Private Markets Monthly, November 2023: Understanding The Risks Inherent To Private Credit, With David Tesher And Paul Watters

As investors increasingly allocate capital across private debt markets, they want greater transparency in a relatively opaque space. Private Markets Monthly is S&P Global Ratings’ new research offering, where Head of Thought Leadership Ruth Yang interviews subject matter experts on what matters most across private markets—now and moving forward.

In this edition, Ruth talks with David Tesher and Paul Watters, the Credit Conditions Committee (CCC) chairs for North America and Europe, respectively, about the risks inherent in private markets, the differences between the U.S. and European markets, and whether private credit poses a systemic risk. The CCCs set S&P Global Ratings’ house views on risk.

How do credit conditions and other risk factors affect private credit?

David: The key risks associated with private credit are generally the same as those for the public debt markets—although the emphasis will differ depending on where a borrower is in its life cycle and, just as importantly, broader credit conditions.

Paul: As an assessment of the external operating environment, we utilize our regional and global CCC forums—covering Asia-Pacific, Emerging Markets, Europe, and North America, which cascade into our global coverage—to evaluate the trends affecting the current and future states of economies, industries, and credit markets. Our senior researchers, economists, and analysts (covering corporates, financial institutions, insurance, structured finance, sovereigns, and U.S. public finance) meet each quarter to update our base case, consider alternative scenarios, and rank exogenous risks. These views are cascaded to our analytical teams to inform their rating deliberations and form an integral part of our credit rating analysis.

David: We approach this framework and research with an eye toward providing financial market participants around the world with a primary resource for identifying and understanding prevailing and potential credit risks. The risk factors for a rated or unrated borrower are the usual "5Cs" of credit: character, which is its management/governance and financial policy; conditions, or country and industry risks; capacity, which is the competitive position and diversification/portfolio effect; cash, being the cash flow and liquidity; and capital, meaning leverage and capital structure. When we look through the CCC lens, we see borrowers facing a challenging financing and economic environment, as well as elevated geopolitical, technological, and climate-related risks. In North America, tight financing costs, the potential for a U.S. recession, and persistent cost pressures, among others, are the pre-eminent prevailing risks.

Paul: Naturally, financial risk is more intense for speculative-grade entities—and creditworthiness of the vast majority of private credit borrowers is the equivalent of speculative-grade (rated ‘BB+’ or lower). The risk of tighter financing conditions is particularly pertinent for private debt-funded companies, for which maintaining liquidity and cash-flow-related credit ratios are essential indicators of viability. Another risk is that Europe will slip into recession. Economic growth is weaker in Europe than in the U.S., reflecting higher energy prices, greater geopolitical risk, and economies more exposed to China’s slowdown—and so credit quality could erode more quickly than in the U.S.

What are the key differences between the U.S. and European markets, and how do conditions differ?

Paul: For starters, the European private debt market is about half the size of the U.S.’s. Regarding transaction size, the sweet spot for direct lenders in Europe are loans of €100 million-€350 million, corresponding to companies generating €20 million-€60 million of EBITDA—smaller than the median in the U.S. However, the growth in private capital and increased competition is pushing private debt lenders toward larger transactions to compete with the broadly syndicated loan (BSL) market. European private credit vehicles are also generally less diverse than those in the U.S., with a greater focus on direct lending and so-called special situations, as opposed to hybrid debt-equity solutions, asset-based lending, and venture debt. There is a strong regional component to the European market. Regional banks still play an important part in funding the European private credit markets. Additionally, when investors assess borrowers across the continent, they have to consider regulatory regimes (and their differences) in France, Germany, Italy, etc.—as well as potential restructuring costs in those countries.

David: In both regions, financing comes predominantly from private funds, managed accounts, and institutional investors. In the U.S., retail investors can access private debt markets through business development companies (BDCs), which were created in 1980 by an act of Congress to provide capital to small and medium-size borrowers, and don’t exist in Europe. Loans originated by a BDC may be redistributed to private debt funds, or middle-market collateralized loan obligations (CLOs) that are managed by the same institution, resulting in larger pieces of the deal for the same asset manager. Through its lending platform, an asset manager can allocate a loan across several of its managed vehicles, which are frequently enhanced by leverage.?

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How does the opacity of private credit play into systemic risk?

David: There seems to be considerable information asymmetry about borrower quality between institutional investors and fund intermediaries—as the latter can devote more resources to understanding their private credit borrowers. This tension between investors seeking more transparency and fund intermediaries looking to avoid disclosure is more meaningful for credit investors (as opposed to equity investors), raising concerns over the degree of systemic risk that private credit represents. Certainly, there is some contagion risk to banks and pension funds, specifically. While banks don’t generally participate as direct lenders in the private credit context, they often provide private credit lenders with some of the capital they use to extend loans—in some cases to companies the banks would otherwise not lend to because of concerns about creditworthiness. Banks could therefore be indirectly exposed to troubled borrowers but without the oversight they’d have in the BSL market. Pension funds invested in private credit funds are exposed in much the same way. And this holds true in both regions—albeit to varying degrees.

Paul: The smaller scale of private debt in Europe certainly lessens the systemic threat; the disbursed amounts translate to about 1% of European total nonfinancial corporate debt. But shocks to opaque, illiquid, and unregulated markets could expose vulnerabilities elsewhere in the financial system. Moreover, information asymmetry becomes more important when less sophisticated retail investors enter the space–which may become easier with the relaunch of the European Long-Term Investment Fund concept in January 2024 that aims to raise nonbank financing for long-term infrastructure projects and small and midsize enterprises.

Private Markets Monthly, Edition 2

Contributors: David Tesher, Paul Watters

Written by: Joe Maguire and Molly Mintz