How Risky Is Private Credit? Analysts Are Piecing Together Clues

Now analysts are piecing together clues showing how risky those loans might be.

A recent analysis by S&P Global Ratings used the firm’s confidential credit assessments for clients to offer a rare view of roughly 2,000 private corporate borrowers with more than $400 billion in debt between them. Without identifying the companies, the firm ran stress tests to see how they might fare in varying economic scenarios.

The findings offer a glimpse into the private credit market, which grew in popularity after the financial crisis in 2008-09 and surged more recently after conventional lenders pulled back following this year’s banking crisis.

Much of that private lending has gone to smaller, less-profitable companies that are already loaded with debt. With the market growing, the Securities and Exchange Commission recently approved new rules for private fund managers.

The S&P analysis offers a snapshot of the market in the meantime. The firm’s analysis looked at midsize companies with corporate debt pooled in collateralized loan obligations. Since slices of many of those loans are also directly held by private credit funds, S&P said the sample represents a sizable portion of the private credit market.

S&P used the confidential “credit estimates" that it provides to collateralized-loan managers for companies with private debt in CLOs. The estimates are akin to credit ratings and tend to be updated about every six months on average.

The tests showed that many of the companies that have turned to the private credit markets would struggle with any financial stress if the Federal Reserve’s interest-rate policy was to persist.

“If rates stay higher for longer—or higher forever—then these companies are not equipped," said Ramki Muthukrishnan, head of U.S. leveraged finance at S&P Global. He said companies would struggle to pay their debt.

Just 46% of the companies in the analysis would generate positive cash flow from their business operations under S&P’s mildest stress scenario, in which earnings fell by 10% and the Fed’s benchmark rates increased by another 0.5 percentage point, the ratings firm said. Private credit sponsors would be left facing difficult choices over which companies to keep supporting, Muthukrishnan said.

“It needs to make economic sense for them to throw good money after bad, and they have a whole lot of companies in their portfolio," he said.

S&P has been lowering scores on several of its credit estimates, a move similar to a downgrade on a rated bond. The firm lowered its scores for 87 companies into its “ccc" territory from the start of the year through the end of August, a heightened rate similar to that at the start of the pandemic.

The firm said the downgraded companies often had capital structures it viewed as “unsustainable absent favorable economic and financial conditions, or upcoming loan maturities without a definite plan to extend, refinance, or redeem the debt."

Separately, analysts at Bank of America said recently that they expect the rate of private debt defaults to reach 5% next year if interest rates remain high.

Some recent higher-profile bankruptcies involved companies that used private credit. The orthodontics company SmileDirectClub filed for bankruptcy in September, after borrowing $255 million in a private loan last year. Bed Bath & Beyond took out a $375 million private loan last year before filing for bankruptcy in April.

S&P’s analysis wasn’t all gloom.

The firm found that many of the companies appear to have some runway left. Under current conditions, the companies in S&P’s sample had a median liquidity of nearly 2½ times as much cash and other assets available to cover their needs, including maturing debt.Companies also have some time for rates to come down. While roughly $30 billion of debt is set to mature next year, that balloons to north of $60 billion in 2025 and nearly $100 billion in 2026.

Write to Ben Foldy at ben.foldy@wsj.com