The strength of private credit runs into obstacles to protect delinquencies

After a year and a half of rate increases, the private credit market is resisting the onslaught relatively well. The floating rate nature of this space means absolute returns have strengthened with each increase in central bank rates, with a greater proportion of corporate cash flows now flowing to lenders.

From here, central banks could take two main paths, each with challenges for the market. In the first case, a “higher for longer” rate strategy would start to cause problems for borrowers, as rising debt costs would reduce interest coverage ratios. On the other hand, central banks could go on to cut rates, but this would imply a weakening of the economic context, which would bring its own problems to borrowers in this space, according to most experts.

In either case, one could expect to see more loans in the leveraged finance sector downgraded to a CCC credit rating, or even falling into distressed territory. The default rate in the European loan market is already rising, albeit from historic lows. In August, the twelve-month par default rate on European leveraged loans was 1.27%. This figure is higher than the 0.41% recorded in January, but is still well below the 2.92% average since 2007.

However, private credit continues to resist. Despite these looming pressures, we believe there are several reasons to be optimistic. For starters, equity investment promoters have a record amount of liquidity at their disposal, estimated at $2.72 trillion globally as of early September. Many general partners in Europe have demonstrated their willingness and ability to use this cash to support their portfolio companies in increasingly creative ways.

Additionally, investors can take comfort from the position of senior secured loans at the top of the capital structure. Although fewer companies include subordinated debt in their financing stack, equity checks remain strong and the average transaction leverage ratio has decreased. “Whatever path central banks take from now on, default rates could rebound from historic lows… But European private credit markets look prepared to resist,” said Cyrille Javaux, credit manager at Fidelity. .

“It is unlikely that financing operations will occur in the primary market”

“Throughout the third quarter, the increase in demand we have seen in new and growing collateralized loan obligation (CLO) vehicles (see structured credit section) has not been matched by a new monetary supply in the European primary loan market, which has pushed the technical bid to focus on the secondary sector,” highlights the expert from the American manager.

By mid-September, there was little sign of a flood of new borrowing to satisfy this demand. An $8.4 billion debt financing package has been launched supporting GTCR’s acquisition of global payments technology company Worldpay, while PAI Partners is expected to soon fund its acquisition of Infra Group with a $500 million loan . a few euros. But so far this year, leveraged buyout volumes have slowed.

In 2023, until September 14, only 5,160 million euros of European loans have been granted in support of new acquisitions, compared to 16,760 million euros in the same period in 2022 and 30,530 million euros in 2021. “We consider “The expectations of private equity buyers and sellers about valuation multiples are beginning to converge, paving the way for a more efficient takeover market,” JP Morgan’s credit department says in a recent report. Meanwhile, There are headlines about some possible acquisitions of public companies to private companies.

“However, it is unlikely that financing operations will occur in the primary loan market before the first quarter of next year at the earliest,” adds the North American bank. Meanwhile, supply through the end of the year is likely to continue to be dominated by modification and extension operations, continuing the trend seen throughout most of 2023. “Although most of the 2024 maturities have already been resolved, around 4 0% of operations in the European market expire by the end of 2026, which means there is still ample room for more modifications and expansions before the end of the year,” Fidelity states.

After a quarter in which the supply of new CLOs was slow (only two operations were closed between June 10 and July 23), the European primary market remains firm, with a volume so far this year of 17.05 billion euros as of September 14, and the full year should be in line with expectations at the beginning of the year, slightly below the 26 billion euros recorded in 2022, according to official emissions data. Issuance remains on track to equal the €22 billion recorded in all of 2022. More managers are now lining up and a wave of issuance is expected in the coming months.

However, it is difficult to see how the market will absorb all of these new operations. Headwinds include the slower pace of new borrowing coming from the primary market to supply new CLOs, while CLO prices have become increasingly tight. In September, the price of triple A tranches from the primary market was around Euribor plus 170 basis points, well below the Euribor range of 185 basis points to 190 typical points at the beginning of June.

In the first half of the year, one of the tightest trades occurred in February (before the turbulence caused by the Credit Suisse crisis) and a BBB tranche was priced at E+500. A similar operation took place at the beginning of August, and in September a CLO was closed with its triple B tranche at E+480. No refinancing or realignment of previously completed deals has been seen so far this year, but they could emerge in the fourth quarter. Although market prices remain higher than those recorded in 2021, issuers that completed operations in 2022 with one-year demand protection periods could soon return to investors to readjust conditions. The road still involves some danger.

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