Credit fund stress tests may be ‘overly optimistic’

Although valuations are unlikely to fall in the short term, managers should be wary of expecting a rapid recovery in the global economy.

Private credit managers’ stress scenarios may be overly optimistic in reflecting the crisis caused by the coronavirus, according to research by bfinance.

In a note on private markets, bfinance’s senior director of private markets, Trevor Castledine, wrote that Q1 private credit portfolios are, with some justification, unlikely to be subject to major valuation reductions. However, he added that managers should be conscious that existing stress models may reflect a shorter period of reduced economic activity and a faster recovery than may be possible.

“Predictions are challenging due to uncertainty on how long social restrictions will stay in place,” said Castledine. “Figures from the [global financial crisis] are not hugely helpful due to the different root causes of that crisis, today’s lower interest rates and the relative immaturity of the mid- and lower-mid market at that time.”

The firm reports that, so far, there have been few defaults and that most of these have come from positions that were already on watchlists. However, defaults are expected to rise, though private credit has a higher expectation of recovery than high-yield bonds or leveraged loans.

Nevertheless, bfinance expects significant variability between managers. It also expects those managers without in-house restructuring expertise to struggle and end up being forced to sell positions they are unable to manage.

It does not expect earnings erosion for borrowers to be a big problem for credit funds. This is because bfinance believes lower interest rates should give more cashflow headroom, depending on the extent of EBITDA adjustments, and because portfolios have recently positioned for a downturn with reduced exposure to cyclical sectors.

The firm reported that managers it has spoken to are seeing requests for extra liquidity from their portfolio companies. The latter are usually seeking a cash injection from a private equity sponsor, though some lenders are also providing short-term liquidity facilities.

It also warned that levered strategies face a significant risk that one or two defaulting positions could lead to their lenders tightening their credit lines and drive forced selling.

Refinancing risk is another potential problem. High volumes of dry powder make it more likely that refinancing will happen, but this may not be on terms borrowers like and some may seek out short-term bridge financing instead.

According to bfinance, investors may consider investments in opportunistic strategies in the coming months, with a time lag before most problem positions become apparent. It believes these investments could provide exceptional returns.