Private credit’s default recovery rates are worse than its biggest rival

THE dangers of private credit firms overvaluing their own assets has become one of the booming US$1.7 trillion industry’s most contentious topics in recent weeks. New data on how much money they expect to get back from defaulting borrowers will only add fuel to that fire.

As the private credit industry has battled with investment bankers over the lucrative business of lending companies money, one of its biggest selling points has been that its tougher loan protections and one-to-one relations with borrowers would give it extra protection when those companies hit trouble. New analysis by KBRA Direct Lending Deals casts doubt on those assumptions.

Looking at loans to companies that defaulted over the past year, the data shows that those made by private credit firms were valued at an average of 48 US cents in the aftermath of the default, showing how much they expect to recover on each dollar lent. That is worse than loans by bank-led syndicates, where the average value was 55 cents a month after default.

The analysis also shows that direct lenders tend to be much more optimistic about their loans’ prospects in the months running up to a default, a finding that goes to the heart of the current debate about the wisdom of relying on private credit fund managers to “mark” their own loans. In the six months before a default, the average direct loan was valued at 76 cents, and 70 cents three months prior. For syndicated loans it was 67 cents and 61 cents.

Eric Rosenthal of KBRA DLD, the analytics arm of ratings agency KBRA, says private credit recoveries are not too far out of whack with syndicated loans, but he notes the much steeper drop from where direct loans had been marked: “That private credit recoveries are in line with broadly syndicated loans might seem a little surprising. Especially when considering that even three months prior to default, the average private credit ones are roughly 12 points higher.”

On a brighter note for private credit, it has had far fewer defaulting borrowers than syndicated lenders or junk bond providers. The default rate in 2023 was 2.3 per cent for direct lending and 3.5 per cent for syndicated loans, according to KBRA DLD. That is reflected in the sample size for the analysis, which included 17 private credit defaults and 74 in syndicated loans in the last 12 months.

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In recovery

The new details on post-default loan values come against a backdrop of wider worries about falling recovery rates when corporate borrowers hit trouble. While the global economy has been more robust than expected, many companies have been put under severe strain by higher interest rates. Providers of leveraged loans would have expected to get back 70 to 80 per cent of their money from struggling businesses in the past, but recent examples have been way below that – as the new data confirms.

In a few recent examples from private credit, a loan to Jenny Craig, a weight loss brand that went bankrupt, was priced at 20 cents on the dollar on the day of its default. A second-lien loan to Numet Machining Techniques, which entered Chapter 11 insolvency, was 10.5 cents. Williams Industrial Services Group, was at 50 cents on default day, as was AmeriMark Interactive, according to KBRA DLD. These loans were all marked at least 45 cents lower than where they were three months before defaulting.

Moody’s Ratings also estimates that recovery rates for direct lending and leveraged loans will be broadly similar. But there are hints of more trouble ahead, according to Ana Arsov, global head of private credit for the ratings company.

“Private credit loans have been given a lot of amendments and that’s postponed defaults,” she says. “Many private credit funds haven’t been tested. They haven’t been through a real default cycle.”

The syndicated loan market tends to lend to bigger companies, where there are more levers to pull to restructure and improve performance. That may explain why its recovery rates are holding up against those of direct lenders.

Arsov also points out that some private credit firms should manage a default wave better than others, especially those with well-established workout teams for distressed situations and those whose borrowers are less leveraged than is often the case in the syndicated loan market. “Not all private credit funds have robust restructuring teams,” she says. “Firms like Ares and Antares (via GE Capital) have had the same restructuring team for 20 years.”

“I expect defaults to pick up, especially for companies with high leverage,” says Patrick Marshall, head of private credit at Federated Hermes, while acknowledging that the industry also needs to work harder to give investors greater comfort on subjects such as loan values.

“First of all we have to become more transparent to become an established asset class,” he adds. “All direct lenders will tell you that they’re senior lenders, but they’re stretching.” BLOOMBERG