Private credit has grown rapidly over the past decade, moving from a niche area of institutional investing into a more prominent part of financial markets. In simple terms, private credit refers to loans made by non-bank lenders directly to companies, rather than through traditional banks or public bond markets.
While many investors may not have direct exposure to private credit within their portfolios, it has attracted increasing attention. With that growth has come greater scrutiny, particularly around liquidity, credit quality and whether current valuations fully reflect the underlying risks. These are important considerations, and they warrant a balanced and measured assessment.
The growth of private credit
Over the past decade, private credit, encompassing direct lending, mezzanine finance, distressed debt and related strategies, has grown rapidly. Industry estimates suggest the asset class is expected to approach US$2.5 trillion in size by the end of the decade. Much of this growth was driven by the retreat of traditional bank lenders following tighter regulation after the Global Financial Crisis, which created a structural funding gap that private capital moved to fill.
Non-bank lenders now provide a significant share of new loan capital to mid-market and non-investment grade borrowers, particularly in the United States, where this trend is more advanced than in Australia. As a result, credit risk has become more widely dispersed across investors, rather than concentrated within highly leveraged, deposit-taking institutions.
For investors, private credit has offered an attractive combination: higher yields than comparable public bonds, with all-in returns currently running around 200–300 basis points above certain segments of public credit, alongside returns that tend to exhibit lower reported volatility. This lower volatility is partly a function of how private credit is valued, with loans assessed periodically rather than repriced daily in public markets. This has made private credit an attractive source of income in many portfolios.
A different environment now
That backdrop is now shifting. Interest rates have moved materially higher and remained elevated. Credit conditions have tightened, and many borrowers who accessed capital at favourable rates in 2020 and 2021 are now facing a more challenging refinancing environment. These changes do not alter the role of private credit, but they do bring a number of underlying risks into sharper focus.
Liquidity: understanding the trade-off
Private credit is, by design, illiquid. Loans are typically held to maturity and are not traded on public exchanges, so they cannot be easily sold. Investors in traditional closed-end structures have generally understood and accepted this trade-off, expecting to earn an illiquidity premium, or additional return, in exchange for committing capital over longer periods.
More recently, attention has turned to the growth of semi-liquid or ‘evergreen’ private credit vehicles, including publicly traded Business Development Companies (BDCs). BDCs are US-listed investment structures that pool capital from a broad investor base, including retail investors, and use that capital to provide loans to mid-sized private companies. These vehicles typically offer periodic redemption windows, making them appear more liquid than traditional private credit funds. However, the underlying loans remain illiquid, which can create a mismatch between investor expectations and the structure of the assets. The rapid growth of these structures has also attracted increased regulatory scrutiny, particularly around liquidity management, leverage and disclosure.
The risk is not that private credit becomes worthless, but that in periods of stress, some vehicles may need to limit withdrawals, sell assets at a discount, or restrict new lending. This is primarily a structural risk rather than a reflection of underlying credit quality. For investors in well-managed closed-end funds with long-dated capital, this issue is less immediate, with the more relevant consideration being whether any semi-liquid exposure is appropriately sized within the overall portfolio, given broader liquidity needs.
Credit quality and defaults
The more substantive debate relates to credit quality. Private credit portfolios are largely composed of floating-rate loans to mid-market companies, where interest payments rise and fall with prevailing interest rates. When base rates were near zero, interest coverage was generally comfortable. With rates now higher, debt servicing has become more demanding, particularly for more highly leveraged borrowers.
There are also some trends emerging that warrant attention. Paid-in-Kind (PIK) structures, where interest is not paid in cash but instead added to the loan balance and repaid later, have become more prevalent. While this can ease short-term pressure on borrowers, it increases the amount that must eventually be repaid and can signal underlying cash flow pressure. At the same time, covenant-lite lending is becoming more common. Covenants are protections built into loan agreements that give lenders early warning signs or additional control if a borrower’s financial position weakens. Fewer covenants reduce these protections.
While these risks are real, they are not uniform across the market. They vary by sector, borrower and structure. Default rates remain relatively subdued, with stress most evident among smaller, more highly leveraged borrowers, while fundamentals across much of the private credit market remain resilient.
One sector under increasing pressure within private credit is software, where some businesses are contending with higher borrowing costs and evolving competitive dynamics, including the impact of artificial intelligence. Many of these companies were established during the low-rate period, with debt levels now being tested in a more demanding environment.
History offers some perspective here. When e-commerce disrupted traditional retail between 2016 and 2019, default rates within the retail sector rose materially, yet the broader leveraged loan market remained resilient over the same period. This highlights that sector-specific stress, while challenging for affected borrowers, does not necessarily translate into broader systemic credit risk, provided portfolios are diversified and underwriting standards remain disciplined.
Against this backdrop, elevated concerns about liquidity and redemptions appear to reflect idiosyncratic issues and sentiment rather than a broad-based deterioration in fundamentals.
Valuation: stability and transparency
One of the most commonly discussed criticisms of private credit is that its reported volatility may understate underlying risk. Because valuations are based on periodic assessments rather than daily market prices, returns can appear more stable even during periods of market stress.
This is a valid structural observation, but it needs to be considered in context. Public market pricing is influenced not only by fundamentals, but also by investor sentiment, technical factors and liquidity conditions, which can drive prices away from underlying credit fundamentals.
Private credit valuations, which are typically based on borrower cash flows, covenant compliance, and collateral values, may, in some cases, provide a more stable reflection of underlying credit quality. The smoothing effect of less frequent valuation is real, but so too is the volatility introduced by sentiment in public markets.
That said, there is meaningful variation in how managers approach valuation. Differences in methodology, frequency and independence of review can make comparisons across managers challenging. For investors, the key consideration is whether valuation processes are robust, consistent and subject to appropriate oversight.
Manager selection is critical
Perhaps more than most asset classes, private credit returns are driven by manager skill, specifically underwriting quality, covenant discipline, portfolio monitoring and the ability to manage and recover value from stressed loans. The dispersion between top-quartile and bottom-quartile managers is considerable and is likely to widen further as the cycle matures.
The rapid growth of the asset class has attracted new entrants with varying levels of experience and discipline. Identifying managers with the infrastructure, track record and culture to navigate periods of stress, and who have maintained disciplined underwriting through the period of rapid market growth, is, in our view, the most important lever in managing private credit risk.
Our perspective
Private credit remains a legitimate and potentially valuable component of a diversified portfolio, but one that requires careful implementation. The concerns currently being discussed, including liquidity, credit quality, covenant erosion and valuation transparency, reflect a market that has grown quickly and is now being tested in a more demanding environment.
Importantly, not all investors will have direct exposure to private credit, and for many, it may sit outside of their managed account portfolios. Nonetheless, it remains relevant given its growing role in financial markets and the attention it is receiving.
In our view, the key is not to make broad judgements about the asset class as a whole, but to recognise that risks vary significantly depending on structure, sector and, most importantly, manager.
Managed well, private credit can continue to play a useful role as an income-generating diversifier. Managed poorly, or accessed through structures that do not align with an investor’s needs, it can introduce risks that are difficult to identify early and harder to exit once conditions become more challenging.
We’re here to support you through all market conditions. If you have any questions or would like to discuss anything about your portfolio in more detail, please don’t hesitate to reach out.
