Higher default rates loom for corporate direct lending

The corporate direct lending sector will see rising default rates next year which will test the mettle of provisions put in place to protect investors, a Schroders executive has said.

The $1.7trn (£1.3trn) private credit market is booming, with the most substantial growth coming from corporate direct lending. Lenders have benefitted from the higher interest rate environment as most facilities are tied to floating rates.

Michelle Russell-Dowe, Schroders Capital’s co-head of private debt and credit alternatives, said that “everybody should be expecting increased default rates”, rising to at least four to six per cent per annum.

Read more: Private credit’s returns attract investors and asset managers alike

“Corporate direct lending, especially European corporate direct lending, has seen massive growth and hasn’t necessarily been around for a big test on the European side,” she told Alternative Credit Investor.

“The amount of time a company has to handle its problems when it’s paying five, six or seven per cent interest on its debts is a lot longer than it has to handle its problems when it’s paying 12, 13 or 14 per cent.

“So that increase in interest expense and the decrease in interest coverage by proxy should tell you that the default environment is going to change.

“That being said, I think it will really test the mettle of the provisions being put in place to protect investors, such as covenants and structuring that you can do in the private credit markets.”

Read more: Asset managers respond to more demand for private debt liquidity

Russell-Dowe warned that the spectacular growth of corporate direct lending could “certainly be a problem”, particularly if it encompasses less restrictive lending standards.

“While default rates will go up, idiosyncratic risk is probably one of the biggest risks,” she said. “The traditional direct lending market has more leverage to this type of risk than other types of private debt that incorporate diverse pools of thousands of claims or thousands of borrowers.”

Additionally, Russell-Dowe said she expects liquidity to a bigger issue going forward and questioned whether investors in traditional corporate direct lending products can continue to expect cash back at maturity.

“Now, there’s probably a lot of investors that with a maturing private allocation who are getting calls saying, ‘you’re not going to get your money back because we’re extending our fund’, or ‘we need you to participate in a follow-on offering’,” she said.

“So people will think more about the laddering of the liquidity they need and the ways to get it. There will be a greater consideration of how to diversify private debt allocations in order to have a range of potential cash flow maturities.”

Read more: ‘Megatranche’ private credit loans on the rise

Despite the challenges, Russell-Dowe expects this to be “an evolutionary year for private credit”.

“With much higher income on offer, I think private credit’s attractiveness as an allocation is quite a bit greater and we’ll have a lot more clients looking at it,” she added. “That increase in the interest income is much more favourable, not only for the higher level of return, but for the additional protection that debt affords in a market that’s likely to see a greater degree of default or volatility.”