Private credit’s ‘zero-loss fantasy’ is ending as rising defaults loom
Deteriorating asset quality, collateral write-downs and a growing rush for exits are roiling private credit markets and prompting comparisons to the Global Financial Crisis.
But the surge in loan defaults, painful as they are, could help relieve stress in the $3 trillion industry and provide what one industry professional calls a “healthy reset” following the first major liquidity test.
Ares Management On Tuesday, it opted to block investors from withdrawing from its $10.7 billion private loan fund. Apollo Global Management It also announced similar measures in one of its vehicles. Ares capped redemptions in its Ares Strategic Income Fund at 5% after withdrawal requests rose to 11.6%, according to a Bloomberg report.
Including other managers Blue Owl Capital and Cliffwater have also scrambled in recent weeks to halt or restrict withdrawals as rising default fears led investors to pull out of the industry.
Comparisons to the development of the 2008 Global Financial Crisis are now intensifying as concerns about underlying credit quality grow.
Morgan Stanley recently warned that default rates on private credit direct loans could rise to 8%, well above the historical average of 2-2.5%; concentrated in sectors vulnerable to AI disruption, such as printing and software.
‘Important but not systemic’
However, Morgan Stanley analysts led by strategist Joyce Jiang also noted that an 8% default increase was “significant but not systematic,” pointing to lower leverage among private loan funds and business development companies compared to 2008.
Ares Management.
So what would a hypothetical increase of this magnitude look like in practical terms?
“An 8% default rate moves private credit from the ‘zero loss’ fantasy into a more normal credit asset class – a healthy reset that is painful at points but ultimately frees up capital for stronger businesses,” said Sunaina Sinha Haldea, global head of private equity advisory at Raymond James.
He said normalization from extremely low defaults would be “painful for some funds” but “will be healthy for the asset class if it pushes for better underwriting and more realistic valuations.”
William Barrett, managing partner at Reach Capital, said a default rate of 8 percent or 9 percent would occur largely through so-called “shadow defaults,” such as maturity extensions and covenant waivers. Lenders use these “fix-and-fake” tools to keep borrowers afloat and avoid immediate bankruptcy.
He added that although payment-in-kind agreements delay cash returns, increase debt and have the potential to signal greater stress in the system, they also act as an effective “relief valve” that stabilizes companies and prevents outright failures.
Apollo Global Management.
“From a real economy perspective, this means capital gets trapped in restructurings, leading to tighter lending conditions in the future,” Barrett told CNBC via email. he said.
pressure points
Attention has since turned to software exposure in direct lending (estimated at about 26%, according to Morgan Stanley), following fears that agency AI could disrupt the software-as-a-service model that caused publicly traded SaaS stocks to tumble.
Software is the largest sector in Apollo Debt Solutions BDC with more than 12% share. Blue Owl also has heavy exposure to SaaS lending.
KarataşFlagship private credit fund BCRED, which also saw a rise in repayment requests in the first quarter, suffered its first monthly loss in three years, falling 0.4% in February. This comes as the fund flagged a number of loans, including loans linked to SaaS company Medallia, according to a report by the FT.
But industry professionals say these are not the only pressure points.
“AI-exposed software is only the first fault line; the real risk is with highly leveraged, interest-rate-sensitive borrowers whose business model is priced in for free money, especially in the U.S. where private lending is growing the fastest,” Haldea told CNBC via email.
Funds that are concentrated in unstable sectors or hold covenant loans with weaker protections are also vulnerable, as are highly leveraged health care expansions, Barrett said. He highlighted some smaller issuers that recently recorded a default rate of 10.9% due to lack of resources to absorb shocks.
‘Excessive’ leverage
The current unrest underscores the need to better distinguish between investment-grade and below-investment-grade private debt, according to Brad Rogoff, Barclays’ global head of research.
He said below-investment-grade loans generally involve more “excessive” leverage, are mostly tied to software exposure and are concentrated in the United States.
Investment grade, by contrast, tends to include private placement senior tranches, asset-backed mortgages and similar assets. “There’s a different risk profile between the two,” Rogoff told CNBC’s “Squawk Box Europe” on Tuesday.
Karataş.
Rogoff also noted that private loan funds are generally less leveraged today than the investment banks caught up in the 2008 crash. “The real difference between this and 2008 is that you have a lot of influence over similar types of assets with full recourse to the person who owns them,” he said.
Despite recent noise about the liquidity mismatch between retail investors and semi-liquid instruments, most private credit capital remains in traditional structures, largely backed by institutional investors with long-term investment horizons.
UBP’s head of private markets advisory Nicholas Roth said the current wave of redemption requests represented the first real test of liquidity “on a large scale” for the asset class.
He noted how default rates were “high but manageable” but added that repayment pressure, slowing deal flow and price dispersion by market were simultaneously impacting the industry.
“The adjustment period will separate strong platforms with structural liquidity buffers from weak platforms that rely on subscription momentum to fund exits,” Roth told CNBC via email.
