‘No crisis’ in direct lending

With default rates in the leveraged loan market still around the 1 percent mark – compared with around 4 percent during covid and 8 percent during the global financial crisis – one panellist at this week’s PDI Europe Summit 2023 proclaimed “no, there is no crisis in private debt”.

While it was acknowledged that default rates may yet tick up, it was not considered likely that they would reach anywhere near GFC levels. The direct lending market – private debt’s largest segment – is now far more liquid than it was back then and has long experience of investing primarily in sectors able to demonstrate resilience to downturns.

But, while not a crisis, a deterioration in returns was mooted amid a sense that difficult trading conditions for borrowers will take their toll eventually. One panellist said there was unlikely to be a credit crunch akin to those of 2008 and 2020 but we’ve not yet seen the full ramifications of interest rate rises.

Moreover, it may be quite some time before the extent of any pain becomes visible. With covenants having become almost completely absent at the larger end of the market and often of a “lite” nature in mid-market deals, companies may be able to avoid defaults – but that doesn’t mean to say they’ll avoid liquidity issues.

While sponsors receive plaudits for having responded proactively to problems they think may arise in the near future – for example by putting M&A activities on hold, raising cash to meet earnout obligations or investing extra capital themselves – it’s questionable how much they can do about the looming issue of refinancing risk.

But while borrower stress is a major talking point, new deals are viewed with relish from the buyer’s perspective. “Within private debt today, we’re seeing record yields together with lower leverage (down by about a turn) and LTVs. You’re getting paid more to take less risk,” said one panellist. While the ability to deploy capital might be questioned, the vibe at the summit was of a pick-up in activity which is being seen already and is expected to extend into the second half of the year.

What chance of the US’s regional banking woes producing a contagion effect? Little chance was the view. “We had a very uncomfortable weekend after SVB when people ran some worst-case downside scenarios,” said a panellist. “But as soon as the market figured out the Fed would backstop the deposits, there was a huge sigh of relief and things moved on very briskly.”

So far, so good then – but with market participants allowing themselves little room for complacency.

Write to the author at andy.t@pei.group