Debt Service Coverage in Private Markets Is Improving, Actually | Nicholas Brooks

Debt service coverage ratios in private markets deteriorated sharply when central banks raised rates aggressively after COVID, with the European median falling from roughly 3 to 2.5 and the US median from roughly 2.5 to 2, measured across a database of 400 to 500 companies. Nicholas Brooks, head of research and investment strategy at ICG, which manages over 126 billion dollars, attributes those declines primarily to the speed and magnitude of rate moves rather than to EBITDA deterioration. Since 2024, US interest coverage ratios have actually risen, meaning corporate balance sheets have strengthened rather than weakened, and Brooks directly disputes claims that a private credit-caused financial crisis is almost inevitable, arguing the debt levels he observes are sustainable.

EBITDA growth for private companies has held up well, with European private company EBITDA running around 8 percent and US around 6 percent over the past three to four years. Brooks attributes the US-Europe gap to a higher healthcare weighting in the US private markets database and an unusually severe post-COVID margin squeeze in that sector driven by wage inflation. Software exposure in ICG's European database runs around 14 percent and in the US around 12 percent, with broad private market software exposure sitting in the 11 to 15 percent range. Higher figures of 20 to 30 percent cited elsewhere refer specifically to 2020 and 2021 vintages when buying software companies at elevated valuations was the dominant trade, and inconsistent classification of IT services and industry-specific software-as-a-service products across analysts and BDCs further distorts comparisons.

Median coverage figures mask significant dispersion, with some companies below an interest coverage ratio of one and others well above three. Brooks says this dispersion is driven more by micro factors such as management quality, leverage level, interest cost management, and recapitalization history than by shared macro themes, and he expects dispersion across and within sectors to continue growing. Corporate indebtedness has been roughly flat to down since the 2008 financial crisis despite the rise of private credit, because private credit largely replaced bank lending rather than layering new debt on top of existing obligations.

BIS research published in December 2024 identifies the debt service ratio as one of the better early warning indicators of systemic financial crisis. BIS data shows debt service ratios for the non-bank private sector have been trending down since 2008 to 2009 and are well below crisis-era levels, though the data lags by at least two to three quarters. Brooks argues that strong corporate, household, and systemically important bank balance sheets collectively explain much of the resilience markets and economies have shown to external shocks, and that systemically important banks are well ring-fenced as a direct lesson from 2008 to 2009.

Brooks identifies government debt as the biggest medium-term financial risk, contrasting it with the relative health of private sector balance sheets. The US fiscal deficit runs at approximately 6 to 8 percent of GDP annually on IMF data, and the trade-weighted dollar fell close to 10 percent last year, which Brooks views as rational given that fiscal trajectory. He points to the Liz Truss UK mini-budget as a test case showing how quickly markets can react to perceived fiscal irresponsibility, and notes that US Treasury bonds have been selling off on some of the most stressful days rather than acting as a risk-off safe haven. He warns that if governments do not appear to be getting debt under control, longer-end yields could keep rising in a self-reinforcing cycle, and that this volatility risk is coming sooner rather than later. He expects further medium-term dollar weakness if deficits remain unchecked, and notes that many in the Trump administration are comfortable with a weaker dollar as a tool for boosting exports and reshoring manufacturing.

A large and largely committed pipeline of AI infrastructure investment in the US, alongside Germany and Europe committing to significant defense and infrastructure spending increases, provides downside protection to both economies over the next few years. NVIDIA earnings per share are up 80 percent year over year. Brooks cautions that companies already positioned to benefit from AI infrastructure spending have largely seen that reflected in share prices, and that an AI investment bust if return on invested capital does not materialize is more relevant to a 2027 timeframe than the near term. He draws a parallel between AI's economic transition and globalization, noting that both create efficiency gains at the aggregate level while producing clear winners and losers, and that governments need to support vulnerable groups during the transition or political problems will worsen.

On-paper returns for private equity and private credit from inception through approximately 2021 were good to extraordinary and exceeded hedge fund aggregate returns, but a lack of exits means those returns have not been fully realized, and selling large companies valued around 40 billion dollars is structurally difficult because the universe of viable buyers is limited to other giant asset managers. Some private credit funds have already triggered 5 percent gating mechanisms under outflow pressure. Publicly traded BDCs may represent value given they are trading at a significant discount if concerns about private credit ultimately prove unwarranted.