In higher-for-longer rate scenario, how resilient is private credit?

Article published by Abby Latour on PitchBook | LCD

Borrower companies in the Technology Software and Services sector are especially prone to increased stress, a report by S&P Global Ratings said.

The report, entitled Testing Private Debt’s Resilience Through The Credit Estimate Lens, analyzed over 2,000 credit estimated (CE) issuers with over $400 billion of outstanding debt, putting them through three stress scenarios. Credit estimates are not borrower companies that request ratings, so they are typically private companies, often smaller, than rated large-cap borrowers. S&P Global Ratings provides credit estimates, which are a “point-in-time confidential indication of the likely long-term credit rating” to CLO managers regarding their holdings.

The analysis noted that three sectors have been especially popular for private credit lenders in recent years, primarily due to their growth prospects and potential resilience through business cycles: Business and Consumer Services, Technology Software and Services, and Healthcare Services. Together, the issuers accounted for 55% of CE issuers.

Of these, Technology Software and Services is the most vulnerable through stress scenarios, which are mild stress, moderate, and severe stress.

“Although its leverage metrics are comparable to those of Healthcare, CEs in the Technology sector had a materially weaker median interest coverage ratio and covenant headroom. In a moderate stress scenario, we expect median leverage for tech issuers would exceed 10x, along with interest coverage below 1x and covenant headroom of less than 10%,” said the report, published on Nov 2.

The Business Services sector is in a stronger position “with a turn less of leverage and significantly more covenant headroom than the other two sectors,” the report said.

The analysis said that certain credit agreement features were more susceptible to stress scenarios: recurring revenue covenants and PIK (pay in-kind) interest optionality.

“Issuers with ARR covenants, which are initially based on recurring revenues rather than the more traditional EBITDA metric, are primarily present in the technology space and comprise 78 names (less than 4% of the portfolio). More than 70% of those entities are already estimated at the 'ccc' category since these are typically early-growth stage companies with very low EBITDA and cash flow, in addition to high leverage,” the report said.

“Accordingly, they are more dependent on revenue growth and retention, as well as relatively higher sponsor equity contributions.” S&P Global Ratings published a report in July, saying it expected recurring revenue borrowers to face challenges as companies reduce spending.

The report categorized PIK interest in three ways: borrowers paying mostly cash interest along with a smaller PIK component; borrowers with a PIK toggle option, allowing them to choose cash or PIK payment, which is common in recurring revenue loans and early-stage tech companies; and PIK interest resulting from an amendment due to an inability to pay cash interest. The third category poses the greatest risk and is usually due to performance issues.

In the analysis, S&P Global Ratings reviewed credit estimates completed between August 2022 and August 2023. The majority, 78% of the CEs had a 'b-' score, and 13% were 'ccc' category. The entities were tested under three scenarios: mild, moderate, and severe stress, with S&P Global Ratings-adjusted EBITDA declining 10-30% combined with Sofr increases of 0.5-1.5%.

“Median leverage ratios could rise to double digits in a severe stress scenario, and would remain elevated in all stress scenarios,” the report said. “Concurrently, in all stress scenarios, the median interest coverage ratio falls below 1.5x, with a range of 1.1x-1.4x, implying that many issuers would experience challenges servicing debts solely from the cash flows they generate.”