Private Credit’s Cracks Widened Before Turmoil

njwy7ljliy0sg715j834g(2w_media_dl_1.png Shared National Credit report

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(Bloomberg) — The companies that get private credit loans are looking increasingly wobbly and banks are among those that could eventually be on the hook for losses.

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Many companies getting direct loans from private lenders are struggling to produce cash, by at least one key measure: At the end of 2024, more than 40% of borrowers had negative free cash flow from their businesses, the International Monetary Fund warned in a report this past week. That’s up from closer to 25% at the end of 2021. 

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Borrowers that aren’t generating enough cash flow are at greater risk of defaulting, a particular concern as trade wars lead to fears of economic stagnation.  

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Market participants are alarmed that the deterioration in debtors’ credit quality has yet to show up in accounting valuations, while a rise in dividend recapitalizations is “further straining borrowers’ debt sustainability,” the IMF wrote.

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The report adds to a series of alerts from watchdogs, who fret that vulnerabilities in the $1.6 trillion private credit industry could spill over into the banking arena. Any increase in defaults among direct lenders’ customer base could have a knock on impact for banks because they now have more than $500 billion of exposure to private credit, which the money managers use to lend more to customers.

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“The risk of earnings erosion and cash flow problems has increased, with idiosyncratic pockets of risk in some industries or borrowers” such as health care and software, the IMF wrote of direct lenders. “Even before the tariffs, nearly half” of the borrowers “had negative free operating cash flows, prolonging their reliance on payment-in-kind provisions and amend-and-extend restructurings.”

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Private equity firms in particular have relied on PIK notes, which allow borrowers to defer interest payments for their portfolio companies after a surge in borrowing costs hit valuations. More than a quarter of net investment income in the fourth quarter for a set of the lenders came from deferred interest, according to data compiled by Bloomberg Intelligence. That’s an increase of about nine percentage points in a year, according to the data, which is based on business development companies, a type of private lender.  

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“As financial volatility increases, uncertainty proliferates,” said Elad Shraga, chief investment officer at Signal Capital Partners. “It is reasonable to assume that PE exits will be delayed, in some cases meaningfully, therefore sponsor-driven credit might face increased stress,” adding he worries about the rise in PIK usage.