Ronald Verhagen (AF Advisors): A meltdown in private credit – is this time different?
This column was originally written in Dutch. This is an English translation.
By Ronald Verhagen, Director of Investment Consultancy at AF Advisors
Tensions in the private credit market are mounting. With defaults on the rise and liquidity under pressure, comparisons with 2008 are inevitable. But that parallel is too simplistic. Whilst the risks are real, the current situation points more to a necessary correction in a rapidly expanding, illiquid market than to a systemic crisis
The current stress has a clear catalyst. The problems are concentrated in software companies, which typically account for 15% to 25% of private credit portfolios. It is precisely these companies that are under pressure due to uncertainty about their earning capacity caused by the rise of AI. Historically, the average direct lending private credit default rate has been around 2%, but that estimate is too low given the current situation.
Morgan Stanley recently warned that default rates could rise to 8%. This does not yet point to an acute meltdown, but it does indicate a structural deterioration in underlying credit quality that could gradually accumulate. At the same time, liquidity mechanisms are being visibly tested. Recent instances of exit restrictions (gating) at firms including Blue Owl, BlackRock, Apollo and Blackstone illustrate the mismatch between illiquid assets and the liquidity provided via an evergreen structure.
The difference from 2008 starts with the structure of the system. The subprime mortgage crisis was driven by extreme leverage and the repackaging of risk via securitisations, whereby losses became immediately visible through mark-to-market valuation. Private credit operates fundamentally differently. It is less intertwined with liquid financial markets, has limited secondary trading, and valuations are based on models (mark-to-model). As a result, losses do not become immediately apparent, but are delayed and often only gradually incorporated into valuations.
It is precisely this delay and gradual nature that creates a specific risk: investors may be inclined to exit at outdated intrinsic values when they suspect that the underlying loans are worth less. This can accelerate exits and intensify downward pressure on valuations. At the same time, analyses show that even in stress scenarios the impact on the banking system remains limited, pointing to a non-systemic correction. What is often overlooked is that these dynamics differ fundamentally from 2008: market forces and price discovery accelerate the process, but illiquidity actually slows it down. Market dynamics are thus shifting from sudden panic to prolonged uncertainty.
Leverage also plays a role, but to a much more limited extent than before 2008. Private credit funds typically operate with leverage of around 1.0x to 1.5x, considerably lower than the often extreme levels of structured credit products at the time. This reduces the likelihood of forced sales and a rapid escalation of losses. However, this does not mean that the risks disappear. Instead of abrupt market disruptions, a different pattern is emerging: losses resulting from declining credit quality are building up slowly in portfolios and only become apparent later, which makes the dynamics of the current correction fundamentally different from those of 2008.
The declining credit quality is evident in the increasing use of Payment-in-Kind (PIK) structures. Under PIK, interest is not paid but added to the principal. This alleviates short-term liquidity pressure for debtors but increases leverage at the corporate level. The recently published academic article ‘When Flexibility Becomes Forbearance: Payment-in-Kind in Private Credit’ demonstrates that PIK is primarily used with weaker borrowers and is associated with structurally poorer performance. The use of PIK thus acts as a signal of stress, not as a solution.
Private credit is a rapidly growing market and plays an increasingly significant role in corporate financing, particularly in the mid-market segment. At the same time, the investor base has changed significantly with the entry of more retail investors. The rapid growth of evergreen funds is crucial in this regard. These structures offer periodic liquidity, but invest in intrinsically illiquid loans. These funds therefore carry a risk of liquidity mismatch that must be managed.
Significant net outflows can cause friction. Managers must protect existing investors, whilst also serving those wishing to exit. In the event of rising redemptions, managers must then fall back on cash buffers, credit lines or, in the worst case, secondary sales at a discount. The result is not a sudden and sharp fall in prices, but gating (delayed redemptions) and pressure on valuations.
Incidentally, Dutch institutional investors generally have a different exposure to private credit than through semi-liquid structures. They typically invest via segregated mandates or traditional closed-end funds. In both cases, the capital is committed for the long term and there are no interim exits. Consequently, mechanisms such as gating or liquidity restrictions at fund level play hardly any role here.
However, this does not mean that these portfolios are immune to stress. The risks manifest themselves in the underlying loans. Deteriorating credit quality, increasing use of PIK structures and restructurings can lead to write-downs. Investors may even be able to benefit from this situation if their private credit managers acquire sound loans from semi-liquid funds at a substantial discount.
Certain private credit funds may not survive this correction, but the likelihood of a sudden, sharp meltdown is very limited. What is currently unfolding is a slower process of repricing risks in (part of) the direct lending market. This time is truly different. The system is absorbing the risks in a different way to a meltdown: more slowly, less visibly and probably also less systemically.