FXTRADING Financial Focus (Asia-Pacific 08/18)Private Credit Risks Rise as Assets Reprice

The rapidly expanding private credit market has come under increasing pressure in recent years as borrowers debt-servicing capacity weakens. Some large funds have begun marking down asset valuations, selling loans, and even taking control of defaulting companies. Data show that among the 20 largest publicly listed business development companies, the median share of non-accrual loans as a percentage of cost rose to 2.8% in the second quarter, up from 2% at the end of the first quarter and returning to levels last seen around 2017. Fitch Ratings has also reported that the private credit default rate climbed to a record high in July, indicating a gradual rise in credit risk across the industry.

Much of the current risk can be traced back to the low-interest-rate environment of 2020 and 2021, when financing costs were cheap, private equity dealmaking was active, and corporate valuations and leverage levels were generally elevated. With interest rates now remaining high, some companies are being forced to devote a larger share of their cash flow to interest payments, leaving less room for investment and expansion. If revenue growth falls short of expectations, debt structures that were previously sustainable can quickly come under strain. As a result, deals completed at high valuations during that period have become a major source of risk today.

Pressure has already emerged across the portfolios of several major institutions. FS KKR Capital reported that troubled loans accounted for 7.1% of its portfolio in the second quarter, still well above the industry average. Blackstone and KKR have marked down loans related to Medallia, while Ares has taken impairments on loans associated with Cornerstone OnDemand.

As asset quality deteriorates, funds have begun actively reducing risk. Some credit vehicles managed by KKR, Blue Owl, and Apollo recorded repayments and loan sales exceeding new lending in the second quarter, indicating that the pace of industry expansion is slowing. BlackRock-managed TCPC sold approximately $523 million in loan assets and is evaluating further asset disposals and other measures.

Capital markets have also begun reassessing the risks surrounding private credit. Over the past year, some publicly listed BDCs managed by KKR and BlackRock have fallen by more than 15%, while returns from related Apollo funds have also declined significantly. Private credit previously became an important growth engine for large alternative asset managers because of its relatively high yields and stable management fees. However, that model is now being tested as defaults, impairments, and capital outflows increase. If investment returns are no longer sufficient to compensate for credit and liquidity risks, investors may become less willing to continue allocating capital to these products.

However, it is still too early to view the entire roughly $2 trillion private credit market as being in a full-blown crisis. Institutions including Blue Owl and Ares argue that most borrowers remain operationally and financially stable, with problems largely concentrated among highly leveraged deals originated in earlier years. Going forward, the key question is whether stress spreads to more industries and higher-quality borrowers. If lenders continue tightening underwriting standards, financing could become more difficult and expensive for small and medium-sized businesses, gradually weighing on corporate investment, hiring, and M&A activity.

From FXTRADINGs perspective, private credit is undergoing a broad repricing of asset quality, with rising defaults, asset impairments, and tighter lending likely to remain the main sources of pressure in the period ahead. If funds continue to reduce new lending, highly leveraged companies could face greater refinancing difficulties, potentially leading to more debt restructurings and bankruptcies. At the same time, the adjustment may encourage the industry to strengthen underwriting standards and create new investment opportunities for institutions with ample capital and strong risk-management capabilities. Private credit has not yet entered a systemic crisis, but the period of rapid expansion driven by low interest rates and elevated valuations has clearly cooled..