Red flags in private credit markets as macro conditions increase pressure

Increased exposure to lower quality loans and relaxed underwriting standards are alarm bells for private debt portfolios as higher interest rates and tougher economic conditions put pressure on the market.

According to CRISIL Global Research & Risk Solutions, part of S&P Global, there is a combination of factors affecting the market in the medium term, including a weakened macroeconomic environment, an increase in covenant loans and elevated portfolio risks.

The group analyzed the portfolios of more than 30 lenders, with total private credit assets under management of $1 billion in the United States and Europe.

It revealed that high and medium risk sectors accounted for more than half of the portfolios in the sample.

High-risk sectors include healthcare equipment and services and capital goods, while medium-risk sectors were technology hardware and equipment, and software and services.

According to CRISIL analysts, in a high-stress scenario, default rates for high- and medium-risk sectors are expected to jump 400 basis points and 380 basis points, respectively, from current rates. In a peak=stress scenario, this could reach 730 basis points and 550 basis points, respectively.

The researchers noted that monitoring mechanisms need to be improved.

Indeed, relaxed underwriting standards continue through the end of the credit cycle due to competitive pressures, and asset managers continue to increase their exposure to lower quality loans and securities.

They suggested private credit managers focus on improving credit monitoring, building robust internal early warning systems, and deploying bespoke dashboards and customized solutions for specialty lending. .

“We believe investors will need to exercise caution over the coming quarters. Several warning signs point to potential credit stress in the event of macro volatility. When viewed on a stand-alone basis, the variables below seem harmless; however, a combination of these in a bearish market scenario could easily lead to market dislocation,” they added.

These variables include rising interest rates and inflation which impact middle market borrowers facing higher operating costs and interest payments; increased credit risks due to borrower-friendly structures; and increased sector and borrower concentration risks combined with weaker borrower profiles.

Private credit fundraising

Capital continues to flow into private credit funds, although at a slower pace than in 2021, which was a record year.

The managers raised $82 billion across 66 funds globally in the first half of the year, according to PitchBook. Direct lending remained the most popular strategy, accounting for more than a third of capital raised.

But PitchBook’s head of private markets research, Dylan Cox, believes the macro backdrop presents a double-edged sword for the industry.

“On the one hand, the floating rate nature of many of these instruments makes existing loans more lucrative, as coupon rates will rise in step with central bank rate hikes.

“On the other hand, rising rates could make new fixed-income investments – such as corporate bonds, government bonds, and real estate-related debt – relatively more attractive to allocators,” he said. he noted.

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