"Private Credit Soundness: Assessment Needed to Avoid the 'Average Trap'" [Click e-Stock]

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The rapid growth of the U.S. private credit market, combined with recent financial market uncertainties, is fueling risk concerns. There are growing calls to assess the soundness of both the borrowers and the overall market, as a series of redemption requests for private credit funds threatens to spill over from a psychological contraction into a full-blown systemic crisis.

On April 15, Shinhan Investment Corp. emphasized the need to preemptively assess the soundness of the private credit market. Currently, the U.S. private credit market is characterized by a polarization of risks, with the strong indicators of large asset managers obscuring underlying vulnerabilities. Private credit funds managed by large firms have strong crisis management capabilities, backed by high borrower EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and ample liquidity. The average borrower EBITDA is approximately $100 million to $300 million, which exceeds the market average of $99 million. In addition, most of these loans are first-lien secured, which enhances their recoverability and credit quality. With robust capital and liquidity management capabilities, these funds can respond flexibly to redemption requests.

In contrast, the situation is different for small and mid-sized asset managers. If redemption requests surge rapidly, these managers may be forced to liquidate assets quickly to secure liquidity, increasing the likelihood that risks will be directly exposed to the market. The economist noted, "The solid crisis response of large asset managers is partially masking actual liquidity stress signals in the market and slowing the pace at which risks are transmitted."

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It is also considered premature to feel reassured about the borrowers in private credit and their financial health. There are concerns about sectoral concentration among borrowers. More than half of the major asset managers' private credit funds are concentrated in software, healthcare, professional services, and commercial services. Among these, software is the largest borrower group, followed by healthcare and professional services.

According to Shinhan Investment Corp., as of the first quarter of 2024, the overall distribution of private credit fund borrowers remains similarly concentrated in commercial services, software, and healthcare. Jin Kyung Lee, an economist at Shinhan Investment Corp., explained, "The similarity between the portfolios of top asset managers and the overall market means that a credit shock in a core sector could easily spread beyond an individual fund to become a market-wide risk." She added, "The actual soundness of the private credit market will depend on how resilient these core sectors-where funds are heavily concentrated-can remain financially in a high interest rate environment."

She also said, "In fact, within the IT services sector, system infrastructure and IT consulting segments have experienced a decline in interest coverage ratios and an increase in debt compared to the trend over the past five years." She continued, "Although these two segments account for only 7.8% of the overall IT services sector, there is increasing qualitative polarization within the industry. The credit risks of marginal companies are being masked by the solid performance of high-quality borrowers, suggesting that risks may be more significant than what is reflected by the average indicators."

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The credit default swap (CDS) premium for the IT sector is also a warning sign to watch. This is because CDS premiums reflect the market's perception of future fear. According to analysis by Shinhan Investment Corp., while CDS premiums for most sectors have remained near historical averages over the past ten years, those for IT-including software-are currently near historical highs.

The increasing proportion of PIK (Payment-In-Kind) loans in the private credit market is also a concern. In PIK loans, borrowers pay interest by adding it to the loan principal instead of paying in cash. This suggests that the practice of covering interest with additional debt is becoming prolonged. If interest rate cuts are delayed, the accumulated interest burden could quickly emerge as a shock. The economist explained, "Although factors fueling credit risk remain, the relatively strong soundness of large borrowers is masking risks in the current environment."

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The scale of bank lending to non-bank financial institutions (NBFIs) has also been cited as a potential risk factor. In particular, there is a need to closely monitor certain regional banks with a high proportion of NBFI loans relative to their assets and equity capital.

According to analysis by Shinhan Investment Corp., the NBFI loan proportion at Axos Financial and Customers Bancorp exceeds 10% of assets and 100% of equity capital. Bank of California and B1 Bank also have NBFI loan ratios near 100% of their equity capital, placing them in the potential risk category. The economist cautioned, "Compared to large banks, these institutions have more fragile funding structures, so if large-scale redemption requests from private credit funds are concentrated, they could be exposed to localized liquidity squeezes and credit risk." He warned, "It is time to be alert to the possibility that localized cracks could dampen market sentiment and deliver short-term shocks to the liquidity environment."

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