New direct lending loans see uptick in quality
The 2024 cohort of direct lending loans are of a higher credit quality than in previous years, with conditions expected to improve further next year.
At Morningstar DBRS’ 2025 Credit Outlook London event last month, Cristina Ramirez, VP, sector lead of European private credit ratings at Morningstar DBRS, said that “new deals in 2024 are stronger than those signed three years ago.”
“Investors are incorporating higher interest rates, leverage is lower and credit quality this year is different,” she added.
Kevin Meyer, managing director, head of origination at Churchill Asset Management, agreed that the 2024 cohort of direct lending loans demonstrates stronger credit quality compared to prior years.
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“The financing markets remain active, but bankers have been more selective, focusing on ‘financeable deals’,” he added.
“This contrasts with the 2022-2023 vintages, where some transactions faced challenges due to concerns around financing attachment points and broader market headwinds, often stalling processes. In 2024, only higher-quality, A-to-B assets have successfully found a home, while riskier opportunities have been directed toward lenders with a different risk appetite.”
However, Albane Poulin, head of private credit at Gravis, thinks that this year has been more about “setting the scene” and that the real improvement in credit risk will occur next year.
“Starting with the macroeconomic conditions, higher interest rates, higher inflation and general market uncertainty have, in some cases, led to more conservative underwriting standards, especially in the real estate lending sector,” she said.
“Some lenders have also set stricter covenants in loan agreements providing better protection and greater control.
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“Default rates rose in 2024, especially in the US, where the healthcare sector, telecom sector and business services were the largest contributors to defaults reflecting macroeconomic pressures and secular declines.
“Now interest rates have peaked and started to fall, and inflation has moderated, borrowers’ ability to service their debt is expected to improve. Lower funding costs will reduce refinancing risk and default rates will fall in 2025.”
While newer direct lending deals are seeing an improvement in their risk profile, older deals are expected to see more downgrades by ratings agencies.
Mid-market companies have been hardest hit from higher rates in recent years due to higher leverage on deals.
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Most of their financing tends to be variable, floating rate loans which were heavily impacted when central banks began aggressively hiking interest rates in 2022.
Morningstar DBRS has been taking 3.4 negative rating actions for every positive one, in this segment of the market.
