(Bloomberg) -- The companies that get private credit loans are looking increasingly wobbly and banks are among those that could eventually be on the hook for losses.
Many companies getting direct loans from private lenders are struggling to produce cash, by at least one key measure: At the end of 2024, more than 40% of borrowers had negative free cash flow from their businesses, the International Monetary Fund warned in a report this past week. That’s up from closer to 25% at the end of 2021.
Borrowers that aren’t generating enough cash flow are at greater risk of defaulting, a particular concern as trade wars lead to fears of economic stagnation.
Market participants are alarmed that the deterioration in debtors’ credit quality has yet to show up in accounting valuations, while a rise in dividend recapitalizations is “further straining borrowers’ debt sustainability,” the IMF wrote.
The report adds to a series of alerts from watchdogs, who fret that vulnerabilities in the $1.6 trillion private credit industry could spill over into the banking arena. Any increase in defaults among direct lenders’ customer base could have a knock on impact for banks because they now have more than $500 billion of exposure to private credit, which the money managers use to lend more to customers.
“The risk of earnings erosion and cash flow problems has increased, with idiosyncratic pockets of risk in some industries or borrowers” such as health care and software, the IMF wrote of direct lenders. “Even before the tariffs, nearly half” of the borrowers “had negative free operating cash flows, prolonging their reliance on payment-in-kind provisions and amend-and-extend restructurings.”
Private equity firms in particular have relied on PIK notes, which allow borrowers to defer interest payments for their portfolio companies after a surge in borrowing costs hit valuations. More than a quarter of net investment income in the fourth quarter for a set of the lenders came from deferred interest, according to data compiled by Bloomberg Intelligence. That’s an increase of about nine percentage points in a year, according to the data, which is based on business development companies, a type of private lender.
“As financial volatility increases, uncertainty proliferates,” said Elad Shraga, chief investment officer at Signal Capital Partners. “It is reasonable to assume that PE exits will be delayed, in some cases meaningfully, therefore sponsor-driven credit might face increased stress,” adding he worries about the rise in PIK usage.
Shadow Banks
Private credit firms typically lend to weaker and smaller companies, making them more exposed to a downturn in the economy. The trade wars that sparked concerns about the outlook for growth come amid growing signs of potential problems emerging among the wider group of nonbank lenders in the US.
Nearly 21% of nonbank loans there were already classified last year, meaning repayment is uncertain, according to a report published by government regulators last month that looks at larger loans held by three or more lenders. To help limit the risk of turmoil in shadow banking spreading to the traditional banking system, the Financial Stability Board plans to release policy recommendations in July around their use of leverage.
Still, while “over-geared companies are at risk to big shocks in the economy,” if the direct lending was “sensible and proportionate in the first place, those borrowers should be able to wear this volatility,” said Claire Madden, a managing partner at Connection Capital. “Private credit lenders can be supportive partners in times of stress to allow borrowers to fight another day.”
Week In Review
Markets showed signs of stabilizing this week, after weeks of growing fear tied to tariffs.
On Monday, American Express was the only US high-grade primary bond seller looking to raise capital. As the week wore on, more companies began piling in, and the coming week could be more active for debt sales.
The leveraged finance and private credit markets saw sporadic sales as investors made sense of tariff-related news.
A $4.5 billion debt sale priced this week, funding QXO Inc.’s acquisition of Beacon Roofing Supply Inc.
Jane Street Group sold $1.35 billion of high-yield bonds on Wednesday, the latest deal for one of the more-active issuers of junk-rated debt.
Private lenders led by Apollo Global Management Inc. and Blackstone Inc. are providing a $4 billion loan to support Thoma Bravo’s acquisition of Boeing Co.’s flight navigation unit and other digital assets
Wall Street banks are stuck holding a $1.1 billion leveraged loan supporting HIG Capital’s buyout of Toronto-based Converge Technology Solutions Corp.
Morgan Stanley is unloading the last of what had been a $13 billion albatross for the banks that funded Elon Musk’s buyout of Twitter. Here’s a peek at some of the social media platform’s latest financials.
Overall, banks in the business of lending to risky companies are still willing to arrange financing packages, even as some lenders run into tariff-induced turmoil that’s left them unable to offload debt to investors.
Europe’s junk bond market reopened on Wednesday, with the first first offering since early April, following weeks of tariff-induced volatility.
Rite Aid Corp. is running low on cash and preparing to sell itself in pieces as it heads toward its second bankruptcy, less than a year after the drug-store chain’s emergence from Chapter 11.
WW International Inc., also known as WeightWatchers, is preparing to file for bankruptcy within weeks after reaching a debt-restructuring deal with a majority of its lenders.
Goldman Sachs Group Inc. is among about half a dozen Wall Street banks preparing to sell $4.25 billion of debt backing Sycamore Partners’ buyout of UK pharmacy Boots, part of the private equity firm’s acquisition of Walgreens Boots Alliance Inc.
Ascend Performance Materials Inc., a chemicals business backed by SK Capital Partners, filed for bankruptcy and said it intends to restructure with support from its lenders.
On the Move
Brevan Howard Asset Management credit investor Michael Fine has left the macro hedge fund that’s pulled back on some trader risk-taking amid market turmoil.
The mortgage and consumer debt investor Balbec Capital LP has named Peter Troisi as its chief executive officer, replacing founder Charles Rusbasan.
Neuberger Berman Group expanded its specialty-finance team with new hires from Pacific Investment Management Co. and Blackstone. Sean Hinze joined Neuberger in April, after more than a decade at Pimco, to oversee debt transactions tied to hard assets and consumer lending, according to a spokesperson. He will join Laura Johnson, who started at Neuberger earlier this year following a two-year stint at Blackstone and more than six years at Orix, according to her LinkedIn profile.
Royal Bank of Canada hired JPMorgan Chase & Co. managing director Troy Wagner as global head of private capital markets.
Antara Capital founder Himanshu Gulati is leaving the struggling hedge fund to join Marshall Wace.
