More private credit funds are at risk of losing the investment-grade ratings on their debt as they continue to face elevated redemption requests, according to research published by Bank of America Corp.
Three of the largest private business development companies are two quarters or less away from a potential downgrade to their unsecured bonds, if they continue to face quarterly net redemptions of 5%, analysts led by Neha Kohda wrote in a report published Thursday. The median non-traded BDC has roughly one year of runway before a potential downgrade, wrote the analysts, without naming the specific funds.
The findings are the result a stress test the analysts ran of the 10 biggest non-traded BDCs, or funds that pool loans to small- and medium-sized businesses. The actual runway may be shorter than the analysis suggests, because the stress test was based off of BDCs’ own asset valuations, “which are generally more inflated than the market‘s view,” according to the report.
The research comes as BDCs face heightened scrutiny and withdrawals from investors concerned about loan quality and concentration risks related to software borrowers at risk of disruption from artificial intelligence. Already this year, two private credit funds managed by KKR & Co.and BlackRock Inc. lost their investment-grade ratings. KKR subsequently provided additional capital to support its vehicle.
BDCs typically need to cap leverage at 1.25 times debt to equity to preserve investment-grade ratings of their unsecured debt and avoid higher borrowing costs. Over time, redemptions and credit deterioration can push fund leverage above that level, “where often funds start seeing downgrades exacerbating issues further, potentially creating a self-reinforcing downward spiral,” they wrote.
First-quarter results showed further credit quality deterioration, which analysts expect to continue, alongside rising payment-in-kind.
Because non-traded funds have an extra runway of almost two years before they would have to sell illiquid loans, the risk, for now, “is of downgrades, not distress,” the analysts said.
“While liquidity is manageable for a while, it will become credit-relevant once illiquid portfolios need to be sold,” wrote the analysts in the report. “Liquidity is a buffer, but is also a countdown clock to turn fundamentals around.”
Written by: Olivia Fishlow @Bloomberg
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