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The private credit industry, valued at $1.4tn, now faces its first major challenge as loans underwritten at the peak of the market in 2021 contend with higher interest costs and a slowing economy, according to analysts at rating agency Moody’s.
Moody’s specifically highlighted two major players in the sector, Ares and Owl Rock, emphasizing the difficulty that lenders are facing due to tightening financial markets in 2022.
These loans were predominantly underwritten when interest rates were near zero and the US economy was flourishing. However, this landscape shifted after the Federal Reserve aggressively raised interest rates in an attempt to tackle inflation.
“This shift in macro and market conditions will test the ability of non-bank private credit lenders to navigate a recession and an increase in borrower defaults,” stated Christina Padgett, an analyst at Moody’s.
While Moody’s issued a warning, it did not downgrade the ratings or credit outlook of either Ares or Owl Rock, both of which are publicly traded lending vehicles known as business development corporations. Ares and Owl Rock declined to comment.
The private credit industry has evolved significantly since the 2008 financial crisis when major US banks reduced their exposure to leveraged buyouts. Initially, lenders like Ares primarily focused on financing small and midsized takeovers.
However, over time, they shifted their focus to larger deals. This change was driven by a surge in fundraising during the peak of the Covid-19 pandemic, providing these lenders with the financial power to offer multibillion-dollar buyout loans.
Many of the loans underwritten in 2021 were considered high-risk. Some were extended to unprofitable companies that traditional banks were unable to finance, relying on the companies’ recurring revenues and optimistic projections of future profits.
A significant increase in interest rates could lead to financial difficulties for these businesses in meeting their interest payments. Moody’s discovered that the interest coverage ratios of the loans provided by Ares and Owl Rock would eventually halve.
These entities provided loans for some of the largest buyouts in 2021, particularly in the software sector, through partnerships with specialist private equity firms such as Thoma Bravo.
For example, the Ares fund holds nearly $150mn in loans for Stamps.com, an ecommerce shipping company that was privatized by Thoma Bravo for $6.6bn in 2021. They also have $84mn in loans for real estate software specialist RealPage, which Thoma Bravo took private for over $10bn in one of the largest buyouts of the year.
The yield on both loans now exceeds 10%, around 40% higher than the previous year, as indicated by securities filings. This increase reflects the impact of higher interest rates.
Owl Rock, on the other hand, provided loans for 2021 deals such as Thoma Bravo’s acquisition of Talend and Dell’s sale of Boomi to a consortium led by Francisco Partners and TPG.
Some of these loans may soon be repaid, reducing overall credit exposure. Both funds extended loans to Adenza, a financial software company developed by Thoma Bravo. Recently, Thoma Bravo agreed to sell the Adenza business to Nasdaq for over $10bn. If the deal concludes, the loans will be repaid in full.
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