Future problems for private lending will start today

When investment banks were pulling back from the market for risky loans, private credit was ready to step up and make bigger loans. That attracted a lot of attention, and a lot of new funding.

But now these banks are venturing back into the leveraged lending market, even as borrower demand for new loans has been tepid, threatening to throw the market out of balance. How private credit responds will be one of the truest tests yet of its riskiness.

Generally speaking, there are two types of lending supporting the market for riskier corporate borrowers, who may be smaller or particularly leveraged compared with prime borrowers. In private-credit deals, a single nonbank lender, or a small private group working together, directly arranges a loan with a borrower. In the broadly syndicated loan market, the loans are typically arranged by investment banks then parceled out to an array of investors.

Investors are now coming back to the syndicated market, drawn in by high yields and a solid economic backdrop. Through April, over $13 billion of direct lender loans have been refinanced by broadly syndicated transactions this year, according to PitchBook LCD. Last year, that trend was reversed, with about $20 billion of syndicated loans being taken out by direct loans over the full year.

This surge in lender money supply has meant improved pricing for borrowers. In the first quarter, average spreads, or what borrowers pay on top of a benchmark rate, on broadly syndicated new loans from issuers rated single-B were roughly 1.5 percentage points narrower than they were at the same time last year, according to LevFin Insights.

Better terms for borrowers in the broadly syndicated loan market, in turn, puts pressure on private-credit pricing. Lincoln International, an investment bank, works with managers to value private loans. It recently reported that spreads on larger private-credit deals in the first quarter were about 0.25 to 0.50 percentage point tighter than in the fourth quarter.

Lincoln also noted that lenders were refinancing some of their own borrowers, reducing spread levels in those deals by up to 0.5 to 1 point, often with extended maturities and additional protection against an early repayment of the loan.

“Proactive repricing is an indication they need to keep that money deployed," said Ron Kahn, co-head of Lincoln’s Valuations & Opinions Group.

One concern is that lenders could respond to piles of dry powder and lower yields by taking on more risk.

“At some point it is possible that there might be too much money," Kahn said. “But I don’t think that exists yet, and I think private credit has so far been very disciplined."

Through last year, private credit’s loan performance has been in line with historical norms. For example, among a group of business-development companies publicly rated by Fitch Ratings, which are vehicles that make direct loans, non-accruing debt represented 2.2% of the debt’s cost in 2023, according to Fitch. That was up from 1.9% in 2022, but below the 2.3% mark in 2017.

Still, some observers remain on high alert. Moody’s Ratings in a recent report warned of “competitive escalations" between direct lenders and the broadly syndicated loan, or BSL, market. “We expect that credit quality will remain under pressure as convergence of the BSL and direct lending markets continues and lenders get more innovative with financings," Moody’s wrote.

One development drawing attention has been an increasing use of what are known as payments-in-kind, or PIKs, in private-credit lending. This allows a borrower to pay a loan with things like additional debt rather than cash—which can be viewed as a worrisome sign of a cash shortage, or a crucial form of flexibility to avoid far worse outcomes. The percentage of certain large new direct-lending loans with PIKs was 9.4% over the past six months, up from 6.2% back in 2021, according to Lincoln.

The private-credit market is still evolving. The biggest firms have talked about a wider universe of lending that goes well beyond competing for the kinds of deals that could also be syndicated by banks.

Larger firms such as Apollo Global Management have invested in expanding their so-called origination platforms that can produce all sorts of different kinds of debt. The bulk of what Apollo does in private credit is intended to compete in the so-called investment grade market, which aims to generate lower yielding but less risky loans attractive to investors such as insurers.

“We can only grow our business as fast as we can originate," Apollo Chief Executive Marc Rowan told analysts in early May. He said: “The taking of capital because you can take it and then investing it poorly is a quick way to destroy a business. I think we’ve seen lots of examples of that and beginnings of those seeds being set."

Others focus on middle-market transactions that less often directly compete with the bank-syndicated market. “We’ve never been members of the bigger-is-better cult," David Golub, CEO of Golub Capital BDC, which makes direct loans, told analysts earlier this month. He added that the “the specter of BSL execution gives large borrowers leverage over private credit providers, especially during periods when the BSL market is resurgent as it is now."

Private credit has enjoyed a strong run in the past couple of years. But it is what lenders do now that might ultimately matter most.

Write to Telis Demos at Telis.Demos@wsj.com