Private Credit’s Cracks Widened Before Turmoil

The private credit market, long touted as a haven for yield-seeking investors, has begun to show visible strain. From late 2024 to early 2025, a confluence of defaults, liquidity squeezes, and structural vulnerabilities underscored a growing divide between borrower resilience and lender optimism. While default rates dipped slightly to 4.6% in March 2025, the dominance of selective defaults (SDs)—restructurings that avoid bankruptcy but signal distress—paints a darker picture.

The Rise of Selective Defaults: A New Normal in Distress

Selective defaults now account for 60% of global corporate defaults, with private credit issuers leading the charge. In the CE (Credit Estimate) universe of over 3,100 middle-market firms, SDs outnumbered traditional defaults by a 5:1 ratio in 2024. These restructurations—distressed debt exchanges, covenant amendments, or PIK (pay-in-kind) interest toggles—are not mere technicalities. Over 90% of PIK conversions triggered SD downgrades, exposing borrowers’ inability to meet cash obligations.

One stark example: a 2% conversion rate of CE issuers to PIK structures in 2024. While initially a tool for reinvestment, these toggles often paired with maturity extensions or amortization halts, compounding debt. For instance, a mezzanine lender might agree to fully PIK interest until senior debt matures—a recipe for unsustainable leverage.

Liquidity Pressures: The 4% Tipping Point

A 4% segment of the CE portfolio—over 3,100 firms—faces critical distress, marked by:
- Low credit ratings (‘ccc+’ or below),
- Covenant headroom below 10%, and
- Interest coverage ratios below 1.2x.

These firms are trapped in a liquidity vise. Even with sponsor support, 19% of revenue loss from lost clients or legal disputes has pushed some to the brink. For smaller firms (<$50M EBITDA), free cash flow to debt ratios plummeted to -7.9% by late 2024, signaling insolvency risks.

Sector-Specific Weaknesses: Tariffs and Labor Shortages

Tariff-driven cost inflation and immigration policy uncertainty have hit industries unevenly:
- Forest products, building materials, and packaging saw EBITDA interest coverage collapse to 3.1x by late 2024, down from 5.4x in 2021.
- Sectors reliant on immigrant labor, like homebuilding and engineering, face worker shortages, raising costs and delaying projects.

Meanwhile, middle-market firms in SaaS and other recurring revenue models struggle to scale. 25% delayed covenant flip dates (shifting from revenue-based to EBITDA metrics), while some scrapped the requirement entirely—a clear admission of underperformance.

Policy Risks and Market Dynamics

The Federal Reserve’s gradual rate cuts to 3.5% by late 2025 offer limited relief. Tariff volatility remains a wildcard, with downstream effects like delayed inventory draws and reduced consumer spending.

Investor sentiment is reflected in recovery estimates: first-lien recoveries for Q1 2025 issuance held at 64%, far below the historical 75-80% range. This suggests lenders anticipate deeper losses in a downturn—a stark contrast to the market’s earlier optimism.

Conclusion: Cracks Deepening, Caution Advised

The private credit market’s cracks are not isolated glitches but systemic fractures. With 14% of SD issuers requiring multiple covenant amendments and recovery expectations at decade lows, investors must confront a harsh reality:

• Defaults are evolving, not vanishing. SDs now outnumber conventional bankruptcies, masking true distress.
• Liquidity risks are acute for 4% of issuers, with free cash flow metrics signaling insolvency.
• Sector-specific fragility—amplified by tariffs and labor shortages—will prolong volatility.

While speculative-grade defaults dipped to 4.6%, the dominance of SDs and weak recovery estimates underscore a market teetering between resilience and reckoning. For investors, the path forward demands caution: favor larger, cash-rich issuers and avoid bets on sectors with structural headwinds. The cracks are widening—not shrinking—and the next downturn may reveal how deep they run.