Private credit's borrowers are feeling the squeeze

The Secured Overnight Financing Rate (SOFR) now resets above 4.55 per cent, up from almost nothing a year ago, and private credit funds are paying their limited partners double-digit gross yields. For a decade the industry sold itself to pension funds and endowments as a safe harbour in any weather, with floating-rate income and tight lender protections. The cash for those yields comes straight out of the borrowers. For middle-market companies owned by private equity firms, paying 11 to 12 per cent all-in on their debt has become a fight for survival.

A year of rate rises

The Federal Reserve began lifting its target range off the floor in March 2022 and has raised it by 450 basis points since, including four successive increases of 75 basis points between June and November. The latest move, a quarter point on February 1st, left the range at 4.5 to 4.75 per cent. Much of the debt now under strain was written in 2021, when buyout activity was feverish and the floating part of the coupon cost next to nothing. Lenders and sponsors priced those deals as if the margin would be the only part of the bill that mattered.

How the squeeze works

Direct lending is almost entirely floating rate. A typical unitranche loan pays a fixed margin over term SOFR, reset every one or three months, so each Fed decision reaches a borrower's cash flow within a quarter. At a base of 4.55 per cent, an all-in cost of 11 to 12 per cent implies a margin of six and a half to seven and a half points, which looked affordable when the base rate added almost nothing.

Large borrowers in the syndicated loan market sometimes buy interest rate caps. Middle-market companies seldom hedged at all. As SOFR climbed at a speed few had planned for, interest coverage ratios fell from a comfortable 2.5x toward the danger line of 1.0x. A fall of that size means the interest bill has grown two and a half times relative to operating earnings, and no plausible rise in sales restores the old cushion.

Solvent on paper

When interest payments eat all of a company's operating cash flow, reinvestment stops. Maintenance spending gets cut and suppliers wait longer to be paid, all to avoid a formal default.

Direct lenders do not want to book losses on their portfolios, so they are turning to financial engineering. More and more loans carry payment-in-kind (PIK) toggles, which let borrowers pay interest with extra debt rather than cash. That keeps reported performance looking fine today while piling up leverage for later.

The arithmetic of PIK is unforgiving. A borrower that capitalises a 12 per cent coupon for a year owes 12 per cent more principal at the end of it on unchanged earnings, and the following year's interest is charged on the larger balance. The lender books the accrued interest as income it has not received in cash. Listed business development companies, which must publish quarterly accounts, disclose how much of their income arrives in kind, and that share is the clearest public gauge of the strain.

Who is holding the risk

The investors on the other side of these loans are not the banks that dominated leveraged lending before 2008. They are pension funds, insurers, endowments and, increasingly, wealthy individuals buying non-traded vehicles marketed as steady income products. That spreads the risk widely, which is a comfort for the banking system, but it also puts losses in portfolios whose owners were told the asset class was defensive. Many of those investors added to private credit precisely because it had not fallen in 2022 when stocks and bonds did.

The retail end of that market has already shown its limits. In December Blackstone restricted withdrawals from its non-traded property trust, BREIT, after redemption requests exceeded the fund's limits. Private-credit vehicles sold to individuals carry similar restrictions, and they are designed to hold illiquid loans that cannot be sold quickly at the marked price if many investors ask for their money at once.

Marks that barely move

Private loans are valued each quarter by models and outside valuation firms rather than by trading. Through 2022, as prices of syndicated leveraged loans fell, private marks moved far less, which let the asset class advertise low volatility to its investors. That smoothness says more about the accounting method than about the borrowers, and it tends to last only until a loan stops paying.

Sponsors keep their wallets shut

Private equity owners face a hard choice. They can put in fresh equity to cover the cash burn, or they can hand struggling companies over to the senior lenders.

The late-1980s buyout boom is the nearest parallel. Companies loaded with debt ran short of cash once growth slowed, defaults climbed in 1990 and 1991, and Drexel Burnham Lambert, the junk-bond house that had financed much of the boom, collapsed in February 1990. That debt was mostly fixed-rate, so the pain waited for earnings to fall. This time the coupon has done the damage first, before any recession has arrived.

The industry's defence has substance. Most private loans have a single lender or a small club, so amendments can be agreed quickly without the holdout battles of the syndicated market. Sponsors also sit on large uncalled commitments from their own investors, and inflation has lifted revenues at companies able to raise prices. Those advantages buy time, but they do not change the ratio of interest to earnings, and a loan extended on PIK terms is simply a larger claim on the same business.

Refinancing adds a further strain. Loans written in the boom of 2021 typically run five to seven years, so few mature this year, but companies that need to extend, add debt for acquisitions or amend covenants must now do so at today's rates and on lenders' terms. Every amendment is a chance for the lender to raise the margin, add fees or take tighter security, which pushes the interest bill higher still.

With distributions to their own investors drying up and fundraising stalling, sponsors have little appetite for throwing good money after bad. Those that do write cheques will favour their best assets and leave weaker companies to the lenders. The signals to watch are the share of PIK income and non-accruing loans in the fourth-quarter results that business development companies report over the coming weeks, and whether the Fed, which meets again in March, delivers the further increases markets expect. Private credit funds have kept public-market price swings off their books, but fund accounting cannot save lenders whose borrowers run out of cash at a 5 per cent base rate. Defaults and handovers of the keys are likely to rise over the coming year.