• Surge in covenant-lite loans, downturn could lead to sharp credit losses: Aggressive growth in private debt has led to a decline in the quality of underwriting over the past 12-18 months. Historically, credit terms of private debt transactions were more conservative than those of syndicated loans. However, covenant-lite loans have become increasingly common these days. According to a Fitch affiliate covenant review, 33% of the private debt deals in 2021 were covenant lite vs. 15% in 2020, showing growing acceptance for lower downside protections.
  
  
• Rise of mega-size deals: Private credit lenders have shifted upmarket and now participate in billion dollar-plus megadeals. In 2021 alone, there were 17 unitranche² deals exceeding $1 billion, compared with six $1 billion-plus deals in 2020.
  
  
• Borrower friendly structures: As managers competed on terms and pricing to win more customers, more aggressive deal structures (i.e., unitranches) have come into play. Rules about delayed draw term loans were less specific, allowing companies to borrow under general corporate purposes. The combination of large deal sizes and borrower friendly structures elevates credit risk that could potentially drive the default rate to higher single digits (similar to United States private loan default rates that peaked at 8.1% in 2Q20).
  
  
• Shorter deal cycles weakening diligence: With a growing market, there is a lot of pressure on lenders to move quickly and complete their diligence in the shortest possible time. Consequently, the deal cycle has compressed significantly. Deals that used to take up to 12 weeks earlier to get to the finish line, are now closed in a month.
   

Are investors under prepared for a potential sharp downturn?

Many market participants are sounding the alarm on loose lending and the effect of weakening covenants, noting the trends above. While others feel that covenant-heavy loans in the past have been counterintuitive, thereby triggering higher default rates amongst borrowers. Notably, the number of mega-size deals with shortening deal cycles, begs the question if these bigger bets could lead to potential losses in the event of a systemic shock.

Our interactions with some of the larger players, have provided insights on tackling these challenges. Some are focused on upgrading their in-house due diligence and portfolio monitoring capabilities, while smaller players are leaning towards bespoke portfolio surveillance solutions that suit their business model.

Against this backdrop, CRISIL organized a webinar, titled ‘Alternative credit at a crossroads: Time to reset, readjust, and refocus’ on 31^st May 2022, where experts deliberated the different aspects of the industry. The webinar discussion focused on strategies, and solutions that market participants could adopt to successfully navigate the next growth cycle. To read the summary insights and recorded webinar on our website, please click on link.

¹  2022 Preqin Global Private Debt Report
² Lenders combine all layers of debt into a single tranche with a blended interest rate.