KBRA releases research that examines the $1.2 trillion private credit industry is likely entering the most significant period of credit stress it has experienced since becoming such an integral part of the U.S. and European corporate lending landscape. Some of the strategies that helped private credit lenders and their borrowers successfully navigate the COVID-19 pandemic will be important again, but the impact of rising interest rates, the slowing global economy, inflation, and weaker private company valuations, will likely present more sustained challenges as well as higher default rates than experienced during the pandemic. In a new report about the opaque private credit market, KBRA will leverage its expansive view across the landscape of the direct lending industry to offer perspectives on these evolving risks and how the industry responds.

This report examines the potential impact of the industry’s most pressing challenge: rising interest rates. In seeking to quantify this challenge, we applied interest rate stresses to most of the middle market private companies in our portfolio of 2,400+ credit assessments, which are evaluations of the creditworthiness of an unrated issuer that are unpublished and confidential. KBRA’s stress tests found that rising rates alone—before applying any recessionary pressure on revenues or any inflationary pressure on costs—will significantly impact many middle market borrowers. The pain will be especially acute for smaller companies at the lower rungs of the credit spectrum with limited capacity to pay for rising interest costs from current cash flow. In coming months, lenders and sponsors must sort through which of these companies to save, which companies to let go, and how to proceed in either scenario. The coming stresses may test the collaboration between lenders and sponsors that has helped fuel the industry’s growth.

Key Takeaways

• The typical unhedged obligor in KBRA’s credit assessment portfolio is likely already experiencing a 30% increase in interest expense compared to the start of 2022. While this increased interest expense does reduce the financial flexibility of a typical borrower, KBRA’s stress test indicates such conditions do not cause a drastic decline in our portfolio credit assessments.
• KBRA’s conclusion is different once we incorporate further expected rate hikes. The markets are indicating future rate hikes could add up to 225 basis points (bps) to borrower costs by the end of Q1 2023. In a resulting 12.00% interest rate environment, up to an additional 16% of companies in the study portfolio may not generate enough cash flow from their operations to cover their interest expenses. This result excludes the impact of downward recessionary pressure on revenues and upward inflationary pressures on costs—all of which will, along with higher interest costs, begin to fully manifest in corporate cash flows in Q4 2022 and Q1 2023.
• While the above scenario may give some insight into the scope of companies that may ultimately have to go through a negotiated workout process with lenders, the analysis is best generalized toward private credit obligors who are in the lower end of the credit spectrum. With that in mind, KBRA will continue to monitor whether the anticipated level of credit workouts will evolve toward a generally orderly process between lenders and sponsors. The ultimate outcome of the process could cement the legacy of the direct lending industry.

Click here to view the report.

Related Publications

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• Private Credit: Business Development Company (BDC) Ratings Compendium: Where Does the Sector Stand on Liquidity
• Private Credit: Business Development Company (BDC) Ratings Compendium: The Impact of Higher Rates and a Potential Recession

About KBRA

KBRA is a full-service credit rating agency registered in the U.S., the EU, and the UK, and is designated to provide structured finance ratings in Canada. KBRA’s ratings can be used by investors for regulatory capital purposes in multiple jurisdictions.

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