Measure of risk for private credit CLOs signals potential danger

By Scott Carpenter November 17, 2023, 6:55 p.m. EST 4 Min Read

(Bloomberg) -- A measure of risk for private debt backing collateralized loan obligations surged in the third quarter, a sign that companies obtaining loans outside more traditional markets face persistent pressure from high interest rates, according to a report.

In a rare glimpse into the opaque world of private credit, a recent review of credit "estimates" by S&P Global Ratings showed that the quality of debt extended by private lenders to dozens of companies whose loans are bundled into CLOs is deteriorating. Less rigorous than official credit ratings, the estimates are used to evaluate the credit quality of debt inside private credit CLOs, which have recently grown more popular with investors.

"It could be the start of a concerning trend and may speak to the underappreciation of the risks in portfolios of private credit loans," said Michael Pang, a portfolio manager at Tetragon Credit Partners.

In the third quarter, S&P lowered its credit estimates on 91 companies that issued debt through private markets while raising just 19 of them, for a ratio of almost 5:1, according to the review. That ratio far outstripped the roughly 1.4/1 ratio of downgrades to upgrades on loans to companies borrowing in public markets, via broadly syndicated loans, in the same period. It was also a sharp increase from the prior quarter.

"Many companies that took out loans in 2020 or 2021 never envisioned the high interest rates we face today," said Ramki Muthukrishnan, head of US leveraged finance at S&P Global Ratings, adding that larger companies have more options to avoid financial distress.

"Companies that borrow traditional loans in public markets generally tend to be larger, and that means they have more liquidity and options to pay those high rates."

Credit estimates aren't necessarily intended to "estimate" the full rating if one were to be assigned. Generally, credit estimates tend to be marginally lower rated because some assumptions are more conservative than the ones used for full credit ratings, said Muthukrishnan.

To be sure, the spike in weaker credit estimates last quarter doesn't necessarily mean that a wave of distress is headed for companies in debt to private lenders. Private debt is typically extended by just one or a handful of lenders to a single borrower rather than by an array of investors, making it easier for the two sides to amend or extend any debt that's become unaffordable.

Still, many companies might struggle to refinance debt if interest rates remain elevated, according to a separate report by S&P dated Nov. 2. A common reason firms' credit estimates are downgraded is because they face debt maturities in the coming 12 or so months yet haven't put forward concrete plans to refinance, said Muthukrishnan.

Typically, when a company obtains a loan from a private lender, the credit grade it gets from a rating firm isn't publicly disclosed. But over time it's become more common for many of these private loans to be packaged together into a CLO. Known as private credit or middle-market CLOs, they've grown increasingly popular as private lenders look for more ways to attract investor dollars.

Issuers of private credit CLOs need to obtain credit ratings for the CLO tranches, and in order to assign those, raters first need insight into the issuers of the underlying loans. Some they'll already have assigned grades to, but in cases where no rating has been assigned it's necessary to perform a credit estimate.