Private credit markets for middle-market companies have rebounded strongly since the second half of 2021. Still, some credit analysts and market participants warn a turn in the cycle is coming.
Financially weaker, highly leveraged midmarket companies may be in for a rough ride from inflation pressures, rising interest rates, and a possible slowdown in economic growth.
Private credit providers (also called non-bank or direct lenders) are attractive to investors and borrowers because they provide better yield, speed of execution, and closer relationships with borrowers. But “the resilience of this market hasn't been truly tested in a deep, protracted credit crisis,” according to an S&P Global Ratings report on middle-market lending issued February 9.
The $1 trillion U.S. market for private credit has been in a boom period, as investors poured capital into dedicated funds, in part lured by richer spreads.
The pandemic caused some bumps, but in general, the market recovered from the COVID-19 pandemic quickly. Since late 2020, “easy credit conditions evidenced by high liquidity and favorable lending terms have paved the way for more refinancings, mergers and acquisitions (M&A), and leveraged dividends/leveraged buyouts (LBOs),” according to the credit analysts at S&P.
“[Non-bank] lenders were often willing to waive covenants for multiple quarters." — S&P
Benign credit conditions helped middle-market borrowers that had trouble making interest payments during the pandemic’s peaks. “[Non-bank] lenders were often willing to waive covenants for multiple quarters,” S&P said. As a result, among the 1,500 middle-market borrowers S&P reviewed in 2021 (median EBITDA $24 million, median adjusted debt $175 million), the default rate was only 2%.
But once the Federal Reserve starts hiking the Federal Funds rate, new borrowers and those with floating-rate debt face higher interest costs.
More than higher interest rates, the Federal Reserve’s tapering and eventual end of its purchases of Treasury and mortgage securities could unnerve lenders. As a result, middle-market borrowers with poorer credit may see their access to capital impinged.
Markets will see spread decompression, and lenders will differentiate among borrowers, said Reuben Daniels, managing partner of EA Markets. “The markets are going to make a distinction between who's [creditworthy] and who isn't.”
Most of the middle-market borrowers assessed by S&P in its study “have a weak or a vulnerable business risk profile given their small size,” the credit rater said.
On top of that, some are highly leveraged. Software companies in the group of 1,500, for example, had median leverage of 8.94 times EBITDA.
Investment bank Lincoln International’s private market index found that some middle-market companies levered up substantially in 2021. Among the 600 loans in the index, the number of midsize businesses that borrowed seven times earnings or higher jumped in 2021.
Fortunately for borrowers, a turn in the corporate credit cycle could take a while to materialize.
In its non-bank lending survey updated on January 22, Lending marketplace Cerebro Capital found that as of the third quarter of 2021, 26% of non-bank lenders were still easing underwriting standards. And 26% of the 80 non-bank lenders surveyed had lowered spreads over costs of funds.
Matt Bjonerud, CEO of Cerebro, advised middle-market companies to secure capital now, “especially because loan demand is up across all lenders and tightening is looming.”
In the world of larger corporate loans, portfolio managers forecast wider credit spreads over the next three months, “but they don’t expect to see an uptick in defaults until the second half of the year,” said Som-lok Leung, executive director of the International Association of Credit Portfolio Managers.
However, in the private debt market, the timelines and possible outcomes of a tightening cycle are harder to discern.
“A lot depends on the asset managers, their underwriting and portfolio management, and restructuring capabilities,” according to the S&P report. They added: “Nobody is quite sure how big the market is or who ultimately holds the risk given how the risk is distributed.”