What Happens in a Private Credit Loan Default?

What Happens in a Private Credit Loan Default?

Most investors in private credit are concerned about the prospect of a loan default, but few know the ins and outs of the default process. This article explores loan defaults, and clarifies what investors should expect in these scenarios.

5 min read

As a private credit-focused robo advisor, a question we often get from investors is ‘what happens when a borrower defaults?’

The answer is not as straightforward as it may seem. In such a scenario, lenders often employ a variety of strategies–some cooperative, others somewhat combative–in an attempt to help the borrower regain their financial footing. Of course, there is always the prospect of collateral seizure and bankruptcy, should none of those strategies ameliorate the situation.

In this article, we'll explore what happens when a borrower defaults on a private credit loan agreement. We'll delve into the consequences of defaulting, strategies for mitigating its impact, and the differences in default processes between private credit and traditional banking.

Key Takeaways

  • A loan default in private credit can lead to severe consequences, including collateral seizure and reputational damage
  • Proactive communication and transparency with lenders can mitigate the severity of a default
  • Private credit offers more flexibility in negotiation and default management compared to traditional banking

What is a Loan Default?

A loan default occurs when a borrower does not adhere to the repayment conditions of a loan agreement–when they miss an interest payment or fail to repay the full principal amount.

While that sounds straightforward, it’s important to realize that a borrower failing to meet a repayment condition does not automatically trigger a default. In such a scenario, it is at the lender’s discretion whether or not to trigger a default.

Lenders may choose not to trigger a default, if they feel they can work with the borrower to impose certain conditions that will allow the borrower to ‘regain their financial footing’ and resume paying interest, or fully repay the principal amount. In other words, lenders can choose to be strict and enforce default proceedings or they can work with the borrower to find a more amenable solution.

The Role of Covenants: Lender ‘Alarm Bells’

Typically, credit agreements contain covenants, which are financial obligations and business restrictions that borrowers must abide by during the lifetime of the loan. Covenant examples include remaining below a certain debt-to-equity level or not accepting new debt without the approval of the lender.

It’s important to realize that when a borrower breaches a covenant, that does not automatically imply a default. Such a scenario can be thought of as an alarm bell going off, alerting the lender to the prospect of a default.

In the event of a covenant violation, there are several steps a lender can take to lessen the likelihood of a default:

  • Engage in Open Communication with the Borrower: Lending is a relationship business. When a covenant is breached, borrowers are often in a financial predicament that needs remedying. The first step for lenders is to engage early and often with borrowers to ensure that they are being forthright about their financial situation.
  • Work with the Borrower Where Possible: Borrowers may need flexibility when it comes to interest rates or repayment schedules. Lenders should feel comfortable working with their borrowers on how best to navigate this period of financial stress.
  • Trust, but Verify: Lenders should ensure transparency through the required reporting outlined in the credit agreement. Lenders must rely on these reports to monitor the borrower’s financial performance.

The Loan Default Process

When a borrower defaults in private credit, lenders maintain specific legal and procedural steps, which could ultimately lead to them taking control of assets. These are designed to safeguard the lender's investment and ensure a full, or at least partial, recovery of their principal amount.

Typically, lenders will start by offering borrowers concessions as they attempt to resolve their financial situation. Examples include waiving certain covenants or allowing interest payments to be made in kind (delaying the payments, but issuing a higher interest rate). These are often part of a broader restructuring agreement that can provide borrowers a crucial lifeline, enabling them to sidestep defaults and potentially avoid bankruptcy. Such agreements might also include amending loan terms, extending maturities, or negotiating new equity injections.

However, if conditions worsen, lenders may choose to exert influence over borrower decision making. Certain stipulations may be outlined in the credit agreement which allow for lender control over a borrower’s operational decisions. For example, a lender might appoint representatives to the borrower's board in order to facilitate timely interest payment.

If these efforts are unsuccessful, the final arrow in the lender’s quiver is to seize collateral. It’s important to recognize that lenders don’t want to seize borrower assets, as they must then dispose of those assets (liquidate them), which is often a long and arduous process. Asset seizure is a measure of last resort which protects the lender in case of a borrower default, and enables the lender to recoup some or all of their principal investment.

In such a scenario, lenders will adhere to the Uniform Commercial Code (UCC) and, if necessary, obtain court orders to seize borrower assets.[1] Ethically, lenders are expected to act in good faith and ensure fair treatment of the borrower throughout the process.

Differences in Default Processes: Private Credit vs. Traditional Banking

Private credit lenders and traditional banks vary significantly in their approach to managing defaults:

  • Flexibility in Negotiation: Bank loans tend to be more standardized (as banks have much larger portfolios of borrowers). Hence, private credit offers more room for negotiation, allowing for tailored solutions between borrowers and lenders.[2]
  • Risk Tolerance: Private credit lenders may assess and tolerate risk differently than their traditional banking peers. Private credit is less regulated, hence lenders in the space are more apt to accept a certain degree of risk. Banking regulations may even prohibit banks from tolerating borrower covenant breaches of a given magnitude (for example, if a borrower’s debt-to-equity level grows too high, banks may be forced to seize control of borrower assets given their own regulatory requirements). A private credit lender, in contrast, may choose to work with a borrower who breaches a covenant, instead of seizing assets.
  • Recourse Options: Private credit may provide more direct or varied options for recourse compared to the often lengthy legal processes in traditional banking.

The personalized approach of private credit can lead to more efficient and quicker resolutions, contrasting with the slower, more bureaucratic processes in traditional banking institutions.[3]

In Conclusion

The consequences of defaulting can be severe, including reputational damage, bankruptcy, and asset seizure. However, there are strategies that both lenders and borrowers can employ to mitigate these impacts.

For lenders, engaging with distressed borrowers through concessions, restructuring, and open communication can prevent defaults and preserve investment value. For borrowers, being proactive and transparent with lenders is key to navigating financial difficulties.

The flexibility and personalized approach of private credit offer unique opportunities for negotiation and resolution, which contrast with the more rigid processes of traditional banking. As the private credit market continues to evolve, more borrowers may come to value these bespoke solutions. Bank loans are indeed less expensive (lower interest rates), but with less room to negotiate, some borrowers of traditional financing may end up discovering that ‘you get what you pay for.’

  1. Source: [Investopedia]https://www.investopedia.com/terms/f/five-c-credit.asp) - Dec 2023 ↩︎

  2. Source: GSAM - Apr 2023 ↩︎

  3. Source: GSAM - Apr 2023 ↩︎