Heavy weight

Amid high interest rates and inflationary pressures, private credit borrowers are facing negative credit rating activity and are struggling to reduce leverage — but defaults have remained contained, DBRS Morningstar says.

The rating agency said it is on guard for signs of stress that would drive defaults higher.

In a new report, DBRS examined the landscape of corporate issuers that have secured financing from private lenders. These companies are primarily private equity-backed firms with annual operating earnings in the US$10 million to US$100 million range.

So far this year, DBRS said, those firms have struggled with elevated interest rates and labour costs that are pressuring their cash flows. Pricing power has eroded too,

As a result, interest coverage (the ratio of operating income to interest charges) has declined this year, it noted.

“The persistent high-interest-rate environment and heavy debt burdens have left some private credit companies with limited or negative free cash flows, restricting their ability to pay down debt,” DBRS said.

Against this backdrop, negative credit rating actions have increased too, the report noted, with 65% of rating actions this year coming on the downside. Normally, rating activity would be more evenly split between positive and negative actions.

“Overall, we expect negative credit rating actions to increase in the current environment to the extent that borrowing costs remain near current levels,” it said.

Despite the generally weak credits and negative rating action however, DBRS noted that private credit borrowers have so far experienced lower default rates compared with low-rated companies overall.

“We believe this reflects higher covenant restrictions and a close working relationship among management, private equity sponsors, and private lenders,” it said.

Looking ahead, the liquidity and interest coverage metrics will be important signals of possible distress at these companies, it noted.

“Over the next 12 months, we will be examining projected liquidity for evidence of firms needing to draw on lines of credit to cover capital needs, which could indicate fundamental deterioration,” it said. “Material weakness in other key financial metrics, such as operating cash flow as a percentage of debt and free cash generation, may also reveal rising default risk.”