The private credit industry, valued at $2 trillion, is facing increasing strain as troubled loans swell to levels not seen since 2017. A key indicator of this stress is the rise in non-accrual loans among the 20 largest publicly traded business development companies (BDCs), which reached a median of 2.8% of their cost in the second quarter, up from 2% at the end of March. This status signifies that borrowers have either stopped making payments or are expected to default soon. This trend has prompted concerns from analysts, with Fitch Ratings warning of record private credit defaults in July.
Several prominent funds have reported significant issues. FS KKR Capital Group, for instance, had 7.1% of its loan book troubled in the second quarter, considerably higher than the industry average. Firms like Blackstone, KKR, and Ares have marked down the value of loans to companies such as Medallia and Cornerstone OnDemand, and some lenders have even taken over companies like Affordable Care after defaults. The weakness is reflected in BDC share prices, with BlackRock's and KKR's managed BDCs down over 15% in the past year, and Apollo's down 14.5%.
Beyond direct defaults, there's a growing concern about "shadow defaults" and other forms of distress. The percentage of companies taking on unexpected extra lending conditions mid-term, a form of shadow default, increased from 2.5% to 6.4% over the last year. Similarly, the use of "payments in kind" (PIK) provisions, where companies agree to make extra payments if they cannot meet initial interest obligations, rose to 11% from 7% in 2021. While some industry leaders, such as Blue Owl's co-president Craig Packer and Ares' Jim Miller, maintain that credit metrics are healthy, analysts like Oppenheimer's Mitchel Penn suggest that underwriting standards were not as rigorous as they should have been.
Amidst these challenges, some funds have restructured their portfolios, with BlackRock's TCPC selling a $523 million block of loans to shore up its balance sheet and exploring options for its future, potentially including winding down. Investor redemptions have also surged, with Blackstone, HPS (owned by BlackRock), and Cliffwater reporting requests for 7.9%, 9.3%, and nearly 14% of their money back, respectively. Morgan Stanley analysts warn that direct lending default rates could surge to 8%, significantly above the historical average of 2-2.5%, particularly in sectors vulnerable to AI disruption like software, though they deem it "significant but not systemic."
Despite the alarm, many executives within the private credit sector believe the concerns are overblown, attributing media attention to the outflows. However, the rise in troubled loans, share price declines, and increasing "shadow defaults" suggest a period of adjustment for the industry, potentially leading to a "healthy reset" and more rigorous underwriting practices, as described by Raymond James' Sunaina Sinha Haldea.
