High Leverage in Private Credit: Diminishing Returns and Regulatory Challenges in 2025

The private credit market, now a $3 trillion asset class, has long been celebrated for its ability to deliver steady, compounding income with lower volatility compared to public markets a Heron Finance analysis. However, as leverage intensifies and regulatory scrutiny sharpens, the sector's risk-adjusted returns are showing signs of strain. This analysis examines how the interplay of leverage, valuation opacity, and regulatory headwinds is reshaping the landscape for private credit investors.

Leverage: A Double-Edged Sword

Private credit funds have increasingly relied on leverage to amplify returns, particularly in a low-yield environment. Business Development Companies (BDCs), for instance, operate under a 2:1 leverage cap-a policy introduced in 2018 to boost returns but one that now raises systemic concerns, according to a CFA Institute blog post. Explicit leverage, such as debt financing, is transparent, but hidden leverage-embedded in structures like note-on-note financings or total return swaps-remains opaque and harder to quantify, as explained in a guide to hidden leverage. This complexity amplifies fragility, especially during downturns when liquidity constraints can trigger cascading losses.

The Federal Reserve has warned that private credit's lack of access to central bank liquidity exacerbates risks in a Federal Reserve note. For example, falling interest rates in 2023–2025 compressed spreads for fixed-rate lenders, reducing margins and squeezing risk-adjusted returns, as noted in a DLPCapital analysis. While asset-backed strategies may benefit from rate declines, the broader sector faces a trade-off: higher leverage to maintain yields increases exposure to defaults and valuation shocks.

Regulatory Scrutiny Intensifies

Regulators are zeroing in on private credit's valuation practices and interconnectedness with traditional finance. The U.S. Securities and Exchange Commission (SEC) has prioritized transparency in its 2025 examination agenda, targeting conflicts in bank partnerships and mispricing of illiquid assets. Enforcement actions against distressed debt managers for misuse of material non-public information (MNPI) underscore the agency's focus, according to a Bloomberg Law article.

The European Central Bank (ECB) has similarly flagged risks in bank exposures to private credit funds, noting that institutions often rely on fund managers' valuations without independent verification, as described in an ECB supervisory newsletter. Meanwhile, the Financial Conduct Authority (FCA) and the International Valuation Standards Council (IVSC) are pushing for standardized methodologies to address opacity, per IVSC guidance. These efforts reflect a global push to align private credit's governance with public market rigor.

Diminishing Risk-Adjusted Returns

Despite its historical outperformance over real estate and U.S. stocks, private credit's Sharpe ratios have declined as leverage and valuation challenges take hold, as noted in the Heron Finance analysis. A 2025 study by Heron Finance found that while private credit still offers diversification benefits, KKR's outlook also highlighted that volatility has crept upward; KKR underscored these pressures in a KKR outlook. For instance, the proliferation of opportunistic strategies-such as specialty finance and infrastructure lending-has diluted the asset class's core strengths in secured, asset-based lending, according to DLA Piper insights.

Regulatory actions are compounding these pressures. The SEC's emphasis on stress testing and the ECB's warnings about systemic contagion may force funds to adopt tighter underwriting and lower leverage, further compressing returns, as highlighted in the FDIC risk review. Insurers and retail investors, drawn to private credit for yield, now face a reckoning as liquidity risks and valuation uncertainties become more pronounced, a point emphasized in a Martini.ai blog post.

Conclusion: Balancing Opportunity and Risk

Private credit remains a compelling asset class for its income generation and diversification potential. However, the confluence of leverage, valuation opacity, and regulatory scrutiny is reshaping its risk profile. Investors must weigh the sector's historical strengths against emerging vulnerabilities, particularly in a higher-for-longer interest rate environment. As regulators push for transparency and systemic safeguards, the ability of private credit to maintain its risk-adjusted return edge will depend on disciplined underwriting and adaptive governance.