Private debt went through a “golden moment” after the rapid post-pandemic rise in interest rates, said Jonathan Gray, president of alternative-asset giant Blackstone, in 2023. The question now is whether that golden moment is past. With interest rates expected to stay higher for longer, sovereign yields rising sharply, and cracks appearing last summer in US business development companies (BDCs), some investors wonder whether private debt is entering its first real test as an asset class – or even facing a day of reckoning.
Private debt is a broad label. It includes syndicated leveraged loans, direct lending, asset-backed finance and even fund financing. These distinctions matter. Syndicated loans are liquid and volatile, but trade at tighter yield spreads (ie, they promise lower returns). By contrast, direct lending – where investors such as funds lend directly to borrowers – is illiquid and assets are rarely marked to market.
Direct lending is often presented as the core of “true” private debt, due to its potential for higher risk-adjusted returns. So far, that record has proved hard to ignore for institutional investors. Spreads of around 550 basis points over base rates remain appealing, while reported default rates are still modest. As a result, it attracted large inflows from pension funds and insurers. Assets could reach $2.8 trillion by 2028, up from $1.8 trillion currently, according to private-markets data firm Preqin.
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However, this influx of capital and its potential ability to skew industry fundamentals has meant that some participants and regulators have begun to voice concerns about the risks of a private-credit crisis. Some signs of stress have emerged. US BDCs made the headlines last year after a rise in the number of investors who tried to redeem their holdings. Open-ended funds that invest in illiquid assets can enter a vicious cycle when redemption requests rise: as funds sell their most liquid assets (often assets of better quality) to meet redemptions, that news creates an incentive for other investors to also redeem so as not to be the ultimate “bagholders” of the riskiest and less liquid assets. In order to avoid the proverbial rush for the exits, some BDCs were obliged to cap redemptions – which obviously does not improve investors' sentiment.
A more challenging macro-economic environment, slower growth, persistent inflation and rates that are higher for longer also raises the risk that the asset class could be entering a more difficult phase. A further concern for investors trying to understand these risks is that valuations are opaque and largely controlled by managers. However, as the asset class is becoming more institutionalised, index providers such as S&P and Bloomberg are developing private credit benchmarks. Along with BlackRock's acquisition of Preqin in 2024, this suggests private markets will become more standardised and scrutinised despite some fund managers fighting this trend.
Private debt may like high interest rates, but borrowers don't
However, the primary concern at present is that the same high interest-rate environment that makes private debt attractive to investors is also increasing pressure on borrowers. The probability of default is growing, while recovery rates in private debt have never really been measured. Defaults can be obscured: for example, the restructuring of US educational technology firm Anthology last year did not trigger a formal default, as its lenders allowed flexibility in payments. Payment-in-kind (PIK) – where interest is added to the loan principal to be paid at maturity – can similarly mask stress by deferring payments out of cash flow. The covenant-lite nature of some lending offers less protection than investors might expect, while recovery rates in restructurings may be weaker than for senior debt that requires regular repayments in cash.
Meanwhile, diversification in some private-credit vehicles looks weaker than it first appears. A significant share of portfolios are exposed to software and/or software-as-a-service (SaaS) businesses, creating hidden concentration risk. These companies benefit from recurring revenues, predictable cash flows and healthy earnings before interest, tax, depreciation and amortisation (Ebitda) margins, but there are fears that artificial intelligence (AI) fundamentally threatens their business models. AI may not disrupt these companies overnight, but it could gradually erode pricing power, compress margins and weaken exit valuations, making refinancing more difficult.
The sell-off in these software stocks earlier this year, combined with the impact on private debt as investors realise how exposed some lenders are to the sector, has highlighted hidden correlation risks in supposedly diversified portfolios. All lenders now have their eyes on business-software firm Visma, which has reportedly delayed its planned initial public offering (IPO) until 2027 – a decision that perhaps suggests growing caution among investors despite strong operations and cash generation. This highlights another important feature of the market: concentration in a small number of large credits backed by private-equity sponsors. Jitters in private debt can – by definition – be less publicly visible, but the performance of HgCapital Trust, the specialist private-equity investor in software and services that has 13% of its portfolio in Visma, testifies to how sentiment has changed: it is now trading at a 25% discount to net asset value (NAV), having been on a premium in 2024.
Momentum remains in the private debt market
And yet, the market remains active. Despite slower mergers and acquisitions (M&A) activity in Europe during the first quarter, two large refinancings – of TK Elevator (€1.8 billion) and Global Sports Group (€2.2 billion) – drove solid deal volumes. “The prominence of these large-cap deals also suggests direct lenders have successfully taken advantage of the volatility seen in Q1 to reclaim some market share from the syndicated markets,” notes Debtwire. The amount of funds raised in 2022-2024 that are not yet invested (known as “dry powder” in the industry) will allow the market to keep momentum.
The fact that direct lending can offer 100-500 basis points of additional yield over what is available in the traditional syndicated loan market (depending on the amount of leverage used by the vehicle, or if it acquires subordinated debt and junior capital) – combined with the ability to negotiate better structural protections than broadly syndicated loans – should continue to attract strong interest.
Dry powder will help lenders to inject capital if needed and protect their initial investments, tempering the risk of a private-debt crisis. It will be used to address the “refinancing wall”: a large stock of debt raised in the low-rate era now needs to be rolled over at significantly higher cost. So far, this has been managed through extensions and amendments – euphemistically renamed as Liability Management Exercises (LMEs). Widespread defaults are rare.
We also need to keep in mind that there are important regional differences in private debt. The US market is more mature and increasingly competitive as banks re-enter leveraged finance, given an incentive by the Trump administration's new regulations. In Europe, private debt is still expanding, supported by a more fragmented banking system and structurally lower penetration. Note too that public markets are treating private credit as a homogeneous bet on leveraged buyouts. However, outcomes will depend less on the asset class itself and more on managers' capabilities: origination, underwriting discipline and balance-sheet flexibility. Scale is an advantage in stressed environments. Large managers such as Ares, Apollo and Blackstone have the ability to amend loans, provide follow-on capital and manage restructurings internally. Origination is the real moat, because it separates lenders that focus on financing commoditised leverage buyouts (LBOs), which are often syndicated loans, from those that source bilateral or semi-bilateral deals with pricing power and better protections. Collateralised loan obligations (CLOs) – securities backed by a pool of loans, often from LBOs – have held up so far and offer diversified exposure to leveraged loans. However, their lack of control over the underlying loans and consequently over the outcomes when borrowers come under pressure may become more apparent as the cycle turns.
The easy part – that “golden moment” – is over. Higher rates are a source of stress. As refinancing pressures build and dispersion rises, returns will be less a function of a rising tide lifting the whole asset class and more driven by selection, discipline, structure and scale. A broad opportunity is turning into a more challenging game.
High-performing private-debt funds generally require high minimum commitments (ie, institutional size – maybe €2 million - €5 million to a private-debt fund such as CVI with strong exposure to central Europe). Some managers are starting to target individual investors as a source of further capital, but one should always be aware that individuals are less likely to get the best opportunities. Avoid products offered by private banks where layers of fees accumulate.
More interesting are listed funds and managers exposed to the sector. Some merit caution, but fears of a crisis may create buying opportunities in the best ones. In Europe, there is Tikehau Capital (Paris: TKO), which has robust exposure to special situations, ICG (LSE: ICG) and CVC Income & Growth (LSE: CVCG). In the US, Ares Management (NYSE: ARES) and Blackstone (NYSE: BX) have developed the strongest platforms in terms of origination. Apollo Global Management (NYSE: APO) has the strongest exposure to direct lending, but readers may prefer to wait for the dust to settle.
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