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The $1.4tn private credit industry faces its “first serious challenge” as tens of billions of dollars of loans underwritten at the top of the market in 2021 are strained by sharply higher interest costs and a slowing economy, analysts at rating agency Moody’s cautioned on Friday.
The warning from Moody’s, which singled out two of the largest players in the sector — funds managed by lenders Ares and Owl Rock — underlined the challenge facing lenders who raced to win new business before financial markets tightened in 2022.
The loans were largely underwritten when interest rates were close to zero and economic growth was still booming in the US, a world that vanished once the Federal Reserve began to aggressively lift interest rates in a bid to cool US inflation.
“This shift in macro and market conditions will mark the first sectorwide test of non-bank private credit lenders’ ability to manage through recession and an increase in borrower defaults,” said Christina Padgett, an analyst at Moody’s.
While Moody’s has sounded a warning, it did not downgrade the ratings or credit outlook of either of the Ares or Owl Rock funds, which are publicly traded lending vehicles called business development corporations. Ares and Owl Rock declined to comment.
The private credit industry has changed significantly since the 2008 financial crisis when large US banks lowered their exposures to leveraged buyouts. Private lenders such as Ares at first primarily focused on finding small and midsized takeovers to finance.
Over time, they began targeting larger deals. The shift was spurred by a fundraising blitz during the depths of the Covid-19 pandemic that gave groups firepower to provide multibillion-dollar buyout loans.
Many of the deals they underwrote in 2021 were particularly risky. Some loans went to unprofitable companies that banks could not finance and were based on a company’s recurring revenues and ambitious projections of future profits.
A sharp rise in rates could cause some of these businesses to struggle to afford their interest payments. Moody’s found that the interest coverage ratios on the Ares and Owl Rock funds’ loans — the earnings available to make interest payments — would eventually fall by about half.
The two entities lent to some of the largest buyouts in 2021, particularly software takeovers conducted by specialist private equity firms such as Thoma Bravo.
The Ares fund had nearly $150mn in loans outstanding to Stamps.com, an ecommerce shipping company taken private by Thoma Bravo for $6.6bn in 2021. It had a further $84mn in loans to real estate software specialist RealPage, which Thoma Bravo took private for more than $10bn in one of the largest buyouts of the year.
The yield on both loans now exceeds 10 per cent, about 40 per cent higher than at this time last year, according to securities filings, reflecting the effects of higher interest rates.
Owl Rock, meanwhile, lent to 2021 deals such as Thoma Bravo’s takeover of Talend and Dell’s sale of Boomi to a group of buyers led by Francisco Partners and TPG.
Some loans may soon be repaid, lowering overall credit exposures. Both funds lent money to Adenza, a financial software company built by Thoma Bravo. Earlier this month, Thoma Bravo agreed to sell the Adenza business to Nasdaq for more than $10bn. If completed, the loans will be repaid at par.
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