KBRA releases research that examines the impact of terminal reference rates at 6%, 6.5%, and 7% on its private credit assessment portfolio. In a report published in October 2022, we concluded that up to 16% of companies in a portfolio of roughly 2,000 middle market companies, all else being equal, would transition to being unable to meet interest payments from current cash flow if the terminal reference rate rises to 5.5%. The two questions we receive most frequently since the report was published are: (i) What if terminal rates rise even further, and (ii) Has stress started to materialize on the landscape of middle market borrowers, their private equity sponsors, and their private credit lenders?

In this report, we apply the higher interest rate stresses to most of the middle market private companies in our portfolio of over 2,400+ credit assessments, which are evaluations of the creditworthiness of an unrated issuer that are unpublished and confidential. In addition, we present observations from our ongoing dialogue with market participants as they grapple with the early days of a period of rising defaults and restructurings caused by higher rates, a slowing economy, and the ongoing readjustment of middle market company valuations.

Key Takeaways

• A few more rate hikes do not materially change our conclusion. All-in interest costs of 12.5%-13% (terminal reference rates of 6%-6.5%) do not materially change the conclusion of our original report. While not welcome by borrowers, the prospect of a further 50 bps to 100 bps rise is not as significant compared to the movement of all-in rates from 7.5% to 12%, which is already occurring and is shaking out the most vulnerable unhedged companies. In other words, the damage is mostly done.
• By comparison, some “public” companies exhibit similar strain. KBRA’s revised stresses show that, once again, about 16% of roughly 2,000 mostly private middle market companies would transition to becoming unable to meet interest payments from current cash flow. But KBRA also observes that about 15% of the S&P 1500 (which includes midsize as well as large capitalization companies) are firms that have existed for at least 10 years with cash flows that have not covered their interest costs in each of the past three years.
• Liquidity matters. Existing balance sheet liquidity, although getting slimmer, is helping improve some corporates’ ability to make interest payments in the short term, a further reminder that companies that prioritize preserving balance sheet liquidity are better positioned to navigate a downturn in which operating cash flows get strained.
• KBRA-rated structures remain resilient. Pressure on some portfolio companies is mounting due to higher interest costs and the slowing economy. This is leading to more portfolio companies on watchlists and the beginning of a period of amendments, capital infusions, and restructurings. As discussed in previous reports, KBRA continues to believe that KBRA-rated business development company (BDC), structured credit, as well as funds structures (and most lenders in these structures) remain well positioned to absorb defaults and restructurings in their portfolios.
• Sponsor-backed firms with promise will de-lever if necessary. KBRA-rated lenders will generally have the upper hand in discussions with private equity sponsors and borrowers. This is primarily driven by their disciplined lending standards that ensure loan-to-value (LTV) cushions are sufficient to both absorb borrower valuation declines and/or incentivize sponsors to inject more equity―or else lose ownership of companies with still good (albeit sometimes reduced) opportunity for value creation. A failure to inject new equity into good business models can create opportunities for seasoned private credit lenders with restructuring expertise to take operating control and/or sell their stake for an attractive return.

Click here to view the report.

Related Publications

• Private Credit: 12% Is Not Affordable for Many Borrowers
• Private Credit: Well Positioned to Navigate the Looming Storm
• Private Credit: Private Corporate Credit Market Poised for Resiliency
• Private Credit Funds in Pictures: Safety in Numbers
• Private Credit: Business Development Company (BDC) Ratings Compendium: The Impact of Higher Rates and a Potential Recession
• Private Credit: Business Development Company (BDC) Ratings Compendium: Fourth-Quarter 2022

About KBRA

KBRA is a full-service credit rating agency registered in the U.S., the EU, and the UK, and is designated to provide structured finance ratings in Canada. KBRA’s ratings can be used by investors for regulatory capital purposes in multiple jurisdictions.

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