Private Credit Market Faces 5.4% Default Rate, Concerns Grow

The private credit market, valued at 1.7 trillion dollars, is facing mounting concerns as default warnings accumulate. Analysts are increasingly worried about the understated risks in one of the most profitable sectors. Historically, losses have been manageable because private credit firms have shown more patience with borrowers in distress compared to other investors. During the pandemic, direct lenders often negotiated longer debt repayment periods with private equity owners, providing struggling companies with more time to repay their debts.

However, recent analyses indicate growing pressures, including those from lending institutions themselves. The official default rate in the market currently stands between 2% and 3%. When "non-accrual loans" — loans that lenders anticipate will incur losses — are included, the rate jumps to 5.4%. This adjusted default rate is comparable to that of the syndicated loan market.

Despite the slowing pace of fundraising, private credit funds continue to attract investors with returns exceeding 8%. As of July 22, only 700 million dollars have been raised this year, accounting for just 10% of the total alternative asset inflows, the smallest share since at least 2015. Analysts noted that the rapid influx of capital into this asset class has led to a lowering of underwriting standards, which could amplify losses during economic downturns.

Private companies and their lenders have avoided default by allowing borrowers to defer cash interest payments until the debt matures, resulting in a large lump-sum payment at the end. Another method involves setting contract terms at a "lenient" level, making it difficult for institutions to take action against early signs of weakness. The primary selling point of private credit is its low default rate, a reputation built on a narrow definition of default.

If behaviors such as extending maturities and converting cash interest into in-kind payments are included, the rate of borrowers failing to meet their debt obligations would be significantly higher than the current levels. Defaults may be obscured by a "large volume of contractual amendments," as lenders can adjust credit agreements to prevent defaults. The calculated market "shadow default rate" — measured by the proportion of "troubled" in-kind payments to total investments — reached 6% in the second quarter, up from 2% in 2021. During the same period, the official private credit default rate rose from 2.9% to 3.4%.

The complexity is further compounded by the significant differences in the borrower groups monitored by various credit rating agencies and consulting firms, making it difficult for any single institution to gain a comprehensive view of the entire market. Despite these discrepancies, multiple studies agree on an upward trend in defaults. The increasing concentration of low credit-rated borrowers and recent rises in default rates indicate continued challenges.

Some market participants remain optimistic, citing lower interest rates that have eased the pressure on highly leveraged companies and healthy interest coverage ratios within loan portfolios. "As interest rates rise, our market research indicates that certain industries face higher risks, but with rates currently falling, robust companies with strong cash flows can withstand the current interest rate environment," said the head of Asia-Pacific private credit at a major financial group.