4 key lending areas that could affect private equity plans in 2023

Recent economic developments have lenders taking measures not seen since 2020. Find out which lending areas could affect your plans this year.

One surprisingly positive development during the pandemic and its aftermath was how well credit markets held up. Despite the banking industry’s concerns about credit quality back in 2020, repayments held up well, thanks, in part, to a variety of stimulus programs, which kept lending relatively active following the initial shock of the shutdowns.

Today, rising interest rates have lenders concerned again, according to Giulio Camerini and Steve Krase, principals in financial services consulting at Crowe. They discussed the state of the credit markets during the opening session of the Crowe Expertise Week series for private equity. For renewals and modifications of credit, customers have to service their debts at rates from 7.5% to more than 8% – up from 3.5% or 4% a mere year ago. 

Rising interest rates – combined with an economy that’s looking increasingly recessionary – are driving an across-the-board “flight to quality” among lenders. Here are four particularly important lending trends that Camerini and Krase covered in their presentation. 

1. Commercial real estate (CRE) loans – higher rates, lower valuations 
   CRE loans tend to have higher interest rates than residential loans. And as CRE rates go up, so do capitalization rates, reducing the implied value of real estate investments in the near term. The consequence is that CRE appraisals are beginning to move down from where they were just a year ago.
   
   With both higher interest rates and lower valuations, renewals and refinancing for CRE loans will become much more of a challenge. Banks will be taking a closer look at agreements generally, and covenants and other loan terms likely will become more stringent. 
2. Commercial & industrial (C&I) loans – tightening up
   The C&I loan space is seeing a major tightening of requirements instituted by U.S. banks for large, middle-market, and small businesses alike. In fact, they’re approaching previous peaks seen in 2008 and 2020, according to a Board of Governors of the Federal Reserve System survey of senior loan officers. 
   
   Because banks are tightening requirements and the economy is expected to see little to no growth overall this year, a slowdown in C&I loan activity is anticipated as demand falls and covenants become more difficult to meet. 

Exhibit 1: C&I loans

Board of Governors of the Federal Reserve System (US), Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/, January 2023.

3. Leveraged lending market and cash flow loans – more scrutiny
For this area, the watchword is “more” – as in more questions from lenders, more information to provide with respect to budgets and financial projections, and more explanations of possible underperformance, particularly as that relates to covenants.

Banks today are especially focused on borrowers’ deleveraging capabilities. Nearly every private equity-backed company will continue to face greater scrutiny from lenders, especially around financial projections. To avoid problems, it’s important to be proactive and overcommunicate with lenders, especially if issues arise. 

4. Consumer and retail loans – getting more stringent 
Following a brief, pronounced spike in restrictions around minimum credit scores and credit limits in 2020, credit cards and auto loans returned to normal levels. In fact, standards around credit cards fell to their loosest level in a decade the next year.

However, consumer lending is beginning to tighten up again – not dramatically spiking back up to 2020 levels, but steadily climbing in that direction. More constrained access to credit, combined with layoffs and unemployment or underemployment trends, could dampen consumer spending through 2023.

Exhibit 2: Credit card and auto loans

Board of Governors of the Federal Reserve System (US), Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/, January 2023.

What matters for private equity

Because of conditions in these lending areas and the uncertain economic outlook, most private equity groups and their portfolio companies should focus on:

• Maintaining and cultivating excellent relationships with lending institutions, centered around open and frequent communication
• Preparing for longer hold time frames in general

That’s not to say private equity firms need to completely batten down the hatches – opportunities will come this year, and credit will probably be available to pursue them. But private equity firms might find the operating environment noticeably more constrained than in previous years.