Getty Images
After the banking system nearly collapsed during the 2008 financial crisis, Congress in 2010 passed the Dodd-Frank legislation, forcing banks to hold more capital against risky commercial loans. It also pushed corporate lending into the hands of private equity firms like Apollo Global Management, Blackstone Group, Ares Management, and KKR.
The upshot was a $1.7 trillion private credit industry that investors loved.
But now, as the world financial system teeters under the draconian — and uncertain — tariff and fiscal policies of the second Trump administration, this once-hot market faces a reckoning.
“It’s the canary in the coal mine,” says Dan Rasmussen, a partner at Verdad Advisers, explaining that “private credit is the riskiest type of corporate lending being done right now. The companies it finances are the most susceptible to almost any risk because they’re so overleveraged, and they are small, fragile companies in a space that massively expanded in the past few years.”
Direct-lending funds represent a majority of private credit, a broad term that includes a dozen or more distinct strategies. Companies that tap those funds, which cater to middle-market businesses primarily owned by private equity, pay higher interest rates than they would for leveraged loans or high-yield bonds underwritten by banks.
Over the past decade, private credit’s high returns and low default rates during an economic boom made the asset class popular with institutions like pension funds, insurance companies, and sovereign wealth funds that are also invested in the private equity funds offered by the same firms. Private equity firms have bought or taken stakes in insurance companies to manage their fixed-income portfolios, and they are going after retail investors through exchange-traded funds, among other vehicles.
But the asset class may have peaked. Last year, direct lending hit a record-high issuance of $145 billion, up 79 percent from 2023, according to Fitch Ratings, which anticipates a deterioration of credit this year “amid tariffs and policy volatility.” Rasmussen warns: “We haven’t seen a default cycle since 2008. This is an untested asset class.”
It is also a largely opaque one. In a 2024 paper titled “The Credit Markets Go Dark,” professors Jared Ellias of Harvard University and Elisabeth de Fontenay of Duke University write that private credit’s “defining feature is its near-total absence of truly reliable and comprehensive data, both for the market in aggregate and for the individual loans made by private credit funds.”
They note that “the consequences of this are significant and potentially troubling: A segment of the U.S. economy may simply go dark.” The professors anticipate “more examples of wildly mistaken or misleading valuations of private companies,” as well as “a greater incidence of corporate fraud, given that private companies that go dark are by definition subject to less scrutiny, oversight, and enforcement.”
“We don’t know yet . . . whether, going forward, we should expect our economy to be more susceptible to large market distortions and the painful market corrections that eventually follow,” the professors add.
Despite private credit’s lack of transparency to the outside world, there is one small window into it through the public markets, and what is showing right now is unsettling. The stocks of business development companies — similar to real estate investment trusts and marketed to retail investors — have been sinking lately.
The BDCs “went from doing okay to highly distressed over the past two weeks,” Julian Klymochko, the CEO of consulting firm Accelerate, wrote on Twitter after Trump announced his harsh tariff regime, which many economists and financial executives expect will usher in a recession. (The stocks of BDCs, like those of REITs, inherently feel the pain or exhuberance of markets, before their private market peers. They suffered large losses in other downturns, including during the early months of the pandemic. )
“The majority of holdings are senior secured loans to sponsor-backed private companies. Right now, the market is pricing in [a] 20 percent default. If that happens, one in five private equity investments go to $0 and PE fund performance is massively negative,” Klymochko said.
He called out several BDCs of top private credit firms, which he said were trading at discounts of up to 30 percent of their net asset values. Shares of the largest private equity firms have also experienced sharp drop-offs this year. As of April 22, Apollo was down 25 percent year-to-date, Ares had fallen almost 20 percent, and Blackstone was off 27 percent. The S&P 500, meanwhile, was down only 10 percent. (While those stocks have since retraced some of those declines, they still are trailing the market by a wide margin.)
Klymochko tells Institutional Investor that investors are particularly worried about the level of payment-in-kind interest on the books of many private lenders. PIKs are typically additional debt extended to companies at higher rates. (When a borrower can’t make all of its interest payments, the amount of unpaid interest is added to the company’s total debt in what is called a PIK flip.)
Last year, several BDCs showed more than 10 percent of their interest income coming from PIKs, according to Moody’s Ratings and reported by the Financial Times. That is a recent increase from the lower single digits for the top lenders, says Jeff Diehl, managing partner and head of investments at Adams Street Partners, a $62 billion manager exclusively focused on private equity and private credit.
Five of Blue Owl Capital’s BDCs made the Moody’s list, with Blue Owl Technology Corp.'s PIK interest income at almost 25 percent of investment income. (Since the list was compiled, some of Blue Owl’s BDCs have merged, leaving the firm with only three on the list.) Other BDCs with more than 10 percent of their investment income from PIKs included Goldman Sachs BDC and Ares Capital.
Goldman and Ares declined to comment.
Logan Nicholson, a portfolio manager at Blue Owl, says it is “just not the case” in all circumstances that PIKs are associated with stress. He notes that many borrowers have instruments in the capital structure that intentionally have PIK upfront. That can include the option to exchange a cash payment for more debt. “If the borrower chooses the option, then the lender receives additional income,” he explains.
But first-quarter numbers may not be much better for many private lenders. The International Monetary Fund reported last week that more than 40 percent of private credit borrowers had negative cash flow at the end of last year, “prolonging their reliance on payment-in-kind provisions and amend-and-extend restructurings.” And that was before the tariff wars roiled the markets.
Diehl notes that so far there has not been a material uptick in defaults in private credit, “but there are a lot of warning signs that may be coming, and PIK flips are for sure one of those warning signs.” Others include debt-for-equity swaps and “things you can’t see [in the BDCs]. What’s the interest coverage on the company? Does EBITDA cover interest? What’s the loan to value, meaning how much debt versus how much total enterprise value? What’s been happening with the revenue and the EBITDA at the underlying companies? Those are things that investors should pay a lot of attention to when they’re underwriting a manager,” he says.
Some of these problems have been building since rates started to go up in 2022. “When rates rose, some deals that were overlevered saw interest payments rise above company cash flow used to service those payments,” Diehl explains. Other companies, he says, may simply have had performance issues. This year, the failure of the M&A and IPO markets to open up has added to the woes.
In an April outlook, Dan Pietrzak, KKR’s global head of private credit, said he expected deal flow to pick up gradually. But his “downside scenario” of higher inflation and rates “could lead to higher defaults for levered companies where free cash flow is already under pressure.”
The high levels of PIK interest also point to another worry expressed by Ellias and de Fontenay: the potential rise of so-called “zombie” companies among private credit borrowers. Instead of restructuring their debt and moving on, they have the incentive and the ability not to mark down their loans and are stuck in limbo.
This is a change from the bankruptcy and restructuring process surrounding leveraged loans and high-yield credit, the professors say. “In a world where debt no longer trades and where information on corporate borrowers is less widely shared, the core assumption that enabled this ecosystem and set of legal procedures to develop will unravel, and the biases and idiosyncrasies of private investment funds (and their sponsors) will dominate the landscape of financial distress,” they write.
In the end, creditors may take over failing companies, as happened with Pluralsight, a private equity portfolio company whose borrowers now own it. One of those borrowers is Blue Owl, which listed a PIK from the company in a recent securities filing for one of its BDCs.
“If the firms do default, the creditors can take a board seat, can take over the keys to the company so it’s not that it’s going to be a big bang; it’s a slow-moving process,” says EY-Parthenon Americas wealth and asset management leader Gaurav Joshi.
Aside from the relatively small BDC market, the extent of these problems is virtually unknowable to outsiders. “It’s really hard to observe the deterioration of credit quality because it’s an illiquid market,” points out Amanda Fischer, former chief of staff to Securities and Exchange Commission chair Gary Gensler. She worked on the SEC’s since-abandoned private fund adviser rule, which would have provided more transparency to investors, including quarterly statements, annual audits, and transparency around conflicts of interest.
The private funds industry sued the SEC over the proposed rule, arguing that those funds were already offering adequate disclosure. The case was vacated by the Fifth Circuit Court of Appeals, a conservative court that corporate plaintiffs have preferred in recent years.
To be sure, some of the biggest institutional investors may be able to get such transparency from their fund’s general partners. But Fischer, now the policy director and chief operating officer at Better Markets, is skeptical of the industry’s point of view. At the SEC, she says, “we talked to LPs privately and they were like ‘Please, we don’t have bargaining power and we need this rule in order to get access to this information.’” She adds, “At the same time, they had trouble being more publicly vocal on these issues because they didn’t want to be carved out of deals.”
After the financial crisis, regulators intended to push risky lending from the banks, which rely on short-term financing, to managers who would lend long-term savings from institutional investors. But the big unknown is whether significant declines in the world of private credit — which would of course be accompanied by losses in private equity — would create a risk to the overall financial system, just as bank lending did in 2008. Or would the losses on private credit, like any asset, simply be borne by investors, limiting systemic risks? Of course, the decline in value would put a squeeze on pension funds that provide for employee retirements or endowments that use those funds to pay for university operations, potentially creating reputational risk. After all, many institutions have invested up to 40 percent of their assets in privates.
Private credit was on a fundraising tear for a few years, but institutional investors pulled back in 2024, according to PitchBook, which notes that there is a nascent secondaries market in private credit. These secondary funds buy up stakes in private credit funds that investors are willing to sell at a discount to raise cash.
Now there are efforts to bring in retail investors via ETFs or evergreen funds, which — unlike regular private credit funds — have no finite lifespan. “During a potentially recessionary environment, fund sponsors might go searching for retail investors to offload private credit, right as loan quality may be deteriorating and [portfolio companies] seek to subvert or waive covenants,” says Fischer.
Even though regulators intended to move many of these risky loans out of banking and into asset management, Fischer believes Dodd-Frank did not adequately address the nonbank financial sector, which she calls a “failure.” Although the law gives the government the authority to designate nonbank institutions as “systemically important” and regulated by the Federal Reserve, a number of giant firms lobbied to avoid receiving that designation — and have so far escaped it.
The regulated banking system, however, isn’t immune to the potential problems of private credit. That’s because banks have lent more than $500 billion to private credit funds, according to the IMF. This credit extension is what is known as “back leverage.” It is leverage on top of leverage, allowing the funds to borrow at investment-grade levels from the banks and extend credit to their portfolio companies at much higher rates, profiting off the spread. The worrisome detail is that those portfolio companies have obtained leverage of five to ten times EBITDA, according to market participants.
“The Fed monitors this, but I do think that there are gaps in understanding of just how exposed the banking system could be to downturns in private credit,” Fischer says. “There’s really no one looking out for the systemwide potential implications of the growth of private credit.”
The problem is likely to be more pronounced under the Trump administration, she suggests. “Is there a tone at the top where they are more ‘hands off’ from a supervisor’s perspective, and banks in the race to compete with one another become less and less conservative?” Fischer asks. In recent years, big banks have also indicated an interest in muscling into the private credit business, although the recent turmoil may put an end to those efforts — for now.
So far, the alarms raised by a number of regulators in the U.S. and abroad have fallen on deaf ears. In its annual report last year, the Financial Stability Oversight Council, which was established by Dodd-Frank to identify risks to the system, laid out its concerns.
“The opaque nature of private credit lenders makes it difficult for regulators to assess risk management practices and the buildup of risks in the sector,” it noted. “Rising interconnections with banks and insurance companies, limited transparency around private credit valuations, and increased retail investor participation in the industry via semiliquid investment vehicles may indicate expanding risks.”
The role of state-regulated insurance companies in private credit is of particular concern to Fischer. “According to state law, insurers can rely on private credit ratings to determine their capital requirements [for private credit], and there are a lot of questions about the quality of those ratings,” she says, citing the role of the ratings agencies in the mortgage securities crisis predating the 2008 crash.
The discussion always seems to harken back to those events. “Very rapid expansions of novel forms of credit are rarely a good idea, so that’s why you’re seeing an analog to the mortgage crisis,” says Rasmussen. “People always pick some new form of lending that has never had a default cycle and assume that it’s forever. And then they massively expand leverage in that area that goes beyond the point of reason.”
“When that blows up,” he says, “everyone who owned it is very surprised.”
