The fundamentals are holding up

Is the private debt default rate too good to be true? Regular readers of Private Debt Investor’s Loan Note digest may have read our coverage of law firm Proskauer’s announcement that the default rate had dipped between the first and second quarters of this year. Given the economic backdrop and the pressure of interest rate rises being heaped on borrowers, it came as something of a surprise. There was natural speculation that perhaps the finding was a one-off.

However, a study by investment bank Lincoln International has discovered the same trend, with its calculation of the default rate dipping from 4.5 percent in the first quarter to 4.2 percent in the second. This followed a series of rises in the quarterly default rate starting between the fourth quarter of 2021 and the first quarter of 2023, according to Lincoln’s data.

This naturally leads to consideration of why the trend has bucked forecasts. Market sources canvassed by PDI say they have noted a tendency for lenders and borrowers to be highly proactive in responding to issues – you might call it a refusal to be caught on the hop. Structural innovations such as equity cures and PIK toggles have been widely used as protagonists seek to bring leverage and interest expenses down to manageable levels. Refinancings, it is noted, have been commonly used to bring down leverage levels.

Another factor is less to do with what firms have done and more with what they haven’t done – specifically, not putting in place many covenants. Many borrowers are only encumbered by a leverage covenant and not by a debt servicing covenant, meaning that interest rate rises often have little impact on the default rate. There’s another contributory factor that’s not entirely positive: turning off the capex tap to conserve cash, regardless of the potential stunting effect on growth.

But while some of the issues are perhaps being obscured – especially where lack of covenants defers rather than eliminates problems – market sources also say they see no major shift in company fundamentals. Revenues, EBITDA growth and margins are, by and large, holding up well and the overall environment is viewed as stable. Even where issues emerge, action is being taken quickly and there is no sense of genuine distress building up in the system. Moreover, although we may be into a “new normal” when it comes to interest rates, there is still hope that they will come down at some point – perhaps in 12 to 18 months – and provide some relief to borrowers.

To return us to the initial question: is the default rate too good to be true? One quarterly decline is not conclusive, but neither is it necessary – or even justifiable – to see future increases as inevitable.

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