Signals of Distress in Private Credit
Private credit has grown dramatically in the past decade but funds now face scrutiny over the credit risk of the loans they hold.1 Defaults are challenging to observe in private credit, because general partners (GPs) tend to provide little commentary around loan nonperformance. We can use a loan's valuation and cost basis to signal default, however. In this analysis, based on MSCI Private Capital Transparency Data covering the terms of more than 30,000 loans held by closed-end private funds, we treat loans valued at less than 80% of cost basis as nonperforming.
Rising rates took a toll
Reviewing the trends for mezzanine and senior loans since 2020, two periods stand out. In late 2020, our default signal for both loan types trended sharply downward as pandemic-related concerns subsided. And, since mid-2022, defaults for senior loans have nearly tripled as interest rates lifted off from near-zero levels. Given that private-credit funds predominantly hold floating-rate loans, changing expectations for the path of interest rates can greatly impact a borrowing company's future interest-coverage ratio — and thus likelihood of default.
While we suggested earlier that a loan marked at a discount to cost basis indicated default, the discount could also reflect a rise in spreads. In fact, high-yield spreads have generally been declining since mid-2022, which would artificially depress our default-rate proxy. Thus, the true increase in distress is likely to be even more significant than our proxy implies.
Given GPs' continued reticence to discuss defaults, plus reemerging fears of a recession, it is becoming increasingly important for private-credit investors to proactively monitor default risk in their portfolios.
Default rate for senior loans has nearly tripled since mid-2022
Proxy default rates by calendar quarter. Loans with market value reported at below 80% of cost basis are treated as nonperforming.
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1 Jodi Xu Klein, “The $1.5 Trillion Private-Credit Market Faces Challenges,” Wall Street Journal, Oct. 16, 2023.
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