The Federal Reserve’s widely expected pivot to lower interest rates next month is creating a conundrum for one of the biggest winners of the high-rate era: private credit.

While easier monetary policy will come as a relief to borrowers with heavy debt loads, it’s also set to sap the returns of an industry that boomed as rates rose.

“Returns generally are going to come down,” said John Cocke, deputy chief investment officer at Corbin Capital Partners. “I believe direct lending is past the golden age.”

That golden age has coincided with the highest interest rates in a generation. Deals in the US$1.7 trillion market are typically set at a floating rate, meaning lenders got much higher yields from borrowers as base rates soared. This in turn lets funds blast through hurdle rates, the point where they can begin to collect profit - or “carry” - on their returns.

Now the reverse may become true, with lenders likely to wait longer to begin drawing profits from their funds as lower central bank base rates squeeze margins. Once they’ve passed an initial return hurdle, usually 5% to 7%, lenders are in line to get about 10% to 15% of a fund’s gains. Until then, they have to pledge all the profit to investors.

Private credit profits are also shrinking in the face of narrowing loan margins, the spread over a base rate they charge borrowers.

A barometer of private credit performance, the Cliffwater Direct Lending Index, had outperformed high-yield bonds by almost four percentage points on an annualised basis since 2004. Last year their returns near 13% were roughly on par.

At the same time, credit quality is weakening. A July study by advisory firm Lincoln International of 5,500 private companies found almost 40% had debt servicing costs larger than their free cash flow.

Many companies have bought time by switching to payment-in-kind debt that lets them delay interest by tacking it onto principal due. In the US, 17% of loans at the 10 largest business development companies - essentially vehicles for private credit funds - involved PIK, Bloomberg Intelligence found this year.

In fact, the default rate for private credit portfolio companies has been dropping for five consecutive quarters, according to data from BlackRock Inc and Lincoln International.

“There was a period with a lot of fear about interest rates,” said Kirsten Bode, co-head of pan-European private debt at Muzinich & Co. “That has reduced quite a bit because people now agree on the trajectory of interest rates, if not the speed.”

Fed officials are largely in agreement it’s almost time to lower interest rates. Investors are onside, too, with markets fully pricing in a quarter-point cut when the Federal Open Market Committee meets next month.

The European Central Bank already cut its benchmark rate more than two months ago, and the Bank of England followed on August 1.

There’s at least one more silver lining to lower rates. They will help boost valuations for potential buyout targets and revive deal flow that’s languished since the rate-hiking cycle started more than two years ago. A bigger bounty of deals may eventually help lift the bottom line at private credit funds chasing too-few deals and cutting their own lending rates to do so.

“Lower base rates are generally a good thing from a cashflow perspective,” said Ares Management Corp.’s Matthew Theodorakis, a partner and co-head of European direct lending, which runs more than US$70 billion in private credit strategies.

  - Bloomberg