Higher Rates Aren’t Sinking Private Credit — Yet

“Everyone is adjusting to new realities. The terms are changing, covenants are better, leverage is lower, coupons are higher,” says Richard Byrne of Benefit Street Partners.

Getty Images

Getty Images

Richard Byrne, who has been through multiple credit cycles in his career, can’t help but bring up the Titanic when talking about the state of the private credit markets right now.

In the 1997 film version, the “unsinkable” Titanic’s designer tells the CEO of the cruise line that it’s a “mathematical certainty” that the ship will sink, even as the famous musicians go on playing.

Although Byrne, president of Benefit Street Partners, which is now owned by Franklin Templeton, insists that private credit won’t experience the horrible end that met the Titanic, he says it’s an apt metaphor. The dramatic rise in interest rates, as the Federal Reserve battles inflation, is the iceberg.

“The iceberg hit, rates went up, and it’s impacting companies,” he said. When rates rise, capital becomes more costly, lowering borrowers’ so-called interest coverage ratio, the multiple of cash flow available to cover interest payments. This means that a company had better not underperform, and it also increases the risk when loans need to be refinanced at maturity.

“If you had 2.6 times interest coverage before, and nothing else changed about your company, your interest coverage is now 1.6. That’s not a default. But it does mean you have less buffer if something goes wrong,” said Byrne, who has had a long career in credit, including as CEO of Deutsche Bank Securities.

Like the musicians playing on the deck of the ship who can’t see the damage below, investors and credit managers aren’t yet feeling the impact of higher rates on their portfolio companies. But anyone who has been through a credit cycle knows that the existing debt portfolios will ultimately feel the strain of the increase in borrowing costs, according to a new white paper from Benefit Street expected to be published Wednesday.

In recent earnings calls at publicly traded Business Development Companies, which invest in private debt, analysts and investors have asked management if they’ve seen any signs of trouble, whether that’s downgrades, increases in defaults, or requests by borrowers for amendments.

For the most part, BDCs are doing okay and have assured shareholders that there aren’t any negative signs — yet. Credit ratings agency Fitch says its outlook for BDCs is deteriorating, citing the pressure of higher rates on the quality of assets, borrowers’ cushions, and funding flexibility. At the same time, earnings at BDCs have increased because their floating-rate loans have benefited from rising rates.

“BDCs are not currently seeing a deterioration of any meaningful degree in their portfolios — and earnings are all up,” said Byrne. “How could this be? Well, just give it some time.”

Titanic metaphors aside, Byrne says that investing over the last 12 or more years had become boring. The difference, essentially, between the top quartile and the third quartile of managers was usually that the top performers took a lot more risk. Byrne is now excited to put money to work.

“This is the best vintage of anything we’ve looked at for a really long time. That’s because everyone is adjusting to new realities. The terms are changing, covenants are better, leverage is lower, coupons are higher,” he said. That puts the reality of new loans into sharp perspective. “I would just put logic in front of you again: if the new loans have adjusted and are adjusting by things like lower leverage, then how is a higher leverage loan going to refinance at that leverage level? Of course, it won’t,” said Byrne.

Executives at other credit managers told II that they agree, even if they don’t know how much worse it will get. “Our capital is finally worth something,” said one CIO of a credit manager. If managers have the cash to invest and aren’t putting capital into troubled companies, deals are available with the most lender-friendly terms in years.

Byrne, who is also CEO and chairman of two BDCs advised by Benefit Street, pointed out that investors are still waiting it out. BDCs aren’t issuing equity, and private debt fundraising has dried up.

“Most private debt investors are sitting on the sidelines, either because they’re hoarding liquidity or because they’re in vehicles, such as BDCs, that can only invest based on proceeds coming back in the form of prepayments, and those have slowed to virtually zero,” according to the white paper.

There’s a push me-pull me situation at work in the market. But for credit guys like Byrne, two things can exist at the same time, he said. “Maturing loans will no longer be able to refinance at the favorable terms to which they’re accustomed, but for fresh money, what an opportunity it is because you’re getting paid for the first time for the likelihood that there will be higher defaults.”