For three years, defaults have been "soft" (e.g., liability management exercises, PIK interest), masking underlying issues. The market is now entering a second phase of "hard defaults" where losses will be directly felt through restructurings and bankruptcies, changing the nature of the cycle.
Citing a Harvard Law School study, the guest highlights that liability management exercises (LMEs) are merely a delay tactic, not a solution. An overwhelming 93% of companies using non-pro rata LMEs become repeat defaulters, with over 70% of those cases ultimately resulting in bankruptcy.
The use of "adjusted EBITDA," which includes unrealized synergies and cost savings, has doubled over a decade. This practice makes leverage appear lower than it is on a reported basis, concealing significant risk. An S&P study confirmed these adjustments are rarely realized, particularly in the single-B space.
The high-yield bond market is now nearly 60% BB-rated, a significant quality improvement over the last decade. Risk has instead concentrated in the lower-quality, B-rated leveraged loan and direct lending markets, making high-yield spreads an unreliable gauge of overall credit stress.
With 27% of US PE funds below their hurdle rate, distributions have slowed dramatically. The value of assets aged over seven years has doubled to over $1 trillion in five years and is projected to hit $2 trillion by 2030, signaling a growing liquidity problem for LPs and funds.
A third of the U.S. leveraged loan and direct lending markets is considered stressed, equating to $770 billion. This figure is double the percentage from 2019 and three times the dollar amount, presenting a significant opportunity for opportunistic credit investors as it exceeds the $640 billion of available global opportunistic capital.
A software company bought at a 13x EBITDA multiple can see its first-lien LTV jump from 45% to 73% and its equity value wiped out by 85% if its enterprise value multiple simply re-rates down to 8x. This looming valuation crisis threatens many LBOs financed at the market's peak.
Published private market returns mask true volatility. After "de-smoothing," private equity's volatility is 20%, double its published rate of 10%. In contrast, opportunistic credit's volatility is much lower (low teens), making it a superior asset class on a risk-adjusted basis for institutional portfolios.
Even with identical acquisition multiples, the higher cost of debt financing today means a new LBO generates an excess return over cash that is 4.5 percentage points lower than it would have during the zero-interest-rate period (ZERP). This presents a major structural challenge for future private equity performance.