Concerns rise over private credit’s ‘true’ default rate amid market stress

[SINGAPORE] The rising pace of activity in the private debt market, where fund giants are muscling in and large investors such as Temasek have set up their own private credit platforms, is surely a sign of growing acceptance of the asset class.

But concerns are also rising over possible credit deterioration, even as major players gear up to capture a larger share of the lucrative private wealth market.

The yield on private debt can be as high as 8 to 9 per cent, making it attractive at a time when rates on lower-risk assets are declining. But getting a good understanding of the underlying credits in a portfolio will be challenging for individuals and even intermediaries.

Investors take confidence from a low historical default rate, but that masks underlying risks and debt workarounds that are often not transparent.

As for fund managers, success in attracting retail monies is a double-edged sword. Retail monies help to cushion a decline in institutional inflows, but the funds will need to be invested more quickly, raising the risk that there is too much money chasing too few deals of good quality.

Moody’s, in a paper in June, raised concerns over possible systemic risk as private debt’s share of corporate finance, while still modest, masks linkages in the financial system which can amplify shocks when markets are under stress.

“The same linkages that facilitate risk sharing in calm conditions can become conduits for contagion under strain, especially when involving more opaque segments of the network – such as private credit – where risks are harder to monitor,” said Moody’s.

More attention is now focused on credit quality, particularly on “payment-in-kind” (PIK) arrangements, in which interest payments can be deferred and added to the principal. In a recent report, Zain Bukhari, S&P Global associate director for risk and valuations, raised concerns over the rising trend in “selective defaults”.

“A major selling point of private credit is the low default rates. However, this reputation hinges on a narrow definition of default, typically covering only traditional defaults, such as missed payments or Chapter 11 filings.

“It often overlooks instances like conversion of cash-pay interest to PIK, amortisation holidays or maturity extensions without adequate offsetting compensation – events generally considered as a selective default.”

Lincoln International, which values private loans, notes in its second-quarter report that lenders are wrestling with weaker borrowers in their books, particularly deals done in 2021 and 2022, which account for more than half the companies that Lincoln values. “Lincoln has continued to observe higher covenant defaults, elevated use of PIK interest and lenders taking over businesses from sponsors.”

PIK interest, it said, may be a better indication of stress. PIK interest is present on 11 per cent of all deals it values; of those deals, 53 per cent had “bad PIK” – that is, PIK was not elected or available at the deal’s close, but is now utilised.

It said this translates to a “shadow default rate” of 6 per cent, compared to 2 per cent in 2021, “which may be more indicative of the health of private credit”.

Unlike prior years, Lincoln observed that more sponsors are now unwilling to support their portfolio companies. “Whether it is due to sponsors’ fatigue over supporting these companies for the last four years, concern about investing good money after bad when there is no longer equity value or the unavailability of capital due to the fund’s life cycle, some cracks (are) starting to form in the relationships between private sponsors and direct lenders.”

Ashley Lester, MSCI’s chief research and development officer, said MSCI has an indicator of credit distress, based on write-downs by general partners (GPs) of 20 per cent or more in the value of a holding.

“We have not surprisingly seen an uptick in (write-downs) during the period of the run-up in interest rates, and that’s not surprising. Private credit is floating rate, and when interest rates are rising, the debtor has to pay back more money and some of them are going to run into trouble.”

MSCI has tied up with Moody’s to provide independent risk assessments of private credit investments at scale.

He maintains that the most recent evidence shows positive returns from private credit, and outperformance against public credit. “We’ve never seen a full cycle of private credit since the asset class has grown so much. Of course, we don’t know how it will behave in a full cycle, but so far it seems to be holding up pretty well.”

In the private wealth market, intermediaries and their clients are banking on big-name players the likes of Blackstone and KKR to do the due diligence on names in their portfolios. But at a time when some institutions are offloading private debt assets, the big question is also whether lower-quality assets are being sold to funds targeted at the retail and private wealth market.

S&P’s Bukhari sounded a caution: “Retail investors may be channelled into less desirable assets, potentially those offloaded by institutional investors seeking exits. This raises concerns about alignment of interests, transparency and the overall integrity of private credit products offered to retail clients.”

Andrew Tan, Muzinich & Co chief executive for the Asia-Pacific and head of private debt, said there is a risk that the market becomes a “sponsor’s market”, “where large pools of capital chase the same opportunity in a particular segment, leading to greater competition and causing an erosion of underwriting standards and returns”.

For now, expectations over deal flows, particularly in Asia, remain robust. Seatown Holdings, indirectly owned by Temasek, recently closed its third private credit fund with commitments of more than US$612 million.

Separately, Apollo Global Management recently won the mandate to manage Singapore’s US$1 billion private credit fund targeting local high-growth enterprises.

Shaun Langhorne, Clifford Chance restructuring partner, said private credit remains nascent in the Asia-Pacific, where 75 to 80 per cent of the credit market is bank-driven. The firm advised Seatown on its third private credit fund.

The cost of private credit debt is not necessarily lower than bank debt, but flexibility may be a draw, he said. “Private credit capital can be deployed in pretty much any way that makes sense for both parties – in the form of traditional debt, but it can also be quite highly structured... It’s flexible and can be designed in a very bespoke fashion, and that is what sets it apart from other types of more traditional lending.”