Private Credit Risk and Governance Failures: Navigating Regulatory Enforcement and Capital Preservation in Alternative Lending

The private credit market, now valued at $1.2 trillion, has emerged as a critical player in global capital markets. However, its rapid growth has exposed systemic vulnerabilities, governance failures, and regulatory challenges that demand urgent attention. From inconsistent loan valuations to opaque payment-in-kind (PIK) structures, the sector's risks are compounding as it becomes increasingly intertwined with traditional banking and institutional investors. This article examines the intersection of regulatory enforcement, capital preservation strategies, and governance failures in private credit, offering actionable insights for investors.

Governance Failures: Case Studies and Structural Risks

The 2023 Pluralsight loan default case underscores a critical governance flaw: inconsistent valuations. Two lenders assigned 83 cents and 97 cents on the dollar to the same defaulted loan, revealing a lack of standardized practices. Such discrepancies not only distort fund net asset values (NAVs) but also delay recognition of financial distress, exacerbating risks during downturns. This mirrors broader issues in private credit, where fund managers often prioritize maintaining NAVs to justify management fees—a practice that can mislead investors.

Structural risks further amplify these challenges. PIK arrangements, which allow borrowers to defer interest payments, have surged in high-interest-rate environments. While they provide short-term liquidity relief, they increase long-term default risks. For example, a fund with a $1 billion portfolio using PIK structures could face a 20%+ repayment obligation in the future, straining liquidity during economic stress.

The 2024 National Association of Private Fund Managers v. SEC ruling, which overturned a proposed SEC rule for enhanced oversight, highlights regulatory tensions. The Fifth Circuit's decision, citing “regulatory overreach,” has left a governance vacuum, raising concerns about transparency and systemic risk. This case exemplifies the sector's resistance to scrutiny, even as its scale grows.

Regulatory Enforcement: A New Era of Scrutiny

Regulatory enforcement has intensified in 2024–2025, with the SEC taking unprecedented action. In 2024, the agency launched its first-ever enforcement actions against distressed debt managers for failing to prevent the misuse of material nonpublic information (MNPI). These cases signal a shift toward holding private credit managers to public market standards of compliance and transparency.

The SEC's 2025 examination agenda further emphasizes investor protection, particularly for individual (retail) investors. Unlike traditional accredited investors, retail investors face stricter disclosure requirements, reflecting regulators' concerns about their limited ability to assess complex private credit instruments. This includes mandatory clarity on illiquidity, lockup periods, and valuation methodologies.

Bank partnerships with private credit firms have also drawn scrutiny. Regulators are investigating whether preferred access to bank-originated loans undermines underwriting rigor. For instance, a firm receiving favorable terms from a bank in exchange for a partnership could prioritize its own interests over those of investors, creating conflicts of interest. The SEC and Fed are now requiring explicit disclosures about such arrangements.

Capital Preservation in Alternative Lending Structures

J.P. Morgan's analysis of private credit highlights both opportunities and risks. While the asset class has outperformed high-yield bonds by 150 basis points over the past decade, its structural weaknesses—such as weaker interest coverage (2.1x vs. 3.9x in public markets) and higher leverage (5.6x vs. 4.6x)—demand disciplined strategies.

Key capital preservation strategies include:
1. Diversification Across Segments: Beyond senior direct lending, investors should explore asset-backed credit, opportunistic credit, and secondaries. This mitigates sector-specific risks and enhances resilience.
2. Manager Due Diligence: High-quality managers with proven track records and seasoned teams are critical. JPMorgan notes that such managers achieve target returns with minimal impairment, even in downturns.
3. Risk-Adjusted Returns: Senior direct lending, with its seniority in capital structures, offers a buffer against losses. For example, a 10% starting yield would require default rates above 6% and recovery rates below 40% to yield negative returns—a scenario last seen during the 2008 crisis.

Investment Advice: Balancing Innovation and Caution

For investors, the private credit market presents a paradox: it fills critical lending gaps left by traditional banks but carries unique risks. Jamie Dimon's cautionary remarks about private credit mirroring the 2008 crisis are not unfounded, but they also underscore the need for proactive governance.

1. Demand Transparency: Insist on clear disclosures about valuation methodologies, PIK usage, and bank partnerships.
2. Leverage Secondary Markets: While illiquid, secondary markets for private loans are emerging. Investors should monitor platforms like Ares Management or Apollo Global Management for liquidity opportunities.
3. Align with Regulatory Trends: As the SEC and Fed refine frameworks, prioritize firms that proactively address governance gaps. For example, managers adopting standardized valuation protocols or conflict-of-interest safeguards will likely outperform peers.

Conclusion

Private credit's growth is inevitable, but its risks are equally pronounced. Governance failures, regulatory challenges, and structural vulnerabilities demand a rethinking of how capital is preserved and managed. By adopting disciplined strategies, diversifying across lending structures, and aligning with regulatory expectations, investors can harness the sector's potential while mitigating its pitfalls. As the market evolves, the key to success lies in balancing innovation with accountability—a lesson the 2008 crisis and the Pluralsight case have etched into financial history.