We see a critical test looming for private credit fund ratings. Our small, but fast-growing, cohort of rated funds retain plentiful lending opportunities. However, S&P Global Ratings believes the funds will face a rising tide of defaults in 2024.
Our corporate default studies and middle-market credit estimates both show defaults and negative rating transitions at multiyear highs. This will test the resilience of newer funds' investments and returns. While most rated funds look set to weather this period, for those with elevated leverage and tight liquidity this test could harm their ratings.
There is much at stake. Investors poured about $200 billion into private credit funds between January 2021 and the start of 2024, swelling the coffers of general partners (GPs). This saw the size and market penetration of credit funds shift, with ticket sizes growing and the breadth of limited partners (LPs) investing into funds widening. The steep take-off in rates, which has more than doubled the yields of many private credit assets, has further propelled the growth of these funds.
How Do We Rate Private Credit Funds?
The answer to this question lies in addressing where private credit funds end, and where other private credit models begin. We rate private credit funds using our alternative investment fund criteria, under which analysis of a fund's creditworthiness reflects the assets and liabilities of the fund itself. The scope of this means that we do not generally consider a link to the ultimate parent of the fund—typically an asset manager, whose creditworthiness we assess separately.
As such, our ratings reflect a credit fund's ability to repay its recourse liabilities on time in a theoretical liquidation scenario following a 'BBB', or moderate, stress, alongside the diversity and stability of its funding and liquidity.
Our framework also considers broader issues related to the fund such as its record, its risk-management framework, and the transparency and complexity of the fund's model (see infographic below). This piece draws from our analysis of a cohort of private credit funds rated under this methodology, most of which are in the U.S.
Chart 1
The degree of credit funds' exposure to market risk is a driver of how we choose to rate a fund under our alternative investment fund (AIF) criteria.
Typically AIFs have undefined funding maturities. Some, such as closed-end funds, have funding that is more clearly defined. As such, market risk is present for the majority of funds we currently rate. We recently published a Request For Comment in which we explain that we may look to an alternative scenario, focused on asset defaults as opposed to liquidation, for certain private credit funds that don't have an asset-liability mismatch that is typical for other AIFs (see “Request For Comment: Methodology For Rating Subscription Lines Secured By Capital Commitments,” April 29, 2024).
Even if we see more private credit funds whose funding maturities better resemble those of CLOs, we still expect to see asset selection being materially different. CLO funding remains the most efficient form of funding for a portfolio solely consisting of middle market loans. However, the credit funds we rate typically have a more flexible investment strategy, don't have contractual mitigants to counterparty risk, and may be focused on specific sectors such as real estate.
Table 1
Private Credit Fundraising Has Been Strong
Private credit funds raised since 2021 represent about one-eighth of the total fundraising by the world's blue-chip fund houses in that time (see chart 1). Investors' hunt for yield fed that momentum, as did lending demand from private capital markets. This is notable among private-equity sponsors looking for funding away from banks and capital markets, where the flood of private credit has often come with favorable terms and lower cost.
This demand has seen the role and impact of these funds shift meaningfully. In December 2023, Arcmont and Blackstone closed an almost €5 billion deal, a significant transaction at the end of a testing year for the space.
Indeed, 2023 squeezed the resilience of the industry as demand from private-equity sponsors for private debt funding dried up. This was mainly because private-equity funds were themselves struggling to exit their investments and raise fresh debt for new assets. This cool demand saw fundraising by credit funds slow (chart 2).
Chart 2
Direct lending is the most common strategy among private-debt funds, but within private debt, funds also pursue special opportunities, distressed debt, and real asset lending to infrastructure and real estate. These funds are managed by asset managers (GPs) and their main investors are pension and insurance companies, sovereign wealth funds, and wealthy individuals (LPs).
Versus other private market assets, such as private equity or venture capital, the strong asset yield on private debt has been a crucial pull factor for investors. During a period in which yields on investment-grade debt hovered around 0% in some jurisdictions, returns of more than 4% were a material return pickup for investors.
Interest income has risen further alongside central bank and wholesale rate increases in 2022 and 2023, topping out at more than 11% for U.S. speculative grade, leveraged loan issuers in mid-2023 (see charts 3a and 3b). Most of the industry's assets are floating yield, meaning they reprice alongside wholesale rates. However, as global rates start tapering in late 2024 yields will fall.
Chart 3a
Chart 3b
Recent Vintages Need To Live Up To Their Predecessors
The elevated interest rates available in private credit funds do not guarantee strong fund performance, however. Indeed, as Preqin data tracking net internal rates of return (IRR) shows, the sharp rate increases in 2022 came alongside dampened fund performance for many private lending strategies.
Nonetheless, private credit and direct lending funds have recorded an average net IRR of 11.9% over the course of 2018 to 2023, a solid level. This stability has been important for LPs during a difficult 2022 and 2023 for other private capital strategies, such as private equity and venture capital (see chart 4).
Chart 4
After a strong five years of fundraising for the industry the focus of LPs is turning to stable returns. In this respect, prior private debt and private lending strategies have a good record. Older vintages tend to have distributed to paid capital in ratios (DPIs) above 100%--indicating that investors have had all their capital returned to them (see chart 5).
Chart 5
This is an important benchmark, showing that contractual cash flows and robust security packages that underpin private debt can serve to protect investors--even during periods of sharp market dislocation. At the same time, newer and larger-than-ever vintages are under increased scrutiny to prove their profitability after record inflows into the space.
In this regard, newer funds' records are somewhat mixed. Year 2023 vintages in private debt and direct lending are already above a 25% DPI ratio, a level of return about 8 percentage points above 2022 vintages. As asset yields have risen quickly this dynamic is perhaps unsurprising. Even so, we believe that this new rate environment will serve as a mixed blessing--boosting yields but testing fund asset quality.
Global Asset Quality Is Normalizing After A Benign Run
The rising rates environment is already testing global credit quality. Our data shows that defaults in the first two months of 2024 were at their highest level since 2009. Within this, European defaults more than doubled in the first two months of 2024 versus the same period in 2023 as vulnerable firms succumbed to expensive debt burdens (see chart 6).
Chart 6
Conditions are similarly strained among our global population of middle-market credit estimates. We provide these credit estimates to managers of middle-market CLOs. This is relevant for our consideration of private credit fund asset quality as private credit managers can originate and place private middle-market loans across different strategies on their credit platforms--including middle market CLOs, private credit funds, and even business development companies. As such, the credit quality of these estimates is a bellwether to the quality of the underlying portfolios of private credit funds.
To this end, credit conditions look challenging. Average leverage is around 7x in the population, and 20% of the population has an EBITDA interest coverage ratio below 1x. In the event of mild stress (EBITDA -10%, the Secured Overnight Financing Rate up 50 basis points) more than one-quarter of the population would see their interest cover fall below 1x (see chart 7). That outcome would point to a middle-market population that is vulnerable to an extended period of high rates.
For instance, in the first eight months of 2023 alone, 87 credit estimates in our population fell into the 'CCC' category, which indicates significant financial distress and a rising risk of default. Middle-market corporates look set to see further deterioration in credit quality in the next 12 months.
Chart 7
Most Rated Private Credit Funds Can Absorb A Sharp Fall In Asset Quality And Valuations
As global corporate asset quality looks set to embark on a steady normalization, most ratings on private credit funds will be able to withstand this weakening credit quality. Firstly, observed defaults are significantly below the stressed levels we would anticipate in a 'BBB' stress scenario--the scenario that drives our alternative investment fund ratings.
For example, during the 2008 financial crisis, which we assess as a 'BBB' scenario, the default rate on 'B' rated exposures was 4.1%. The default rate on 'CCC' rated exposures was 27.3%. For 'B' level ratings this is some 3.3 times greater than the full year 2023 default rate (see “2023 Annual Global Corporate Default And Rating Transition Study,” March 28, 2024). The 'CCC' level was 30.9% in 2023, exceeding the 'BBB' scenario (see table 2).
Table 2
| Descriptive statistics on one year global default rates (%) | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| AAA | AA | A | BBB | BB | B | CCC/C | ||||||||||
| Minimum | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.25 | 0.00 | |||||||||
| Maximum | 0.00 | 0.38 | 0.38 | 1.00 | 4.24 | 13.84 | 49.46 | |||||||||
| Weighted long-term average | 0.00 | 0.02 | 0.05 | 0.14 | 0.57 | 2.98 | 25.98 | |||||||||
| Median | 0.00 | 0.00 | 0.00 | 0.06 | 0.47 | 3.18 | 25.00 | |||||||||
| Standard deviation | 0.00 | 0.06 | 0.10 | 0.25 | 0.96 | 3.23 | 11.73 | |||||||||
| 2008 default rates | 0.00 | 0.38 | 0.38 | 0.49 | 0.81 | 4.09 | 27.27 | |||||||||
| Latest four quarters (Q1 2023-Q4 2023) | 0.00 | 0.00 | 0.00 | 0.11 | 0.17 | 1.24 | 30.89 | |||||||||
| Difference between last four quarters and weighted average | 0.00 | -0.02 | -0.05 | -0.03 | -0.41 | -1.74 | 4.91 | |||||||||
| Number of standard deviations | -0.28 | -0.49 | -0.14 | -0.42 | -0.54 | 0.42 | ||||||||||
| Source: S&P Global Ratings. | ||||||||||||||||
Our methodology also considers the stressed liquidation value of a fund. By this, we mean the market value of a fund if it was forced to divest its loans to service recourse liabilities.
The additional market risk loss on funds' portfolios in liquidation is significantly above the default rate observed in a 'BBB' scenario from credit losses alone. This haircut falls materially as exposures shift toward better quality counterparties. To this end, the average haircut on private credit funds' asset bases in the selected cohort is 42% under our methodology (see chart 8). This is equivalent to somewhere between a 'B' and 'BB' exposure on average based on a maturity of between three and five years.
Table 3
| Typical haircuts for private debt exposures reflect the material market risk they face | ||||
|---|---|---|---|---|
| Haircut by asset type (%) | ||||
| Corporate bonds and loans (>3-5 year): BBB | 27 | |||
| Corporate bonds and loans (>3-5 year): BB | 34 | |||
| Corporate bonds and loans (>3-5 year): B | 41 | |||
| Corporate bonds and loans (>3-5 year): CCC | 59 | |||
| Corporate bonds and loans (>3-5 year): NR | 59 | |||
| NR--Not rated. Source: S&P Global Ratings. | ||||
Chart 8
Importantly for our ratings, most private credit ratings in our cross section have comfortable headroom above their ratings thresholds for stressed leverage. On average our adjusted stressed leverage is 52% above the relevant ratings trigger--meaning the level at which we would take negative ratings actions.
For instance, fund three in our sample below would have to see its reported net asset value (NAV) fall by 40% from its most recent level to hit the threshold for a lower rating level under our liquidation scenario (see chart 9). Given broad indicators of corporate default this level of stress is still some way off--even if defaults are rising.
Chart 9
The comfortable headroom for much of the sector reflects generally conservative loan-to-value covenants on indebtedness (see chart 10). This is true even if they are more generous than less liquid funds like private equity (see below for further discussion comparing these two sub-sectors). These covenants generally cap indebtedness at a level below 50% of NAV. This is a comfortable start point that accommodates a significant deterioration in fund value before recoveries fall below 100% for creditors.
Indeed, in some examples where indebtedness is approaching loan to value (LTV) limits, tight covenants mean that stressed leverage is, nonetheless, at a very strong level under our framework.
Chart 10
There are limits to this view of headroom. Firstly, a fall in a fund's valuation would not affect our view of leverage in isolation. Sharp drawdowns in value would likely come alongside strained liquidity as assets default or seek debt relief. An example of debt relief would be periods of payments in kind on interest charges.
Additionally, the timing of asset revaluations and writedowns is highly uncertain as not all funds value their assets in the same way, or acknowledge markdowns at the same time. There can be a material delay between credit stress rising, and funds' crystallizing falls in valuation. This may be reflected either in their reporting or in their decision to liquidate an investment.
This potential dislocation further supports our use of stressed asset valuations as per historic market valuations when considering the market risk faced by funds. Finally, sustained drawdowns and opaque valuations would ultimately raise the question of the effectiveness of a fund's performance and record--a relevant consideration in our ratings analysis.
Highly Leveraged Private Credit Models Operate With Tight Headroom
Even though many entities in our sample have comfortable headroom, there is a meaningful part of the population that operate with elevated LTVs and limited downside headroom. For example, for fund four in chart 9 above, their NAV would have to fall by only 8% for there to be ratings pressure.
Fund seven (see chart 10) has significantly utilised its relatively high LTV limit under its covenants. Accordingly, it has limited headroom under our stressed leverage measure. To this end, in chart 9 up to a third of our sample has headroom of 10% or less--analogous to a drawdown of 10% in their NAV--before rating pressure could surface. This is a significant minority and, as their investments come under pressure, our ratings could follow suit. The outlooks are stable in all these cases.
A Stable Stream Of Interest Income Provides A Bedrock To Ratings
Contained leverage is an important part of our relatively high ratings on private credit funds. Just as prominent in the cohort's solid ratings, however, is the stable stream of interest income into rated funds. This predictable inflow enables most funds to comfortably cover their fixed uses of cash by well more than 1x, even on a stressed basis. Typical examples of such fixed cash uses include interest and management fees, and may also involve further committed capital injections.
We apply a haircut to contractual cash flows from assets in line with the default rates seen under our default studies (see table 2).
Indeed, all but the most highly levered funds in our cross section can comfortably meet their liquidity needs and have headroom at our rating level. This view encompasses the assumption that funds draw down the maximum leverage possible under their covenants, maximizing their interest burden (see chart 11).
When we take interest inflows alongside other measures to bolster liquidity, liquidity is a bedrock to most private credit ratings. Indeed, versus many private capital providers, private credit's liquidity coverage is an important rating differentiator. This includes venture capital or private equity, where contractual cash inflows are limited and liquidity is a product of uncalled reserves or stressed asset sales.
Chart 11
Comparing Ratings On Private Credit And Private Equity
Our ratings on private equity and private credit are broadly similar. In our two cross sections the average rating is in the 'BBB' range (see chart 12).
In general, any positive rating differential for private credit funds rests on their stronger liquidity--specifically, the stronger flow of contractual income from their asset base. Beyond that, many of these subsector's strengths tend to stack up well alongside one another. Core strengths of contained leverage limits from lenders and generally close ended funding structures, are offset by weak asset liquidity, and uncertainty in asset valuations and exit strategies.
Certain structures in private credit do carry structurally higher credit risk, in our view, than what can be achieved in private equity fund structures.
Front of mind in this regard is the levered feeder fund structure model. This model enables select LPs to enter master funds through a feeder fund sleeve, whereby their capital is in a blend of senior unsecured notes and equity. The ratio of these contributions can be as high as 90% debt to 10% equity (see chart 13).
Offsetting this is often a material net margin for the feeder fund between the interest paid on liabilities and the contractual interest from investments underneath the master fund. Indeed, to the extent that they generate a more predictable and reliable stream of cash-flows than private equity or venture capital, credit funds generally lend themselves well to feeder fund structures.
In rating these funds, we look through the levered sleeve to the master fund that sits below the feeder itself. In so doing, we consider the blend of strategies and asset exposures of that master fund itself on a pro-rata basis.
Crucially, under our analysis, the high indebtedness of the feeder tends to be a material ratings constraint. Furthermore, given their leverage profile, they would tend to be rated lower than the master fund that sits below them as well.
Chart 12
Chart 13
Flexible Lending Terms Can Help And Hinder Our View Of Private Credit Funds
An essential source of resilience for private credit funds is the granular and flexible terms offered in their lending. In the event of debtor default credit funds can position themselves favourably to support their recovery. Prior to this, however, credit funds use broad measures to preserve the credit quality of their investments.
Prominent among these tools is the option for payment in kind (PIK) on debtors' liabilities. Such structures enable investees to capitalize interest due during periods of stress, preserving their liquidity.
So, these measures can preserve portfolio credit quality and give debtors breathing room. That said, they can also undermine the major strength of our private credit fund ratings: their stable and predictable interest income. For the most levered funds we rate, if 20% of their portfolio moved to PIK from cash payment of interest, they would likely see our view of their liquidity move very close to levels commensurate with a lower rating level (see chart 14).
Toggling to PIK can preserve the fund's credit quality and valuations, protecting the theoretical coverage of their liabilities by stressed assets. However, doing so would likely test our view of that same fund's liquidity.
Chart 14
Related Research
- How We Rate Alternative Investment Funds, Feb. 23, 2024
- ABS Frontiers: The Blurring Of Private Credit Funds And CLOs, Jan. 30, 2024
- Uneven Liquidity And Strained Valuations Are Pushing Some Funds Toward Debt, Sept. 28, 2023
- Credit FAQ: Defining And Rating An Alternative Investment Fund, March 31, 2023
- Difficult Markets Will Test Europe’s Rated Alternative Investment Funds, Dec. 5, 2022
This report does not constitute a rating action.
| Primary Credit Analyst: | William Edwards, London + 44 20 7176 3359; william.edwards@spglobal.com |
| Secondary Contacts: | Andrey Nikolaev, CFA, Paris + 33 14 420 7329; andrey.nikolaev@spglobal.com |
| Philippe Raposo, Paris + 33 14 420 7377; philippe.raposo@spglobal.com | |
| Thierry Grunspan, Columbia + 1 (212) 438 1441; thierry.grunspan@spglobal.com |
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