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Article by Sebastian Zank, Head of Corporate Credit Production at Scope Ratings as published in Insight/Out magazine #31
Direct lending has seen significant growth over the past 10 years and has emerged as a vital funding channel for mid-market companies. While borrowers’ credit profiles have deteriorated over the last two years, we believe the erosion in credit quality has bottomed out.
Assets under management of debt fund managers focused on lending to European companies have reached USD 400bn, achieving compound annual growth of 17% over the past decade. We expect growth rates to slow, at least until the current constraints on economic growth and investment, such as higher-for-longer interest rates, are outweighed by supporting factors.
Given the moderate-to-weak credit profiles of borrowers (typically in the low B to mid BB sub-investment-grade rating categories) thorough credit analysis and due diligence are needed. Especially since the average credit profile of covered entities had deteriorated over the last 24 months because of the impact of variable interest rates, weaker-than-expected operating performance, lower returns from reduced investments, and delayed deleveraging.
That will remain the case even though we believe the erosion of credit quality has bottomed out in light of interest-rate tapering and easing concerns about economic growth. Higher default risk, meanwhile, will likely be mitigated by an array of measures provided by equity sponsors and direct lenders.
Over the last 24 months, we have rated aggregate loan exposure of above than EUR 5.6bn. Scope’s credit assessments are at the issuer level and typically on defined debt positions held by lenders, primarily first-lien senior secured or unitranche loans.
European direct lending is concentrated in the UK, France and Germany which make up roughly 70% of deals. But we believe direct lending in other European markets will catch up. By sector, roughly 60% is concentrated in business and consumer services, TMT (mainly technology/software and IT services) and healthcare. Our ratings, all sub-investment-grade, are a representative sample. Rated entities are typically mid-market corporates with average annual EBITDA of EUR 10m-EUR 50m.
Ratings migration
What is most striking is ratings migration, i.e. how most recent rating actions compare with previous actions. While around half the ratings in our coverage universe could have been maintained or reflect ratings upside, the other half exhibit ratings erosion, either through actual downgrades/lower point-in time ratings or weakened Outlooks.
A number of trends have resulted in negative rating actions or are likely to put further strain on rated companies’ credit profiles. First and foremost, we have seen more pressure on important credit metrics that are either expected to deteriorate significantly (e.g. interest cover) or which we can no longer expect to improve quickly (e.g. leverage).
Variable-rate exposure has also taken its toll. While variable rates are great for lenders, higher-for-longer rates are putting increasing pressure on debt service and biting into borrowers’ liquidity. Median interest cover (EBITDA/net interest) averaged 2.7x to 2.1x in 2022/2023. Our projections for the same entities in 2024/2025 stand at a median of 2.0x-2.1x. This is still comfortable at an aggregate level but around one-in-four rated entities have cover ratios of just 1.5x, which does not offer much headroom.
Similar, but less problematic, is the slower-than-expected pace of deleveraging. Rated entities are likely to maintain high median leverage levels: 7.4x as measured by Scope-adjusted debt/EBITDA for 2023, followed by only gradual deleveraging to a median of 6.8x in 2024 and 5.8x in 2025E. A quarter of rated entities still show leverage of more than 7.0x at YE 2025E, however.
Deleveraging prospects are primarily driven by expected improvements in operating performance, reduced interest payments and returns from business expansion via M&A. We expect deleveraging to happen at a slower pace compared to a year ago as a function of lower potential for debt reduction owing to weakening operating cash flow; limited room for debt reduction due to ongoing debt-funded acquisitions; or subdued investment returns from acquisitions.
A significant share of borrowers are unable to meet expectations for operating performance as it remains difficult for them to cope with the more sluggish macroeconomic environment. This means sustained cost increases, weaker demand, and margin dilution from acquired entities. Unless they have very strong niche market positions, rated mid-market companies typically lack the pricing power to quickly pass on higher operating costs to customers. Hence, they need time to adapt to the more challenging environment and to implement cost-savings programmes before operating performance and credit metrics can be restored or improved.
Likewise, ambitious growth plans driven by M&A and organic investment that were expected to be supported by new debt funding from direct lenders could not and still cannot be executed as initially planned given higher hurdle rates. As a result, the expected returns from such growth strategies have failed to materialise and have not provided the expected return on investment, while the interest costs from dedicated funding are weighing on credit metrics.
The above factors make it difficult for some rated entities to fully comply with debt covenants when buffer-to-covenant thresholds were already narrow during the ‘golden years’ – before the mix of more challenging conditions unfolded. Actual or likely covenant breaches require lot of attention from debt fund managers; capacity which might be needed elsewhere.
Direct lenders shielded from stormy weather
Source: Scope Ratings
Despite the negative ratings pressure, default risk is less pronounced and will likely be contained. First, because of our expectations of an improving picture after 2024. Base rates are expected to taper in coming months hence the general pressure on interest cover will bottom out or even reverse, providing relief on debt service. Investment activity is also likely to resume, with the returns from new investments providing support to cash flows and credit metrics.
Second, companies will gradually adapt to the altered business environment through cost savings programmes, restructurings or simple adjustments to pricing and procurement policies. Also, there is greater flexibility between direct lenders and borrowers on payment terms compared to more traditional financing with banks or groups of professional investors. Borrowers can implement amendments on terms and conditions on a bilateral basis, such as temporary or prolonged agreements of Payment-in-Kind (PIK) interest recognition.
Direct lending borrowers typically have some flexibility to roll over maturities in advance if debt coverage is at risk. While this is similar to the typical ‘amend and extend’ process of banks, we believe that amendments with direct lenders are leaner, take less time and happen much earlier, given the close ties between direct lender and borrower.
Commitment from Private Equity sponsors is also key. Sponsors tend to support portfolio companies in challenging times through equity injections. Also, a large share of borrowers have exposure to shareholder loans, which can be fully or partially converted into equity or carry PIK interest for some time. This can strengthen affected companies’ balance sheets thereby easing pressure on credit erosion or even default risk.
As such, companies with a strong and committed equity sponsors have better chances of weathering temporary or extended challenging times. And director lenders have significant dry powder – we estimate this at 20%-30% of total AuM – which can provide bridge financing to companies.
