Can Private Credit Weather Macro Risks?

Summary

Thoughts on the Market: Can Private Credit Weather Macro Risks?

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Description: Short, thoughtful and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.
• Episode: Can Private Credit Weather Macro Risks?
• Release Date: May 13, 2025

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Introduction

In the May 13, 2025 episode of Thoughts on the Market, Morgan Stanley's Chief Fixed Income Strategist, Vishi Tirupatua, and US Leveraged Finance Strategist, Joyce Zhang, delve into the resilience of the private credit market amidst prevailing macroeconomic uncertainties. The discussion centers on whether private credit can sustain its performance in the face of heightened risks or if a market reckoning is imminent.

Current State of the Private Credit Market

Vishi Tirupatua opens the conversation by highlighting the current landscape of the private credit markets. “Will it stay resilient in the current macro conditions or a reckoning is ahead of us?” (00:09). The focus is particularly on direct lending and middle-market segments, where smaller companies with relatively weaker fundamentals are more vulnerable to economic slowdowns.

Joyce Zhang provides an initial assessment, acknowledging rising risks but emphasizing the resilience of the underlying fundamentals. “Risks are rising in private credit, but I think these risks would be measured given the still resilient fundamental backdrop,” she states (01:01). She notes that unlike previous cycles, there is no significant buildup of leverage within the system, as leverage ratios among direct lending companies have either improved or remained stable.

Risks in Private Credit

The discussion pivots to the specific risks faced by private credit markets. Joyce elaborates that although risks are increasing, they are being mitigated by the current strong fundamentals. “There is no clear sign of leverage building up in the system yet,” she explains, contrasting the present situation with past cycles where excessive corporate leverage led to downturns.

However, she cautions about potential impacts from higher tariffs, which could affect direct lending companies. “Higher tariffs... could have a significant impact on direct lending companies,” Joyce points out, setting the stage for Vishi’s analysis on tariffs.

Impact of Tariffs

Vishi assesses the direct and indirect effects of tariffs on the private credit sector. “We think it's likely [the direct impact of tariffs] to be muted,” he comments (01:50). He explains that direct lending loans are predominantly allocated to defensive and service-oriented sectors such as technology, business services, and healthcare, which constitute over half of the loans in typical Business Development Company (BDC) portfolios.

Despite the muted direct impact, Vishi warns of secondary effects stemming from increased uncertainty and diminished confidence, which could dampen demand. He references data indicating that approximately 15% of direct lending companies have an EBITDA interest coverage ratio below 1x (01:50), and about 40% are generating negative free operating cash flow (03:11). These "tail cohorts" are particularly vulnerable to macroeconomic challenges.

Payment in Kind (PIC) Interest Explained

The conversation shifts to the concept of Payment in Kind (PIC) interest, a critical factor in private credit dynamics. Joyce defines PIC interest as situations where companies under liquidity stress cease paying interest in cash, opting instead to accrue the interest to the principal balance. “It is quite common for companies under liquidity stress to switch to PICs for cash preservation,” she explains (03:11).

She highlights that while PICs can be a precursor to default, not all PIC loans indicate distress. “PIC toggles are actually a key feature that distinguishes direct lending loans from syndicated loans because it provides non-distressed companies the flexibility to reallocate cash for other business needs,” Joyce notes (03:11). Data from Business Development Companies (BDCs) show that higher peak income does not consistently correlate with increased non-accruals (04:19), suggesting that PICs do not universally signal rising defaults.

Structural Features Mitigating Risks

Vishi outlines several structural attributes of private credit that could help mitigate the identified risks. He notes that private credit loans are not marked to market by design, resulting in lower volatility and relative immunity from daily price fluctuations (04:19). Additionally, redemption risks are currently contained through mechanisms like lock-up periods and redemption caps, although their effectiveness in severe downturns remains untested.

Another mitigating factor is the “sticky” nature of capital flowing into private credit. Institutional investors such as insurance companies and pension funds, attracted by higher yields and illiquidity premiums, maintain long-term investment horizons and are more likely to support companies through temporary liquidity issues (04:19). Furthermore, the prevalence of small lender groups in the direct lending market facilitates easier negotiations during restructurings.

Default Rate Expectations

Joyce provides insights into expected default rates within the private credit sector. Referencing data from PitchBook, she notes the presence of substantial "dry powder"—$70 billion in private debt funds and an additional $2 trillion in private equity funds—that can be deployed to support distressed companies and help keep defaults in check (05:44).

She forecasts that syndicated loan defaults are expected to end the year at 4%, which, based on historical relationships, implies a like-for-like default rate for private credit at approximately 5% (05:44). This projection suggests a mild uptick from current levels but remains below the peak observed during the COVID-19 pandemic.

Conclusion

In summary, the episode underscores that while the private credit market faces rising risks amid macroeconomic uncertainties, several factors contribute to its resilience. Strong fundamental trends, structural safeguards, and ample available capital position private credit to navigate potential economic slowdowns effectively. Both Vishi Tirupatua and Joyce Zhang express cautious optimism, highlighting that although challenges exist, the private credit sector is well-equipped to manage and mitigate these risks.

Notable Quotes:

• Vishi Tirupatua (00:09): “Will it stay resilient in the current macro conditions or a reckoning is ahead of us?”
• Joyce Zhang (01:01): “Risks are rising in private credit, but I think these risks would be measured given the still resilient fundamental backdrop.”
• Vishi Tirupatua (01:50): “We think it's likely [the direct impact of tariffs] to be muted.”
• Joyce Zhang (03:11): “PIC toggles are actually a key feature that distinguishes direct lending loans from syndicated loans because it provides non-distressed companies the flexibility to reallocate cash for other business needs.”
• Vishi Tirupatua (04:19): “Direct lending loans are not mark to market by design, so they have lower volatility and are relatively immune from daily price moves.”
• Joyce Zhang (05:44): “There is ample dry powder... [which] can be deployed to backstop distressed companies and help keep defaults in check.”

Final Remarks

Vishi Tirupatua and Joyce Zhang conclude the episode by expressing gratitude to listeners and encouraging feedback on the podcast's content. They emphasize the importance of understanding the nuances of private credit in the current market environment and invite listeners to share their thoughts and insights.

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This summary provides a comprehensive overview of the podcast episode, capturing all essential discussions, insights, and conclusions to inform those who have not listened to the original content.

Transcript

[A]

Welcome to Thoughts on the Market. I am Vishi Tirupatua, Morgan Stanley's Chief Fixed Income Strategist.

[B]

And I'm Joyce Zhang, US Leveraged Finance Strategist.

[A]

Today we'll take a look at private credit markets. Will it stay resilient in the current macro conditions or a reckoning is ahead of us? It's Tuesday, May 13th at 10:00am in New York. Tariffs and policy uncertainty are on the top of mind for people with an eye on the economy and markets. Certainly a frequent topic of discussion for us on this podcast. In this environment, there has been growing concern about the health of corporate credit. And within corporate credit, direct lending or middle market segments where companies tend to be smaller in size and have weaker fundamentals are of particular concern. The business models of these companies are sensitive to slower growth. Joyce, can you map out the risks associated with private credit companies to your.

[B]

Point, risks are rising in private credit, but I think these risks would be measured given the still resilient fundamental backdrop. Looking at fundamental trends, there is no clear sign of leverage building up in the system yet and multiple data sources actually showed that the leverage ratios among direct lending companies have either improved or remained flat. And that's very different from the previous cycles where excessive corporate leverage set the stage for the eventual downturn. So this time around, credit, including both public credit and private credit, is not the source of the problem. But of course these direct lending companies would be impacted by higher tariffs. So Vichy, what's your view on the tariff impact?

[A]

So the direct impact of tariff choice, we think it's likely to be muted. It's quite hard to quantify this exposure, but if you look at a number of different data sources, we find that the direct lending loans are more skewed towards defensive and service oriented sectors. For example, sectors such as technology, business services and healthcare account for over half of the loans in typical BDC portfolios or business development company portfolios of direct lending loans. Well, that said, even though the direct impact could be somewhat limited, there could be second order effects because there is higher uncertainty and weaker confidence and that could weigh on demand. There could be a tail cohort that could be developing. So some data from Lincoln International, for example, shows that about 15% of direct lending companies have EBITDA interest coverage ratio below 1x. Another way of looking at tail cohort is by looking at companies generating negative free operating cash flow. According to S and P data, that's about 40%. These tail cohorts are stretched and are weakly positioned to weather macro challenges ahead. So Joyce, another thing that comes up frequently when we talk about private credit is payment in kind interest or the so called PIC interest. Can you walk us through what is a PIC and why is it a concern?

[B]

So payment in kind interest. It occurs when the company stops paying interest in cash, but instead the interest is accrued and added to the principal balance. It is quite common for companies under liquidity stress to switch to pics for cash preservation. But in many cases pics don't really clean up the company's balance sheet and the company may still end up in a conventional default. So PIC is generally considered as a leading indicator of default by market participants. And to be clear, not all PIC loans are bad. PIC toggles are actually a key feature that distinguishes direct lending loans from syndicated loans because it provides non distressed companies the flexibility to reallocate cash for other business needs. So pics do not necessarily signal higher defaults. And in fact Data showed that BDCs or business development companies with a higher peak income don't always see a greater increase in non accruals. So in other words, the relationship between peak income and defaults is not persistently strong.

[A]

So to summarize, overall fundamentals are on a relatively strong footing, but risks in private credit are rising, especially if we have a potential economic slowdown ahead. On the other hand, there are a few structural features with the private credit loans that could potentially help mitigate some of the vulnerabilities we've just talked about. First thing, direct lending loans are not mark to market by design, so they have lower volatility and are relatively immune from daily price moves. And very related to that redemption risk of private credit funds has been fairly contained so far. These funds usually have tools like lockup periods and redemption caps to guard against unexpected large outflows. But of course the effectiveness of these mechanisms has not yet been tested in severe downturns. Moreover, the capital that is going into private credit is relatively sticky capital. Key investors such as insurance companies and pension funds are healthy maturity type buyers and they are entering in the space for the attractiveness of the higher yields and to harvest illiquidity premia embedded in these loans. So with that long term investment horizon they would be more willing to support companies through temporary liquidity challenges. Also, small lender groups in direct lending market makes it easier to negotiate restructurings.

[B]

Lastly, there is also ample dry powder. According to PitchBook, there is five $70 billion of dry powder in private debt funds and another $2 trillion in private equity funds. And this capital can be deployed to backstop distressed companies and help keeping defaults in check. And in terms of defaults, we are expecting syndicated loan defaults to end the year at 4%, and that's our base case. And based on the historical relationship, that implies a like for like default rate for private credit at 5%, which means a mild uptick from the current level, but is still below the COVID peak.

[A]

Joyce, thanks for taking the time to talk about this.

[B]

Thanks for having me, Rishi.

[A]

And to our listeners. Thank you for your attention. Let us know what you think of this podcast and the topics we cover. And if you think a friend or a colleague might find this information useful, please share thoughts on the market with them today.

[C]

The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.