An increasing number of lower-middle-market borrowers are struggling to meet financial covenants or make payments on time, as high interest rates and slowing growth take their toll.

Ratings agency Morningstar DBRS said while the number of issuers with such problems remains small, it has risen.

“We view this as symptomatic of the cumulative pressure endured by borrowers from high interest rates and slowing operating margin momentum – conditions we would expect to see two years into a rate-hiking cycle,” it said.

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Additionally, the ratings agency noted that some of these companies have not fulfilled their growth expectations, which has led to their difficulties in satisfying their funding agreements.

“In an increasing number of cases, assumptions made in the initial underwriting of the loans regarding growth or profitability have failed to materialize, resulting in capital structures and related costs becoming untenable,” it added.

“However, lenders and borrowers continue to have an incentive to work together to maintain liquidity in situations where the company is more likely to be able to manage through difficult operating conditions.”

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Morningstar DBRS said that it remains “constructive” on the overall credit position of most of its middle market portfolio, but expects more rating downgrades and for defaults to rise to levels similar to 2023, as the credit cycle continues to play out.

Private credit industry stakeholders at SuperReturn Private Credit conference in London earlier this week told Alternative Credit Investor that loan covenants should come under increased scrutiny.

In an article in the Financial Times on Monday, Sabrina Fox, founder of Fox Legal Training, warned of the degrading quality of these types of investor protections and called for credit ratings agencies to analyse loan covenants.

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