Dean D’Angelo
Founding Partner
Dean D’Angelo is a founding partner of Stellus Capital Management and co-head of the private credit strategy.

Private credit has had a great run over the past decade. Direct lenders supplanted banks as the most important credit providers to middle-market businesses and have delivered strong performances so far, albeit in a “benign” credit environment.

Well, things might be changing.

Interest rates are rising, the economy is softening and investors are beginning to ask whether private credit can continue to deliver on its promise of capital preservation and stable income.

Investors might look to the trend in recovery rates for an answer. While default rates are typically a good metric for gauging credit underwriting, the recovery rate, which measures a manager’s ability to recover principal after a default, will be a better metric to identify direct lenders with the right skill sets to drive principal recovery over time and preserve returns in the face of higher defaults.

Default Rates vs. Recovery Rates

To help make this point, let’s look at a typical private credit loan portfolio and see how helpful default rates and recovery rates are at predicting total returns. For this analysis, we modeled a typical pool of direct loans in the current market: first lien, senior secured “unitranche” loans priced at Secured Overnight Financing Rate (SOFR) +6 percent levered 1:1.

In a low default rate environment, a portfolio can do fine with relatively low recovery rates. With fewer deals in trouble, a manager’s ability to drive recovery in these deals becomes less impactful. When default rates increase and managers are dealing with more troubled transactions, their ability to manage those situations and drive strong recoveries become increasingly important.

For example, with a relatively low one percent default rate, even a poor recovery rate of 45 percent can still return close to an 11 percent IRR. Increase that default rate to five percent with the same recovery rate, and the performance drops over 30 percent to a 7.3 percent IRR. With that same five percent default rate, if the manager can achieve a 90 percent recovery rate, the IRR remains relatively stable at 10 percent.

A quick look back at default rates during the last material market downturn – the 2008 financial crisis – highlights what we could experience in the next major downturn. Notably, loan defaults peaked in 2009 at more than 10 percent and remained at or above four percent for more than 18 months.

Managers Need to Maximize Recovery Rates

What can private credit managers do to outperform their peers by driving stronger recovery rates and preserving returns? It boils down to two principles: 1) Building the business around key skill sets grounded in sound underwriting and structuring and 2) practicing active, informed portfolio management.

Here are four core elements to building the business:

Key Skill Sets

  1. Staffing and experience: Managers need to build an investment team around experienced leadership that has managed illiquid positions through economic cycles: They will have a long checklist of “lessons learned” that informs decisions and helps avoid deals that are more likely to experience credit stress.
  2. Focus on quality origination: It is important to have a robust, direct deal “origination engine.” A manager with strong access to deal flow can be more selective. Additionally, focusing on deal flow from experienced private equity investors with an active fund, meaningful initial investment, and sufficient additional capital to support an underperforming company has often been the playbook for success.
  3. Initial Capital Structure: Ensure the business is appropriately levered with a strong equity base. One business can be over-levered at 2x Ebitda and another can be conservatively levered at 4x Ebitda.
  4. Terms: Effective terms and documentation enable lenders to have a “seat at the table” when a business underperforms. Lenders without these protections put themselves in a very difficult spot when things are not going well.

Active Portfolio Management

The second principle – practicing active portfolio management – is refined through experience gained over economic cycles. At the first signs of credit stress, managers need to be in front of the issues and engage with borrowers. Here’s three pieces of advice to this end:

  1. Encourage the private equity sponsor/owner to invest additional equity to pay down debt to a more manageable level and/or support liquidity. An owner’s receptivity to committing additional equity is a key data point on gauging their conviction that a business’ weakness is transitory and can be improved.
  2. Ensure the business has appropriate liquidity to avoid disrupting the company’s operations and potentially degrading its enterprise value. If needed, consider altering terms of cash pay interest to maintain appropriate levels of liquidity in conjunction with an equity investment from the owner.
  3. Introduce a financial consultant when a business is struggling to get smarter on the operations and trajectory of the business in the event that more aggressive action is necessary. Lenders can use the first available opportunity, usually a financial covenant default for which a waiver is required, to install a financial / turnaround advisor.

If a business continues to underperform, even after additional equity support and operational adjustments, the lender needs to be completely focused on capital recovery.

Further Action items:

  1. Stay out of bankruptcy: Keeping the company out of a contested bankruptcy and coming to a consensual path forward is very important in the middle market.
  2. Lead the restructuring process: In certain situations (e.g., an equity account that is far out of the money and unable to support the company with additional capital), a lender-led reorganization or sale process is often the best path forward. We have found allowing owners to retain their equity and continue to participate at the board of director level while addressing debt terms to introduce more operating flexibility makes a lender-led restructuring quite palatable to the owners.
  3. Remain flexible: During the restructuring process, especially as a lender leading the restructuring process, remain flexible and be prepared to inject capital to support recovery.

So what’s the “punchline”?

Private credit is playing an increasingly important role in investment portfolios. Heading into what could be the asset class’s first experience with an economic downturn and tighter credit conditions, investors are right to question how it will perform when tested. No one has a crystal ball, but one factor is paramount: manager selection.

Avoiding the asset class over the next cycle due to uncertain economic headwinds or the “denominator effect” might not be the best decision given the stable returns and consistent income private credit has delivered. Instead, investors should identify private credit managers with the skill set and track record to preserve capital and ensure returns amid challenging market conditions.