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.
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.
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.
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.
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.
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.
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.