Navigating Bank Loan Defaults: A Guide for Middle Market Companies

The Growth of Private Credit Gives Companies Refinancing Options

In the current economic climate, with major uncertainties around new trade tariffs, consumer confidence and public markets, companies with bank loans are increasingly finding themselves in danger of default. After tariffs were announced in April, JPMorgan raised its estimated risk of a U.S. and global recession in 2025 from 40 to 60%. Provisions for loan losses among the 10 largest U.S. regional banks are already projected to increase by nearly 28% in Q1 2025 according to estimates compiled by LSEG.

Hearing from your lender that you are in default, or close to it, can be jarring. Fortunately, a lender ecosystem exists for borrowers who can't meet commercial banks' underwriting criteria, giving companies a path to a more flexible capital structure should it be needed.

Oftentimes loan defaults aren't due to the borrower's failure to make a payment on time; instead, the borrower fails to meet financial covenants that serve as a tripwire to alert lenders to potential payment issues down the line. For example, a company's EBITDA may drop such that it doesn't meet the required debt service coverage ratio ("DSCR"), which, in its simplest form, is the ratio of EBITDA to required principal and interest payments. Financial covenants are usually set with some cushion – for example, a DSCR may be set at 1.5:1, roughly amounting to a 50% cushion above debt service requirements. Defaults therefore do not necessarily mean that a company is unable to pay its debts or is insolvent, but rather that the credit is not suitable for a commercial bank, which has limited flexibility in the loans it can offer or carry.

The Private Credit Alternative

Fortunately, there are other types of lenders who have greater flexibility than commercial banks. The largest category is private credit funds – investment vehicles akin to private equity that make commercial loans, typically to middle market companies with revenues between $10 million and $1 billion, and aren’t regulated to the same degree as banks. These funds have grown significantly in the last decade, now amounting to approximately $2 trillion globally as of 2024, roughly double the level in 2020. According to Preqin, the private credit market is estimated to grow to $2.64 trillion by 2029.

The landscape includes nearly 1,100 credit funds globally, up from only 100 in 2011 per Preqin. They cover a wide spectrum of risk and return: some make loans that are quite similar to commercial banks in terms of their risk and cost profile, but target companies that for one reason or another don't qualify for or don't want bank debt – for example, if the borrower isn’t willing to have the principal owners sign a personal guarantee. Others (including mezzanine lenders) target riskier credits and have a significantly higher cost of capital, sometimes including equity upside in the borrower in the form of warrants. Some funds offer both loans and equity co-investment, which can fit companies that have some degree of equity-style risk. The range of options means that for most borrowers, there are likely alternative credit funds ready to step in should a bank require repayment.

Steps to Take When Facing a Default

1. Understand the Nature of the Default

The first step when facing a potential default is to understand the nature of the default and how the bank proposes to address it. With some technical defaults (such as late reporting or a curable, temporary failure to meet financial covenants), the bank may just want to understand the company's situation, monitor it going forward with enhanced reporting, and perhaps extract a minor fee. In such circumstances, the default can be addressed with a short amendment that waives the default under the agreed conditions.

In some cases, however, the default is of sufficient concern that the lender will want its loan repaid. A sign that this has happened is that the loan is transferred from your relationship banker to the workout group, whose mandate is to resolve problematic loans. If the company does not have immediate means to repay the loan, the best course may be to refinance out the debt with private credit. Banks will usually give borrowers some time to get this done, provided the bank is confident that the borrower is pursuing the path urgently and effectively.

2. Assemble your Refinancing Team

Getting the right help and advice when facing a default is paramount. Engaging a lawyer who specializes in credit is essential. Credit documentation is complex and highly technical and having a lawyer who understands both the current default situation and the nuances of private credit agreements will be critical to negotiating favorable terms. The right legal counsel can help identify and address potential pitfalls in new loan agreements and ensure that your company's interests are protected throughout the refinancing process.

Investment banks like Fluential Partners who specialize in credit financings can be immensely helpful in this process. For starters, commercial banks will be reassured if they know that the company has engaged an advisor with a track record of successful refinancings. The investment bank can then provide the lender with regular progress reports so they know the process is proceeding on schedule, as well as helping the company fulfill any financial reporting that the bank requires – for example, a 13-week cash flow projection detailing incoming and outgoing funds, which banks require if they are concerned about short-term solvency.

3. Run a Competitive Process

Investment banks then run a rigorous, competitive process designed to reach the right private credit funds on an expedited basis and obtain multiple term sheets. Unlike commercial banks, private credit funds are not necessarily easy to find, and investment banks spend years understanding which lenders fit particular needs and cultivating relationships with them. During a typical process, an investment bank might reach out to 40-60 potential lenders and obtain 5-10 term sheets.

4. Negotiate Optimal Terms

With competitive bids in hand, your investment bank will then help negotiate the terms of the final term sheet with the winning lender. This is an essential part of the process since the terms of such debt vary greatly between lenders and are usually negotiable. Examples of operative terms that need to be negotiated include (among others):

• Maturity, or the date certain by which the loan must be repaid in full.
• The principal repayment or amortization schedule, which may or may not align with the maturity – for example, the loan may be due in three years but amortize on a four-year schedule, leaving 25% of the principal due at maturity. Or amortization may not start until the second year, easing the company’s short-term cashflow burden.
• Interest rate, which is often variable and, in some cases, can change over the life of the loan based on leverage or company performance. Rates are typically based on an index, like SOFR or Prime, plus a “spread.”
• Additional fees such as upfront fees (sometimes called an original issue discount, or “OID”) and monthly or quarterly monitoring fees.
• Prepayment penalties. The ability to repay the loan early at a reasonable cost is particularly important if the loan is expensive and the company thinks its condition may improve to the point that lower-cost financing will be available before maturity.
• Distributions that the company is allowed to make during the term of the loan – overly restrictive provisions may prevent owners from taking distributions even if cash is available to do so.
• Financial covenants such as leverage and debt service coverage ratios. Covenants are highly bespoke in the private credit universe, tailored to protect the lender while ideally allowing management sufficient leeway to operate the business.

Responsible investment banks will try to match loan terms to the needs of the business and build in flexibility for contingencies.

5. Complete Due Diligence

Once the terms have been negotiated, your advisor will then help you respond to diligence requests of the new lender, which are often extensive. If you do not have audited financials, the incoming lender may require a “quality of earnings” report from an accounting firm, which your investment bank can help shepherd. Some questions or concerns almost always arise during diligence, and a good advisor can help you resolve such issues with the new lender and get the refinancing over the finish line.

Timeline for Refinancing

A typical refinancing process run by an investment bank takes 6-10 weeks, depending on the borrower’s readiness and the scope of diligence performed by the incoming lenders.

Conclusion

While defaulting on a loan can be stressful, especially in today's uncertain economic environment, the good news is that there is a well-defined process to address this scenario, and the right team can help you resolve it successfully. With private credit markets continuing to grow and evolve, there are usually viable options for companies seeking to refinance out of bank debt into more flexible structures.

Please feel free to contact us if you have any questions on this article or the credit refinancing process.

Securities and investment banking services are offered through BA Securities, LLC Member FINRA, SIPC. Fluential Partners, LLC and BA Securities, LLC are separate and unaffiliated entities.