Payment Defaults In Private Credit Remain Relatively Infrequent

Payment defaults in private credit remain rare based on data from our credit estimates on middle-market borrowers.   The CE general default rate (excluding selective defaults) is 0.5% on a trailing-12-month basis at the end of first quarter 2024, compared to a rate of just under 2% in the broadly syndicated loan (BSL) market. However, there is limited availability of information on defaults in the private debt market. We reviewed S&P Global Ratings' universe of over 2,000 credit-estimated issuers, which currently represent approximately $500 billion of debt held by middle-market collateralized loan obligations (CLOs) and identified 66 cases of payment defaults that occurred between 2020 and mid-2024. For purposes of this study, we have only assessed instances where companies missed an interest or principal payment without a forbearance agreement in place.

General payment defaults are less frequent than selective defaults (SD), for which there is a breach of the original promise of payment for any single class or instrument but not the entire capital structure; this is typically in the form of a distressed exchange transaction, which is effected to avoid a traditional default and one where the lenders are not adequately compensated (such as a below-par exchange, an amend-to-extend transaction, deferral of interest, or postponement of scheduled principal payments).

CE defaults picked up in 2023 relative to the prior two years.   Last year, we recorded 19 payment defaults among credit-estimated entities as higher interest rates began to squeeze the liquidity of weaker borrowers – who in turn were unable to make timely interest and/or principal payments on their debt. Not surprisingly, many of these companies have also struggled with other challenges including elevated operating expenses like costs of labor, shipping, fuel and other key inputs; sometimes in tandem with deteriorating demand which negatively affects their top line.

The 19 defaults in 2023 exceeded 17 combined defaults from 2021-2022, a period which was generally characterized by stronger demand and lower benchmark rates as borrowers dealt with lingering supply chain issues and disparate cost inflation. Naturally, the highest level of defaults occurred in 2020 as restaurants, travel services, and live-event organizers and servicers were caught off-guard with unprecedented business restrictions during the onset of the COVID-19 pandemic.

So far in 2024, the pace of CE payment defaults has slowed.   We believe better financing conditions, a resilient economy, and moderated inflation could be reasons for this trend, along with issuers' top-line growth. These factors have also helped borrowers navigate challenges seeking short-term relief in the form of loan term extensions, payment-in-kind (PIK) structuring, and sponsor equity infusions--which have kept quite a few troubled entities afloat.

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Defaults Are Usually Addressed Out Of Court

Middle-market CLOs have been able to offload defaulted debt at relatively high levels.   Based on a sample of 20 defaulted loans, we saw that U.S. middle-market CLO managers were able to exchange them out of their portfolio for about 80 cents to the dollar, on average. Although we don't view the exchanges as a proxy for recovery rates in the broader private debt market, we note the average exchange price compares favorably to historical first-lien recoveries in the BSL market, which were in the low- to mid-70s range according to our most recent global study, "Are Prospects For Global Debt Recoveries Bleak?" published March 14, 2024. The 80 cents to the dollar average was also in-line with historical first-lien recoveries for issuers with less than $350 million of outstanding debt, based on "U.S. Recovery Study: Loan Recoveries Persist Below Their Trend", which was published Dec. 15, 2023.

Out-of-court restructurings remain the preferred route for distressed middle-market issuers and lenders.   Based on our analysis, only 14 companies in our data set filed for bankruptcy, with most defaulted issuers addressing their obligations outside of the court system. This process is often quicker, significantly less expensive, and generally preserves more value for creditors. Even in the BSL and high yield bond markets, stressed borrowers in recent years have restructured their debt out of court more frequently, sometimes with liability management exercises (LMEs) that resulted in different recoveries for lenders at the same priority level. Given the tighter documentation and relationship-driven nature of lending, such outcomes are less likely in the private credit space.

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Workouts often result in lenders restructuring debt with more flexible terms for borrowers or swapping debt for equity.   In situations where we were able to determine a resolution for the payment default, we found that many cases were resolved after the default through refinancing or amendments from existing lenders (38%). As an example of this, the lender may capitalize accrued interest and extend the debt maturity date, which could be coupled with providing new subordinated debt, a broader PIK arrangement, or additional equity infusions from sponsors to provide liquidity for the borrower.

For PIK transactions, we have seen a blend of full PIK and partial cash plus-PIK deals. A handful of companies have also utilized the PIK feature for a certain period, only to return to the table with lenders again to extend it. This is different from situations where a company enters into an agreement with lenders ahead of a payment default to proactively address issues like an upcoming debt maturity or a scheduled principal payment that gets pushed back, or where a debt instrument moves from cash payments to PIK, all of which are more likely to be selective defaults.

Furthermore, debt-to-equity conversions (often for a controlling stake) were not uncommon as they constituted more than a quarter of the workouts even though many sponsors are loathe to relinquish control due to their sizeable equity stakes in many of the original leveraged buyouts (LBOs) and prevalent disparities in portfolio company valuation.

A smaller subset (12%) of defaults resulted in the company being acquired shortly after the missed payments. Liquidation (or sales of most of a company's assets) accounted for roughly 6% of the workouts. We note that in 18% of the cases, we were unable to determine the result of the restructuring due to scarcity of public information and limited required disclosure from CLO collateral managers after we are notified of a credit estimated entity's payment default.

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Default Exposure

Larger borrowers in the private market are not immune to default.   Compared to the average committed debt amount of approximately $250 million among the 66 defaulted entities, six of them had more than $500 million of committed debt, with all but one of those defaults occurring in 2023 and 2024. We also noticed that slightly more than half of the defaulted entities had some sort of subordinated debt (second lien or other mezzanine excluding preferred stock).

Several lenders were exposed to multiple defaulted entities, whereas there was very limited financial-sponsor concentration.   We counted seven collateral managers who had individual exposure to at least five defaulted borrowers during the timeframe for our study, which may be primarily attributable to the sheer scale of these lenders. Conversely, there wasn't much concentration of defaults among any given sponsor; as only two private-equity firms were exposed to more than one defaulted entity.

While in many cases sponsors have been willing to inject capital into underperforming portfolio companies, we believe they will become increasingly selective with the investments they continue to support if we see an extended period of high interest rates. We've already seen at least 15 instances from our study where sponsors gave control in certain companies over to their lenders after failing to agree to an alternative restructuring.

Defaults Varied By Sector

The health care sector had a disproportionate share of defaults, followed by business and consumer services, and hotels, restaurants, leisure.   The health care industry is currently challenged by high labor costs, physician shortages, and a restrictive regulatory regime (including the "No Surprises Act" and lower Medicare reimbursement rates), which have led to increased defaults in both the BSL and private credit space. Granted, a significant portion of the health care defaults occurred in 2020 as the onset of the pandemic led to postponed elective procedures, supply and resource constraints, and cost inflation. However, even with the COVID-19 pandemic in the rearview mirror, the health care and software sectors have continued to exhibit an elevated share of payment defaults as overleverage and heavy interest charges have eroded borrowers' cash flows and liquidity.

In a similar vein, the business services and leisure industries were hurt during the pandemic by greatly reduced foot traffic and spending on travel, dining, and gyms, with the hotel, restaurant, and leisure space still exhibiting payment defaults in subsequent years. For more information on these sectors' ability to absorb stress, readers can reference "Scenario Analysis: Testing Private Debt's Resilience Through The Credit Estimate Lens," published Nov. 2, 2023.

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Higher-For-Longer Interest Rates Could Increase Defaults

We believe a higher-for-longer interest rate environment would likely accelerate middle-market payment defaults.   Though sponsors and lenders have been creative in extending lifelines to entities under stress, the liquidity cushion provided by equity contributions and PIK options offer only a temporary reprieve for companies who are unable to generate cash. In a higher-for-longer interest rate scenario, we could see more SDs and in extreme cases, general payment defaults where sponsors are no longer incentivized to support portfolio companies from a valuation standpoint.