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Credit Ratings

Private Credit and Unrated Debt

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Private Credit and Unrated Debt

A rapidly growing segment of fixed income — now estimated at $2+ trillion globally — is issued by companies and funds that don't seek rating-agency ratings. Private credit includes bank loans, private placement debt, and structured credit where borrowers avoid ratings deliberately. Without agency ratings, investors must conduct independent credit analysis or rely on lenders' due diligence. This creates both risk (asymmetric information) and opportunity (higher yields compensating for research burden).

Key takeaways​

  • Private credit (unrated debt) grew from roughly 5 percent of fixed income in 2010 to 15+ percent by 2024
  • Borrowers avoid ratings to maintain flexibility, avoid public disclosure, and bypass covenant complexity
  • Lenders compensate for information asymmetry with higher yields, covenants, and collateral requirements
  • Private credit provides yields 200-400 basis points above comparable rated debt
  • Institutional investors (insurance, pensions) are shifting allocation toward private credit to chase yield

Why borrowers avoid agency ratings​

Publicly-rated debt subjects borrowers to quarterly covenant monitoring, regular analyst scrutiny, and downgrade risk. The costs are significant:

  • Disclosure burden: A rated issuance requires quarterly financial statements, annual audits, and investor presentations. A private placement avoids this, allowing companies to maintain competitive secrecy.

  • Covenant complexity: Rated debt carries dozens of covenants. Leverage ratios, interest coverage, debt-service coverage, minimum liquidity, asset sales restrictions. Private lenders negotiate covenants but usually allow greater flexibility in exchange for higher yield.

  • Refinancing pressure: A publicly-traded bond creates refinancing risk. If the company is downgraded and the bond trades below par, refinancing becomes expensive. Private credit lenders can refinance negotiated terms directly with the same lender, avoiding market repropricing.

  • Accounting and tax exposure: Public debt requires detailed financial reporting. Some businesses (real estate partnerships, family offices) prefer to avoid the tax and accounting scrutiny.

For a middle-market company with $100 million EBITDA, issuing public debt ($150-300 million) triggers costs: underwriters ($3-5 million), legal/accounting ($500,000-$1 million annually), and covenant monitoring overhead. A private credit bank loan (to the same company) avoids these, reducing net cost by $4-6 million over the first year.

Private credit structures: loans, placements, and funds​

Bank loans and credit facilities: A company borrows $200 million from a syndicate of banks. Typical terms: floating-rate (SOFR + 300-500 basis points), 7-year maturity, covenants on leverage, interest coverage, and asset sales. Loans are held by banks and sold in the secondary market. Mutual funds and insurance companies can buy them.

Private placements: A company issues $100-300 million in senior unsecured debt directly to insurance companies or pension funds. Typically fixed-rate, 10-15 year maturity. Covenants are negotiated between borrower and lenders; not standardized.

Direct lending funds: Private equity firms raised capital to lend directly to middle-market companies. The fund lends $50-200 million per borrower, takes board observation rights, first lien on assets, and strict covenants. Returns are 8-12 percent.

Sponsor-backed credit: Private equity sponsors need leverage for leveraged buyouts. Lenders provide senior secured debt (first lien, 1.5-2.5x leverage), mezzanine debt (second lien, subordinated), and equity. A typical LBO of a $500 million EBITDA company uses $300 million in debt, $150 million mezzanine, $50 million equity.

These structures exist on a spectrum from bank-like (diversified, senior, low default) to high-risk (highly leveraged, concentrated, subordinated).

Yields in private credit markets​

Private credit yields approximately as follows:

  • Bank loans on large cap: SOFR + 250 bps (total 4-4.5 percent, assuming 1.5-2 percent SOFR). Duration close to zero (floating rate).
  • Middle-market first lien loans: SOFR + 350-400 bps (5.5-6.5 percent). Duration 1-2 years if fixed rate.
  • Mezzanine and subordinated debt: Fixed-rate 9-12 percent. Duration 4-5 years.
  • Distressed credit: 12-18+ percent. Duration variable.

These yields are 200-400 basis points above comparable rated debt. A BBB-rated 5-year corporate might yield 4 percent. A comparable private credit first lien yields 5.5+ percent. The extra 150+ basis points compensates for:

  • Information asymmetry (lenders conduct due diligence but it's not continuous)
  • Illiquidity (private credit is harder to sell than public bonds)
  • Covenant enforcement risk (covenants are detailed but enforcement is costly)
  • Refinancing risk (if credit deteriorates, refinancing is difficult)

Information asymmetry and due diligence​

Unlike rated debt where investors rely (sometimes foolishly) on agencies, private credit requires investors to conduct independent analysis or rely on intermediaries (banks, credit funds) who conduct it.

This creates information asymmetry. A direct lender to a private company might have board observation rights and access to monthly financial statements. A passive investor in a private credit fund knows the fund holds diversified portfolios but not the specific terms, financial metrics, or covenants of each loan.

This asymmetry has historical caused problems. The 2008 financial crisis demonstrated that many bank loans syndicated in 2006-2007 had minimal documentation, almost no covenants, and were issued to financial-engineering companies (CDO sponsors, RMBS issuers) that had no business borrowing.

Post-crisis, due diligence improved. Modern private credit investors require:

  • Detailed underwriting (3-5 years historical financials, projections, stress tests)
  • Covenant packages (leverage, coverage, asset restrictions, cash sweeps)
  • Board observation or monthly reporting
  • Collateral (first or second lien on company assets)

Investors able to conduct this analysis or access managers who do can generate excess returns. Investors relying on past performance or brand reputation without understanding covenants take outsized risk.

Covenant design and enforcement​

Covenants in private credit are detailed and extensive. A typical first-lien loan has:

  • Maximum total leverage: Debt / EBITDA under 3.0x. Forces deleveraging if business slows.
  • Minimum interest coverage: EBITDA / Interest under 2.5x. Prevents borrowing beyond cash flow capacity.
  • Asset sale restrictions: Can't sell more than $X without lender consent. Prevents stripping value.
  • Minimum liquidity: Must maintain $Y in cash or revolver. Prevents insolvency.
  • Restrictions on capex, distributions, acquisitions without lender consent.
  • Financial reporting: Monthly financial statements within 10 days of close. Real-time monitoring.

These covenants are enforced actively. If a company violates leverage covenant, the lender can:

  1. Issue a waiver and charge a fee (200-300 basis points of loan amount)
  2. Increase the interest rate permanently (100-200 basis points)
  3. Tighten other covenants
  4. Accelerate the loan (demand repayment)

The lender's ability to enforce depends on negotiating power. A company with strong cash flow and alternative financing sources negotiates looser covenants. A leveraged company with no alternatives accepts strict covenants.

Systematic private-credit growth and concentration risk​

Private credit assets have grown from $500 billion in 2010 to $2+ trillion by 2024. This growth reflects:

  • Search for yield: As Treasury yields fell (2010-2021), investors chased higher returns in illiquid credit.
  • Regulatory constraints: Banks face capital requirements on traditional loans, so shifted origination to private-credit funds.
  • Institutional demand: Pensions and insurance companies with fixed liabilities seek stable returns and accepted illiquidity.

This growth creates concentration risk. A few large private-equity and credit platforms (Ares, Apollo, Blackstone, Carlyle) control 20-30 percent of direct lending. If stress hits these platforms simultaneously (e.g., widespread covenant breaches requiring simultaneous workouts), coordinated action becomes difficult.

Additionally, private credit defaults are opaque. Public-bond defaults are announced and tracked. Private-credit defaults may be worked out quietly, with lenders taking haircuts or extending terms without transparent disclosure. The true default rate in private credit is unknown.

Illiquidity and exit risk​

Private credit is illiquid. If you own a $10 million position in a middle-market loan and need to exit, selling at par is rare. Secondary markets exist but bid-ask spreads are wide (3-5 percent for performing loans, 10-20 percent for stressed).

This illiquidity forces long time horizons. Private-credit investors must hold through business cycles. If a company faces temporary stress (a recession quarter, operational misstep), the lender can't easily exit — they must work through the issue or take a loss.

For some investors (insurance companies, pensions with long-dated liabilities), this horizon-matching is desirable. For others (mutual funds with daily redemptions), private credit is unsuitable.

The mismatch between daily-redemption funds and illiquid assets created problems post-2008. Some mutual funds held private credit or structured credit with illiquid positions. When redemptions spiked, funds were forced to sell at fire-sale prices or suspend redemptions. Regulatory changes (2016 onward) restricted mutual funds' private-credit allocations to limit this risk.

Opportunity and risk asymmetry​

Private credit rewards skill in credit analysis. An investor able to assess management quality, competitive positioning, and covenant safety can earn returns well above what rating-agency analysis would suggest. Many insurance companies and large asset managers have built proprietary private-credit platforms generating 8-10 percent returns on leveraged middle-market loans.

But asymmetry cuts both ways. A company with weak covenants, deteriorating cash flow, and non-professional management might default at 20-30 percent rates over a cycle. Yield spread of 150-200 basis points doesn't compensate for 20 percent default probability.

The skill is distinguishing the two. This requires operational knowledge, relationship banking, and comfort with illiquidity. It's not suitable for passive investors or those relying on brands or past performance.

How private-credit decisions flow​

Next​

Private credit is the fastest-growing segment of fixed income and demonstrates that rating agencies are increasingly peripheral to credit markets. Institutional investors with resources to analyze credit directly are shifting away from agency-rated debt toward private structures offering higher yields and greater control. The next article examines a different but equally important category: sovereign debt, where rating-agency influence remains high despite demonstrated predictive failures.