealers at trading desks throughout the market.

At the other end of the credit spectrum, private credit has no real secondary market at this point and relies upon valuations. Portfolios can have valuations provided either by the asset manager or third parties. In both cases, valuations are heavily dependent on cash flow analysis. When banks lend to asset managers (who lever up their funds) and warehouse such loans, the information around pricing on such loans is not transparent.

As a result, investors and other market participants have raised concerns about inconsistencies in how different funds might mark the same loan. There have been examples featured in the public sphere which emphasize the degree of subjectivity and gaps in private debt valuations, opacity around the extent of impairment on distressed loans, and delays in price discovery (which can affect perception of credit risk). For example, specific focal points have included private loans to Pluralsight and insurance claims manager Alacrity Solutions—which were sharply marked down by holders following near-par quarterly valuations that obscured the implied credit risk of these borrowers. Both companies were later restructured with direct lenders taking over ownership from the private equity sponsors.

Since reporting for private debt investments can be sparse, disclosures in periodic BDC filings and middle-market CLO trustee reports can provide insights on key risk elements like valuation, PIK income, non-accruals, and transactional activity.

In our credit estimate payment default study, we note that (based on a small sample set) CLO managers appear to be able to substitute impaired securities out of their portfolios at levels comparable to historical first-lien recoveries in the BSL market--through a provision called security substitution that allows them to do the swap. While the secondary market for private credit remains illiquid and fragmented, this could change over time as the private debt asset class continues to grow in scale and seeks to appeal to a broader investor base.

As we assess emerging and established risks in 2025, we will continue providing transparency and insight into the structure of public and private markets. Private credit's relative differences to the BSL market could exacerbate credit risks, particularly as the space continues to grow—but in some cases could also serve as mitigants in an uncertain environment.

Considering that most of our credit estimates are on smaller and highly levered companies, these entities are likely to remain comparatively vulnerable to unforeseen stresses. Lack of pricing and general information transparency continues to be a focus area as private credit looks to expand into new frontiers.

Related Research

• Systemic Risk: Global Bank-Nonbank Nexus Could Amplify And Propagate Market Shocks, Feb. 18, 2025
• Systemic Risk: U.S. Banks' $1 Trillion In Loans To Nonbanks, Like Private Credit, Creates Risks And Rewards, Feb. 18, 2025
• Systemic Risk: Private Credit's Characteristics Can Both Exacerbate And Mitigate Challenges Amid Market Evolution, Feb. 18, 2025
• Systemic Risk: Global Nonbank Financial Institutions Press Ahead, Feb. 18, 2025
• Systemic Risk: Global Banking Regulation At A Crossroads, Feb. 18, 2025