The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Edward Chancellor

LONDON, Feb 14 (Reuters Breakingviews) - The era of ultralow interest rates fostered a leveraged buyout boom and a desperate hunger for yield among investors. The private equity industry satisfied both itches, spending trillions of dollars to acquire companies while in more recent years also supplying much of the lending for buyouts. The interests of equity owners were pitched against those of creditors. As interest rates have climbed, the results of this unequal contest have become evident. Private credit – the name given to corporate lending that comes neither from banks nor financial markets – probably has a future. But it must be weaned from its dependence on private equity.

Buyout firms were the prime beneficiary of the prolonged period of easy money that followed the global financial crisis of 2008. At the peak of the boom in 2021, private equity investors launched deals worth $2.3 trillion. A large portion of the debt supporting those acquisitions was supplied by private credit funds. This alternative to bank syndicated lending was particularly well suited for buyouts since the loans could be arranged speedily with bespoke terms for each deal. Private credit funds charged higher rates but also reported lower default rates than similarly risky corporate lending, such as high-yield debt and leveraged loans. Since 2000, private credit has delivered higher returns than the S&P 500 Index .SPX of largest U.S. stocks. No wonder investors flocked to this hot new asset class.

In the United States, private credit funds grew by 20% annually in the five years to 2023, reaching $1.6 trillion by the middle of that year, according to the International Monetary Fund. The fast-growing industry overlaps with its private equity cousin in multiple ways. Not only are the largest private credit funds owned by alternative asset managers like Blackstone BX.N and Apollo Global Management APO.N, but more than two-thirds of private credit loans went to private-equity sponsored companies. In practice, one or two firms normally led the buyout while their competitors’ private credit units supplied much of the debt. The argument in favour of this arrangement is that private equity firms had a strong interest in supporting their deals and at times were prepared to inject more cash into portfolio companies rather than see them fail. Repeated interactions among the same handful of alternative asset managers should in theory also encourage good behaviour.

Yet the interests of equity owners and lenders often conflict. To maximise returns, buyout firms have an incentive to load as much debt as possible onto their deals. They want cheap loans on easy terms. As long as a few of their portfolio companies deliver stellar returns, they are willing to accept the occasional failure. Creditors, on the other hand, enjoy little upside from capital gains and therefore seek to avoid losses across their portfolios.

The era of easy money shifted the balance of power from lenders towards borrowers. The average valuation of a leveraged buyout climbed from 8.5 times EBITDA in 2011 to 12 times in 2022, according to Morgan Stanley. Competitive bidding among debt providers resulted in fewer of the loan covenants that traditionally protected creditors. Towards the end of the last decade more than 80% of buyout loans came without restrictive covenants. An increasing number of these loans also came with the option for the corporate borrower to make interest payments with credit notes rather than cash – so-called payments in kind $(PIK)$.

Rising inflation and higher interest rates brought the private equity party to an end. Deals have stalled and private equity groups are having trouble finding an exit from their investments. Rising borrowing costs have pushed overleveraged firms closer to the edge. The average private equity-owned company’s operating profit was just 2 times its interest bill by 2023, down from 3 times a couple of years earlier, according to JPMorgan. An increasing portion of borrowers have resorted to making non-cash payments. In the United States, nearly 10% of the net income reported by business development companies – U.S. investment firms that are large holders of buyout debt – now comes from PIK payments, according to S&P Global.

While covenant-lite and PIK loans postpone the day of reckoning when the default finally arrives, creditors usually find themselves worse off. Recoveries on defaulted buyout loans averaged around 48% of par value between 2022 and 2023, compared to 55% for bank loans, according to the IMF. On occasion, a lack of covenants enables indebted firms to force creditors into a debt restructuring. Some private equity firms have even moved the assets of their sponsor companies beyond the reach of secured lenders. At times they enlist the support of a minority of lenders in these operations, resulting in what’s known as “creditor-on-creditor violence.”

Despite these advantageous loan terms, Moody’s reports that private equity-backed companies suffered a default rate of 17% - a measure that includes loan renegotiations - between January 2022 and August 2024. That’s twice the rate for companies not backed by financial sponsors.

If the growth of private credit was simply due to abnormally low interest rates and the accompanying private equity binge, then we might expect the business to shrink substantially over the coming years. But private credit also a benefitted from the rash of financial regulations after 2008 that made banks increasingly risk averse. The regional banking crisis in the United States that followed the collapse of the Silicon Valley Bank two years ago reinforced this trend. Private credit firms have expanded their activities into other forms of lending, like asset-backed finance. The industry also has a significant advantage over banks: namely, there’s little or no mismatch between the duration of its assets and liabilities. The secular retreat of banks from corporate lending therefore is unlikely to end.

Given the many problems that are surfacing with buyout loans, investors’ attention is turning to the smaller “non-sponsor” part of private credit. This type of lending has several attractions. There’s less competitive bidding than in private equity-led loans. Instead, the debt provider sources its own deals and negotiates directly with the corporate borrower. Covenants are generally more restrictive, resulting in lower historic credit losses compared with sponsor-led deals, according to PitchBook. Non-sponsor private credit is more complex to arrange but pays higher interest rates. Loans typically are provided to companies experiencing abnormal turbulence. The bloody aftermath of private equity’s epic boom should provide rich pickings.

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(Editing by Peter Thal Larsen and Aditya Srivastav)

((For previous columns by the author, Reuters customers can click on CHANCELLO/edward.chancellor.bv@gmail.com))