European defaults rise as rate pressure applied
“The burden of increasing interest rates continues to build,” says S&P Global Ratings, as it tips the European trailing 12-month speculative grade corporate default rate to reach 3.75 percent in June next year – up from this year’s June figure of 3.0 percent.

Although the forecast is more optimistic than the last one in March, the challenges are still evident. “While a recession may well be avoided, growth is still stagnating and cash interest paid has risen roughly 15 percent from a year ago for European firms during the second quarter,” said Nick Kraemer, head of S&P Ratings Performance Analytics, in a recently published article (login required).

S&P identifies firms’ ability to service debt amid flagging cashflows as the main risk. Some protection is offered by high cash balances or the ability to free up cash through hiring cutbacks, stock buybacks or dividends – but these options are less available to lower-rated issuers.

The consumer products sector had the highest number of so-called “weakest links” in Europe in the second quarter. This was driven by inflation contributing to weaker consumer sentiment and a shift in demand from branded consumer goods to private label and discounted products.

Direct lending going strong
US direct lending has been experiencing a strong period for performance, according to the Q2 2023 version of the Cliffwater Direct Lending Index.

According to the CDLI, the second quarter saw a 2.81 percent return, following a 2.69 percent return in the first quarter. The increase has been driven by growth in income as a result of higher interest rates. CDLI yield climbed to 12.07 percent during the second quarter.

CDLI-S, the senior debt-only version of the index, returned 2.78 percent in the second quarter, while CDLI-V, the venture debt-only index, delivered 3.13 percent.

The CDLI trailing-year return stands at 9.69 percent and the annualised return since inception of the index in 2004 at 9.37 percent. A statement from Cliffwater said private debt was today’s “fastest growing institutional asset class”.

On a less positive note, credit losses are on the rise – although they have still not yet reached the long-term historical average of 1 percent. The near-zero loss years of 2021 and 2022 may not be seen again for a while, however. Cliffwater said most signs of loan stress showed only “modest” changes.

Reduced M&A activity has contributed to a worsening liquidity environment and seen the average loan life move up to 5.26 years at the end of June from its 3.07 years historical average.

Size matters in European sub lines
Insufficient liquidity in Europe’s subscription line market benefited large GPs at the expense of mid-size ones in the second quarter, our colleagues at Private Funds CFO report.

Data from law firm Cadwalader found that pricing for big sponsors declined from Q1 levels while rising for mid-size ones. Lenders preferred engaging with bigger managers in Q2 because of their perceived lower credit risk due to more diversified borrowing bases, Michael Hubbard, head of European GP solutions at Cadwalader, told Private Funds CFO, noting that longer fundraising periods are also contributing to higher pricing for mid-size sponsors because they have less diversified LP bases when they seek sub lines at their first close.

These pricing discrepancies are also a clear sign that there is not enough credit from banks to go around for both groups of managers, or even all of the largest managers. “The amount of capital across the banking market for subscription lines is not infinite,” noted Samantha Hutchinson, a partner at Cadwalader. And growth in big GPs’ fund sizes means they need more sub-line capital, posing allocation challenges for banks.

Cadwalader’s advice to avoid this looming supply-side crunch? Attract capital from institutional investors. The law firm is spending more time exploring models to accommodate non-bank capital providers. “For that to have gone from taking up very little of our time three years ago to taking up a considerable chunk of our time really just underlines how big an issue this is for the subscription market,” Hutchinson said.

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