Signals of Distress in Private Credit

Private credit has grown dramatically in the past decade but funds now face scrutiny over the credit risk of the loans they hold.¹ Defaults are challenging to observe in private credit, because general partners (GPs) tend to provide little commentary around loan nonperformance. We can use a loan’s valuation and cost basis to signal default, however. In this analysis, based on MSCI Private Capital Transparency Data covering the terms of more than 30,000 loans held by closed-end private funds, we treat loans valued at less than 80% of cost basis as nonperforming.

Rising rates took a toll

Reviewing the trends for mezzanine and senior loans since 2020, two periods stand out. In late 2020, our default signal for both loan types trended sharply downward as pandemic-related concerns subsided. And, since mid-2022, defaults for senior loans have nearly tripled as interest rates lifted off from near-zero levels. Given that private-credit funds predominantly hold floating-rate loans, changing expectations for the path of interest rates can greatly impact a borrowing company’s future interest-coverage ratio — and thus likelihood of default.

While we suggested earlier that a loan marked at a discount to cost basis indicated default, the discount could also reflect a rise in spreads. In fact, high-yield spreads have generally been declining since mid-2022, which would artificially depress our default-rate proxy. Thus, the true increase in distress is likely to be even more significant than our proxy implies.

Given GPs’ continued reticence to discuss defaults, plus reemerging fears of a recession, it is becoming increasingly important for private-credit investors to proactively monitor default risk in their portfolios.