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2023 was a perfect storm of macroeconomic and monetary pressures. We believe we’re still in the midst of the most aggressive Fed tightening cycle in recent history. Due to the persistence of high interest rates and a slowing economy, we’ve seen an increased level of stress affect the global financial markets.

As these forces persist, we’re witnessing a dramatic shift in the credit markets today. Contending with 5% base rates is tough news for businesses with interest coverage ratios below 1% and an eroding cash flow subject to floating rate debt. Simply put, these companies are struggling to service this level of debt. This problem is more widespread than many realize—of the 305 Moody’s-rated B3 companies, 188 will have interest coverage of 1.0X by the end of 2023[1]. The rapid degradation of interest coverage is significant, and we don’t see this dynamic changing anytime soon.

The extended duration of the current credit cycle has revealed three waves of stressed opportunities, according to John Pavelski, Co-Head of Credit Opportunities for North America at Carlyle.

1. First Wave of Traditional Distressed Sightings: This consists of fundamentally flawed businesses in challenged industries. Companies in this bucket would face difficulties in any business cycle and should have been restructured regardless of the environment.
2. Second Wave of Early-Stage “Disruptive” Business Models: This includes companies with disruptive business models that successfully raised capital during the boom times. The cost of capital for these companies was so low (especially compared to now), that investors are just seeing basic concerns such as limited EBITDA and cash flow generation come to light.
3. Third Wave of “Good Companies with Challenged Capital Structures”: Unlike the prior waves, this group offers healthy fundamentals; however, elevated valuations and leverage levels are causing significant stress. Often facing floating rate debt that has skyrocketed, these companies struggle to adapt to the extended period of elevated interest rates and compromised capital markets.

At Carlyle, we believe this third wave is the most attractive and addressable opportunity set for private credit players who can step in as a white knight for fundamentally strong companies facing a credit squeeze. Borrowers are looking for help reducing their leverage, increasing their liquidity, and buying time to improve their performance.

Faced with complicated situations, many businesses in this third wave are seeking a sophisticated, nimble, and well-capitalized investor capable of delivering a bespoke financing solution. This presents an opportunity for firms that have the scale and skills to provide the right hybrid capital solutions for borrowers. This includes facilitating debt with structured upside, utilizing options such as preferred equity and convertibles, and deploying rescue financing when needed.

For savvy investors, this third wave also presents a unique opportunity to gain exposure to high-quality companies not typically associated with the stressed market. Given the current credit cycle and macroeconomic forces at play, these companies may be unable to access traditional capital markets, resulting in an attractive opportunity for lenders outside those markets.

And given the size of this opportunity and lack of available options for these borrowers, private credit managers can be more selective and judicious in their underwriting. Skilled lenders also have myriad structural protections at their disposal, such as requiring strong, negotiated documentation and board representation, all of which can provide increased downside protection for investors.

In an environment of persistent and elevated interest rates, we’re likely to see increasingly sound companies facing balance sheet challenges. We believe the combination of attractive risk-adjusted returns and downside protection in quality businesses of scale presents a unique opportunity for savvy credit investors.

Part of Carlyle’s Global Credit business, the Private Credit platform provides bespoke, flexible financing solutions to a wide range of companies across Opportunistic Credit, Direct Lending, and Special Situations strategies.

_{[1] Moody’s Investor Services, “Interest Coverage will continue to erode as pressures mount for B3 companies” (July 27, 2023)}