Illustration: Aïda Amer/Axios
For a glimpse of how the Fed's rate hikes are roiling the finances of some American companies, look to the private credit markets.
The big picture: A growing share of U.S. companies borrow money in the trillion-dollar private credit market, where the debt is floating-rate, meaning interest payments go up as benchmark rates rise.
- Companies with floating-rate debt experience the brunt of the pain of rising rates — unlike those with fixed-rate bonds or mortgages that are somewhat immune to the impact.
Why it matters: It increasingly looks like the Fed's July 31 rate hike was the last of this cycle. But the private credit market shows how those earlier rate hikes — more than 5 percentage points' worth — are starting to pinch balance sheets of mid-size companies and could cause yet-to-be-seen upheaval in the economy.
- It's an area many are watching, since companies here tend to be highly leveraged in the first place.
- And since it's a private market, by definition we don't have a ton of transparency into how companies are doing — and the unknown can leave folks feeling a bit jittery.
State of play: Data from investment bank Lincoln International, based on over 2,000 companies with private debt, shows how rising interest costs are creating financial distress. So far, lenders and owners are offering relief in the form of additional capital and breathing room on loan terms.
The details: Lincoln calculates the companies' ratio of earnings to interest payments, or the fixed-charge coverage ratio (FCCR).
- Private companies' average FCCRs have fallen to just 1.1x, meaning earnings just barely cover interest, down from an average of 1.4x in Q1 2022, says Ron Kahn, co-head of Lincoln's valuations group.
- Revenue growth in this cohort is actually stronger than in the S&P 500, according to Lincoln's calculations. The interest payments are the big change.
Between the lines: This is where the rubber meets the road for highly levered companies that are the most vulnerable to ballooning interest costs. If a large number of companies get to the point where they can no longer service their debt, we'll likely see a wave of bankruptcies.
What's happening: In order to preserve cash, these companies are cutting back on capital expenditures — the average Q3 capital expenditures among Lincoln's cohort trended down by 22% since Q3 of last year, the firm found.
- There's also been a "major wave" of companies seeking relief from their lenders, Kahn says.
- During the first nine months of the year, about 15% of the 2,000-plus companies Lincoln tracks had to ask lenders to loosen rules in their loan agreements — for example, rules requiring minimum FCCRs (these rules are known as covenants).
- This is notable because if companies can't meet their covenant requirements — and can't get a deal for relief from their lenders — then they're considered in default under their loan agreements.
Yes, but: So far, there hasn't been an outsize jump in private credit defaults. Law firm Proskauer, which has a large private credit practice, says that defaults actually ticked down during Q3 compared to Q2.
- That's because in private credit, a company may only have one or two lenders to negotiate with for relief, making a deal easier to come by. And many had private equity owners who provided a cash injection in exchange for relief, Kahn says.
That playbook — amending the loan agreement and/or injecting new money — works if there's a belief that rates will ultimately come back down or the economy will really take off.
The bottom line: The big question is how long the playbook will last in a higher-for-longer world.