Private credit managers are bracing for an uptick in stress across corporate America as higher interest rates for longer mean some companies will struggle with their debt loads.
Wall Street heavyweights gathered in Beverly Hills this week for the annual Milken Institute Global Conference just days after the Federal Reserve signaled it is prepared to keep overnight lending rates elevated if economic trends warrant.
On panels and in closed-door meetings, some expressed concern that liquidity issues for borrowers that binged on debt when rates were low are being masked by amendments to loan terms, such as maturity extensions and payment-in-kind arrangements.
A spike in such amendments last year – which has kept default rates low so far – was meant to buy time for rates to fall, a prospect that’s now looking unlikely. But the hidden strain remains as investments made from 2019 to 2022 were highly leveraged, with a view that interest rates would stay low for a long time.
“This cannot be extended forever,” Katie Koch, chief executive officer of the TCW Group Inc., said in a Bloomberg Television interview at the conference. “Eventually those default rates will rise.”
While many borrowers are still notching revenue growth and have absorbed the higher rates, the struggles of weaker companies could provide the first real test for a global private credit market that’s grown to $1.7 trillion of assets. Much of that money was raised by managers who started after the financial crisis more than 15 years ago.
An economic downturn could become a make-or-break point for some who entered private credit in recent years, according to Blue Owl Capital Inc. Co-Chief Executive Marc Lipschultz.
“Some managers will prove that they are marginal and they will be shaken out of the system,” he said.
Opportunity
Yet some firms are preparing to take advantage of any jitters in the direct lending or leveraged loan markets by providing rescue-type financing for troubled borrowers to help bridge gaps in liquidity.
Oaktree Capital Management has been reducing its exposure to broadly-syndicated loans, and shifting to collateralized loan obligations and cash in its multi-asset credit portfolios, to be ready to take advantage of market volatility. The firm is looking to provide more rescue financings to companies with liquidity needs through its private credit business.
Firms including Goldman Sachs Asset Management and Ares Capital Corp. (Nasdaq: ARCC) also already have dedicated funds to provide so-called hybrid capital. These financings are structured to sit between existing senior debt and common equity, and typically allow companies to pay down borrowings, and also meet at least some of their interest payments with additional debt, which frees up cash flow for operations.
“It is going to be ugly,” said Danielle Poli, a portfolio manager at Oaktree, referring to some companies that may not be able to meet their obligations as maturities approach. “Many of these companies are burdened with excessive leverage with holes in their covenants like Swiss cheese.”
Sponsors are prepared to wait until they can earn their way back to higher valuations before exiting company investments, and are finding willing partners in private credit to help, said Jeffrey Solomon, president at TD Cowen.
“That’s a market where you’ve got a lot of savvy people who can figure out how to restructure debt in order to allow for the equity grow,” he said on one of the panels. “Maybe they take a little bit of equity alongside it.”
M&A
A big question among attendees was on the timing of a revival in leveraged buyout and acquisition activity. The tone at the conference was cautiously optimistic as interest rates stabilize and more sellers begin to accept a long-term drop in valuations.
But the hope that a rate cut would grease the wheels of M&A hasn’t materialized.
Leveraged loans and private credit are both open for business to fund new leveraged buyouts, said Peter Toal, head of global fixed income syndicate at Barclays Plc (NYSE: BCS), in an interview at the conference. “Financing is no longer the challenge,” he said. “The markets are very open and conducive and accommodating to new leveraged buyouts.”
