4 Examples of Credit Events in Private Debt

Updated: Nov 15

Credit events are an inevitable part of the private debt landscape, and for that reason, top credit managers will have extensive experience working with companies in financial distress. When choosing a private credit manager, it’s crucial to estimate their ability to protect and recover investors’ capital if a credit event occurs.



Below are 4 examples of credit events and how they can affect a private loan:


1. Failure to Make Payments

Sometimes borrowers may be unable to make principal or interest payments on schedule. This does not necessarily mean that these companies are in financial distress. For example, from time-to-time borrowers may experience project and accounts receivable collection delays that can lead to a shortage of cash on a temporary basis.


Avoiding managers who have concentrated positions and investing with managers who provide access to diversified portfolios of private loans will help mitigate these risks.


2. Insolvency

Insolvency occurs when borrowers do not have the sufficient capacity or assets to service existing debt obligations. When a debtor becomes insolvent, they might undergo a legal process and declare bankruptcy. Bankruptcy is often perceived by investors as a “final point” with no return, however, in practice, private debt managers may undertake restructuring and workouts through ‘work-out’ agreements or a court-monitored process. In an event where a work-out is not feasible, having appropriate collateral support ensures lenders are able to preserve investors’ capital throughout a liquidation process.


Investing with a reliable and experienced private debt manager who brings specialized knowledge of insolvency and work-outs can protect investors from the severity of default events.


3. Corporate Events

Corporate events, such as mergers, acquisitions, and spinoffs can also affect your loan’s risk profile. Due to idiosyncratic nature of corporate restructuring, it is difficult to categorize all potential outcomes and risks. Generally speaking, certain corporate events could refer to changes in company leadership, capital structure, corporate structure, and changes in any of these event categories may affect the overall financial wherewithal of the underlying company. This may change the general risk profile of a borrower as well as the value of the loan’s collateral. Typically, lenders would include restrictions on such corporate events, or they would require lender’s consent to any corporate action being taken.


It is important to consider investing with private credit managers who are continually in active communication with their borrowers, allowing the lender the opportunity to consider the implications of contemplated corporate actions on existing credit exposures.


4. Credit Downgrade

Since private loans can also be issued to a public company, credit downgrades are another risk to consider. A credit downgrade issued by a ratings agency to a company during the life of a loan simply means that the agency’s assessment of the borrower’s risk of default is now higher and the expected loss after sale of any corporate assets or other recoveries, is now higher. If a credit downgrade happens during the life of the loan, investors may end up with increased volatility of returns and ultimately lower risk-adjusted returns. If a default occurs, returns will decline by the shortfall of the lost principal value and any unpaid coupon income (net of recoveries from the sale of corporate assets) incurred during the default process.


Summary

If you are investing in a diversified portfolio of private loans, you should be prepared for the occasional credit event exposure within any private credit portfolio. Listed above are some of the risks that you need to be aware of when accessing the higher yields available in private debt markets.


Choosing an experienced manager whose strategy has been tested by full economic cycle is the first step in mitigating potential risks stemming from credit events. Highly skilled credit managers will have a dedicated team and proven workout processes in place and should be open and transparent in educating investors about their workout expertise.




*This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value.