Trouble Deepens – Optimists Still Push Back
Several months ago, the central question surrounding private credit was whether investors would maintain confidence in an asset class experiencing an unfamiliar wave of redemption requests.
That concern has not disappeared. But the debate has moved on.
The latest evidence suggests that the more important question may now lie inside the loan portfolios themselves: is credit quality beginning to deteriorate materially?
Recent analysis by the Financial Times indicates that problem loans at some of the largest publicly traded business development companies have risen to levels not seen since 2017. Non-accruals are increasing, defaults are rising, and several major funds are marking down troubled investments.
This is an important change in the story.
Earlier concerns centered primarily on liquidity. Investors wanted their money back, withdrawal limits were activated, and managers argued that negative headlines were creating a problem of perception rather than one of underlying credit quality.
There was considerable merit to that argument. Redemption pressure does not automatically mean borrowers are failing.
Now, however, there is more evidence of stress among the borrowers themselves.
A particularly vulnerable group appears to be companies financed during 2020 and 2021, when interest rates were exceptionally low, valuations were high and lenders competed aggressively for transactions. Those companies now face substantially higher debt-service costs. In some cases, cash that might otherwise have financed investment and growth is instead being absorbed by interest payments.
Software remains another area requiring attention. Private credit managers accumulated significant exposure to software companies during the lending boom. The businesses may still be growing, but rapid advances in artificial intelligence have introduced questions about the durability of some business models and, ultimately, their refinancing prospects.
There are already visible examples of impairment. Loans have been marked down, businesses have been transferred from private equity owners to lenders, and some portfolios are being restructured.
Yet the other side of the argument should not be ignored.
Private credit managers continue to report that the overwhelming majority of their borrowers are performing. Some say leverage and interest coverage remain close to historical averages. Recent redemption pressure at several funds has also eased. Certain publicly traded BDCs have recovered from their lows.
This therefore remains a credit cycle — not evidence of a systemic financial crisis.
But perhaps the most significant change is that fewer participants now appear willing to deny that a credit cycle is under way.
That distinction matters.
Private credit has grown into an enormous source of financing for businesses that increasingly depend on non-bank lenders. Its success was built during a period of extraordinary capital availability. The current environment is beginning to reveal which loans were based on sustainable cash flows and which depended too heavily on low interest rates, optimistic valuations and continuing access to refinancing.
For those of us observing the market from the business information and credit-risk perspective, this brings us back to the issue that has concerned us throughout this series: due diligence.
One analyst quoted in the recent debate put the issue particularly plainly: underwriting during the boom was not always sufficiently selective.
That may ultimately prove more important than today’s default percentage.
Private credit managers now have an opportunity to demonstrate that the lessons are being absorbed — through stronger underwriting, independent verification, better monitoring of borrower performance and earlier identification of deteriorating risks.
Investors will be watching for that evidence.
The optimists may well be correct that today’s alarmism is excessive. Most loans continue to perform, and the available evidence still does not point to another 2008.
But the pessimists can no longer be dismissed simply because the financial system has not broken.
The debate has moved from whether investors are nervous to whether the underlying credit is weakening. That is a much more consequential question. The golden age of private credit was built on growth. The next chapter is already being written — and the quality of due diligence may determine how it ends.
Sources: Financial Times, Financial News Media, Continued Intrepid Explorers, LLC Research Supported by ChatGPT
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