Private credit’s ‘zero-loss dream’ fades as defaults and exits surge

The Private Credit Sector Faces a Crucial Test

A wave of investor withdrawals and concerns over deteriorating loan quality are forcing asset managers to impose restrictions on redemptions in their private credit funds. This has led to a growing sense of unease within the sector, with many strategists warning that the current situation could mark the first major liquidity test for private credit.

But not all is doom and gloom. Some industry experts believe that a rise in defaults could ultimately lead to a “healthy reset” for the sector, helping to flush out bad loans and bring about a more sustainable market environment.

Rising Default Rates and Systemic Risks

The risks in the private credit market are concentrated in highly leveraged, rate-sensitive debt, particularly among software companies and smaller borrowers. These borrowers are often reliant on “shadow defaults” and “amend-and-pretend” strategies to delay failures. While these tactics may provide temporary relief, they also signal deeper systemic issues.

Deteriorating asset quality, collateral markdowns, and a growing rush for the exits are rattling private credit markets and prompting comparisons to the Global Financial Crisis. However, analysts argue that while the current situation is concerning, it is not yet systemic.

Morgan Stanley recently warned that default rates in private credit direct lending could surge to 8%, well above the historical average of 2-2.5%. This spike would be significant but not necessarily catastrophic, according to Morgan Stanley analysts led by Joyce Jiang. They point to lower leverage among private credit funds and business development companies compared to 2008 as a key differentiator.

The Impact of an 8% Default Spike

What would a default spike of this magnitude look like in practical terms? Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, suggests that an 8% default rate would take private credit from a “zero loss” fantasy to a more normal credit asset class. While painful in spots, she believes it would ultimately be a healthy reset that frees up capital for stronger businesses.

Haldea notes that a normalization from ultra-low defaults would be “painful for some funds” but “healthy for the asset class if it forces better underwriting and more realistic valuations.”

William Barrett, managing partner at Reach Capital, adds that an 8% or 9% default rate would largely manifest through so-called “shadow defaults,” such as maturity extensions and covenant waivers. Lenders use these “amend-and-pretend” tools to keep borrowers afloat and avoid immediate bankruptcy.

While payment-in-kind agreements delay cash returns, increase debt, and potentially signal greater stress in the system, they also act as an effective “release valve” that stabilizes companies and prevents outright failures, he said.

Pressure Points in the Market

Concerns over credit quality have spread through private markets following the high-profile collapses of First Brands and Tricolor within the U.S. auto parts sector last year. While those failures were tied to asset-based finance and bank-syndicated debt, rather than traditional middle-market direct lending, they brought the broader question of risky debt in private markets into the spotlight.

Attention has since shifted to software exposure in direct lending — estimated at around 26%, according to Morgan Stanley — after fears that agentic AI could disrupt the software-as-a-service model sent publicly-listed SaaS stocks plunging.

Software is the largest sector in the Apollo Debt Solutions BDC, at more than 12%. Blue Owl is also heavily exposed to SaaS lending.

Blackstone’s flagship private credit fund BCRED, which also saw a surge in redemption requests during the first quarter, was down 0.4% in February, its first monthly loss in three years. It came as the fund marked down a number of loans, including debt linked to SaaS company Medallia, according to an FT report.

The Real Risk: Highly Leveraged Borrowers

But these are not the only pressure points, industry pros say. “AI-exposed software is just the first fault line — the real risk is across any highly-levered, rate-sensitive borrower whose business model was priced for free money, especially in the U.S. where private credit grew fastest,” Haldea told Jendela Magazine via email.

Funds concentrated in volatile sectors or holding covenant-lite loans with weaker protections are also vulnerable, as are highly leveraged healthcare roll-ups, Barrett said. He highlighted certain smaller issuers that have recently recorded a 10.9% default rate, due to a lack of resources to absorb shocks.

Distinguishing Between Investment-Grade and Sub-Investment-Grade Debt

The current malaise underlines the need to better distinguish between investment-grade and sub-investment-grade private debt, according to Brad Rogoff, global head of research at Barclays.

Sub-investment grade credit typically involves more “extreme” leverage, often tied to software risk and concentrated in the U.S., he said. Investment grade, by contrast, tends to include private placement senior tranches, asset-backed mortgages, and similar assets. “There is a different risk profile between the two of them,” Rogoff told Jendela Magazine’s “Squawk Box Europe” on Tuesday.

Private credit funds are also generally less leveraged today than the investment banks that were caught up in the 2008 crash were then, Rogoff noted. “The real difference between this and 2008 is that you had a lot of leverage on similar type assets that had full recourse to whoever owned them,” he said.

Despite the recent noise surrounding the liquidity mismatch between retail investors and semi-liquid vehicles, most private credit capital remains in traditional structures, backed largely by institutional investors with long-term investment horizons.

Nicholas Roth, head of private markets advisory at UBP, said the current wave of redemption requests represents the first real liquidity test for the asset class “at scale.” He noted how default rates are “elevated, but manageable,” but added that redemption pressure, slowing deal flow, and mark-to-market dispersion are hitting the sector simultaneously.

“The adjustment period will separate strong platforms with structural liquidity buffers from weak platforms relying on subscription momentum to finance exits,” Roth told Jendela Magazine via email.