Cracks are showing in private credit, says Moody’s

The private credit market is headed for a period of stress as higher-for-longer interest rates strain borrowers and saddle lenders with losses, according to a report Tuesday from Moody’s Ratings.

The rating company is already seeing credit quality deteriorate at some managers. Big direct lending funds managed by BlackRock Inc., KKR & Co., FS Investments and Oaktree Capital Management have already had their credit rating outlook cut to negative from stable by Moody’s on concerns about an increase in their loans on non-accrual status, meaning they’re in danger of losing money on those investments.

Other signs of eroding asset quality, such as an increase in payment-in-kind loans, raise questions about portfolio valuations, according to the report by analysts led by Christina Padgett. The $1.7 trillion industry has grown at a dizzying pace, but its opacity means lenders can be slower to adjust asset valuations when the cycle turns.

Moody’s expects more private funds “will face increasing performance challenges as their borrowers contend with the realities of higher interest rates for a potentially extended period,” the analysts wrote. While lenders may try to help struggling borrowers hoard cash by amending financial covenants or allowing PIKs, “in some cases these actions may only postpone actual losses.”

The shakeout may be particularly apparent in private loans extended to companies that previously had financed themselves through banks with broadly syndicated debt deals, Moody’s said.

There has already been a migration of healthy companies refinancing their private credit debt with cheaper loans originated by banks. In response, direct lenders have started financing weaker and smaller companies and have been forced to accommodate more on price, terms and provisions, Moody’s found. That’s especially the case when a company can’t refinance their syndicated loans and has to turn to private credit to do so. 

“From our perspective, this is the most competitive period ever seen in the leveraged finance market and terms are pretty much the weakest out there,” Ana Arsov, global head of private credit at Moody’s, said in an interview. “If there is a refinancing from the syndicated market into private credit, we always ask if there is some distress there.”