Private credit’s ‘zero-loss fantasy’ is ending as rising defaults loom

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.

But a spike in loan defaults, while painful, could help shake out pockets of stress from the $3 trillion sector and provide what one industry pro calls a “healthy reset” after its first major liquidity test.

Ares Management on Tuesday opted to curb investor withdrawals from its $10.7 billion private credit fund, just a day after Apollo Global Management unveiled similar measures in one of its vehicles. Ares has capped redemptions in its Ares Strategic Income Fund at 5%, after withdrawal requests surged to 11.6%, according to a Bloomberg report.

Other managers, including Blue Owl Capital and Cliffwater, have also scrambled to halt or restrict withdrawals in recent weeks, as rising default fears spark an investor retreat from the sector.

Comparisons to the build-up to the 2008 Global Financial Crisis are now intensifying as concerns over underlying loan quality grow.

Morgan Stanley recently warned default rates in private credit direct lending could surge to 8%, well above the 2-2.5% historical average, with pressure concentrated in sectors vulnerable to AI disruption, such as software.

However, Morgan Stanley analysts led by strategist Joyce Jiang also said an 8% default spike would be “significant but not systemic,” pointing to lower leverage among private credit funds and business development companies compared with 2008.

So what would a default spike of that magnitude look like in practical terms?

“An 8% default rate takes private credit from a ‘zero loss’ fantasy to a more normal credit asset class — painful in spots, but ultimately a healthy reset that frees up capital for stronger businesses,” said Sunaina Sinha Haldea, global head of private capital advisory at Raymond James.

She said 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.”

An 8% or 9% default rate would largely manifest through so-called “shadow defaults,” such as maturity extensions and covenant waivers, said William Barrett, managing partner at Reach Capital. 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 added.

“For the real economy, this means capital becomes trapped in restructurings, leading to tighter future lending conditions,” Barrett told CNBC via email.

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 thrust 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.

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 CNBC 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.

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 CNBC’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.

Nicolas 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 CNBC via email.