(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2024--collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2024.)

Whether private or public, credit is credit. And with interest rates likely to remain higher for longer, weaker borrowers and their lenders are paying far more attention to cash flow metrics and borrowers' ability to service debt.

How This Will Shape 2024

We expect opportunities for private credit and funds to remain robust in 2024, after booming in 2023.  After years of strong fundraising, private credit funds have amassed more than $400 billion in dry powder globally (as of September), leaving them with cash to deploy. While limited partners appear to be responding to restrictive, higher-for-longer interest rates by slowing contributions to alternative assets--especially private equity funds--private credit allocations have held up better. Whether 2024 will be another golden year for private debt investors will depend on their risk appetites and strategic focus, as well as the economic backdrop.

The pool of private credit continues to expand.  In the U.S., private credit is growing its capacity through nontraded business development companies, interval funds, and middle-market collateralized loan obligations. Direct lenders have tended to target traditional middle-market borrowers with $25 million-$100 million (or equivalent in euros) of EBITDA, but the growing trend for club deals has extended private credit's reach to larger and more diverse borrowers. Additionally, distressed and special situations funds--which represent as much as one-third of available capital--are waiting in the wings for rescue financing opportunities.

Challenges for borrowers may be opportunities for lenders.  Given challenging public markets, borrowers are looking for other sources of funding to meet upcoming maturities. Broadly syndicated loan issuance in the U.S. and Europe is down nearly 30%, to its lowest level since 2010 (at $318 billion). Meanwhile, 'CCC' bond issuance has fallen to its lowest level since 2008 (around $2 billion). Private credit is looking to take up some of the slack as upcoming maturities of nonfinancial corporate debt rated 'B-' and lower (in the U.S. and Europe) doubles to $169 billion in 2025, from $83 billion in 2024.

What We Think And Why

Credit is credit, and these borrowers face the same fundamental risks as rated issuers.  Financial risks weigh more on the credit quality of borrowers with weak business risk profiles or high leverage. In particular, companies issuing floating-rate debt, such as from private lenders, will be vulnerable to the higher cost of funding amid higher-for-longer interest rates.

We see this in rising default rates. We expect the trailing-12-month speculative-grade corporate default rate to reach 5% in the U.S. by September 2024 (up from 4.1% in September 2023) and 3.75% in Europe (up from 3.1%) as companies grapple with higher interest rates.

Cash flow metrics are regaining their importance as a key driver of credit quality, alongside measures of leverage.  We see many borrowers laser focused on maximizing cash flow through various measures, including: cutting expenses, protecting margins, trimming inventories and working capital, selling assets, reducing dividends and share buybacks, or raising equity. Cash-constrained borrowers are also using payment-in-kind instruments on their balance sheets and choosing to build cash buffers rather than repay debt.

For businesses that require significant investment, the need to prioritize liquidity could come at the expense of longer-term growth. In addition, some financial sponsors--facing the reality of higher funding costs, lower valuations, longer hold times, and fewer exit routes for portfolio companies--are resorting to new arrangements to raise debt, often hoping to bridge to a more favorable business climate.

Tighter financing conditions will test financial vulnerabilities.  In our base case, we expect policy interest rates to only start easing in the second half of 2024, meaning financing conditions will remain restrictive for a while. This is likely to pressure the credit quality of the more than 2,000 U.S. middle-market borrowers for which we have credit estimates. In the year to August 2023, a significant minority were already struggling to generate positive free operating cash flow, and 78% had a low 'b-' score, with 13% in the 'ccc' category. In comparison, about 30% of global speculative-grade issuers are rated 'B-' or lower.

What Could Go Wrong

Even a moderate stress could diminish the credit quality of private credit borrowers.  Our analysis highlights that many companies with 'b-' credit estimates could be at risk of a downgrade from higher interest rates and lower earnings. We assume a moderate stress scenario of SOFR rising 1 percentage point over our current base case of about 5%, together with a 20% fall in EBITDA. In such a case, only about 35% of this set of middle-market borrowers would likely generate positive free operating cash flow, and about 28% of those with 'b-' credit estimate scores would be vulnerable to a downgrade.

Interestingly, 55% of these credit estimates are for companies in the business and consumer services, health care services, and technology software and services sectors. Technology appears most vulnerable in our stress scenarios, with materially weaker interest coverage ratio and covenant headroom.

Information asymmetry is more problematic for credit investors than equity providers.  Lenders are always more sensitive to downside risks than equity investors. One such risk is the considerable information asymmetry in the private credit market, which is exacerbated by the influx of less-sophisticated retail investors into the asset class.

While tighter documentation and close working relationships help to facilitate an open flow of information between borrowers, lenders, and sponsors, limited partners and institutional investors have a more indirect flow of information. Disclosures about borrowers' operational and financial performance, credit quality, and asset valuations may vary between funds and intermediaries.

Illiquidity could reveal contagion risk.  Without a sizable secondary market, private credit assets are largely illiquid buy-and-hold investments held in vehicles with capital that is typically locked up for at least five years. We think the scale of private debt is unlikely on its own to threaten financial stability in the U.S. or Europe, as it accounts for only about 4% and 1% of total nonfinancial corporate debt in each region, respectively.

However, a material shock in this opaque, illiquid, and unregulated market could expose vulnerabilities elsewhere in the financial system. For instance, there could be some contagion risk to banks, insurance companies, and pension funds. Banks often provide private credit lenders with some of the capital they use to extend loans--in some cases to companies the banks themselves would consider uncreditworthy. Banks could therefore be indirectly exposed to troubled borrowers, but without the oversight they have in the broadly syndicated loan market. Pension funds and insurance companies invested in private credit funds are exposed in much the same way.

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Related Research

• Testing Private Debt's Resilience Through The Credit Estimate Lens, Nov. 2, 2023
• Middle-Market CLO And Private Credit Quarterly: Strong Credit Growth, But Weakening Underlying Credit, Oct. 20, 2023