Private Credit Faces Shakeout as Defaults, Redemptions Test Managers at CAIS Summit

Private credit’s easy-money era is facing a reality check as rising redemptions and fears of a “SaaS apocalypse” test the industry. At last week’s CAIS Summit in Los Angeles, middle-market direct lenders pointed to early cracks in the asset class that are putting manager dispersion, underwriting discipline and liquidity risk in sharper focus.

Tyler Herried, Golub Capital’s deputy head of global investor services, said during an Oct. 13 panel that this year marked the start of a “healthy” phase for U.S. direct lending. “People started to ask hard questions about the asset class, about GPs, about performance, about the companies that you lend to,” he said.

The U.S. private credit default rate hit a record 6.3% in the 12 months through August, up from 6.1% in the 12 months through July, according to Fitch Ratings. Herried cautioned that headline default rates may mask the whole story, since struggling borrowers can swap debt for equity or payment-in-kind.

“Be wary of a general partner’s definition of default because it can be different things to different GPs,” Herried said.

Those underlying strains are also exposing differences in credit quality across managers, said Thomas McDonnell, CEO of Barings BDC.

“We are beginning to see some manager dispersion in the credit cycle now, where there are different levels of non-accruals and PIK rates, et cetera, for different managers,” McDonnell said. “If you’re more aggressive, that ultimately could lead to more negative outcomes as you move forward.”

Ted Koenig, founder and CEO of Monroe Capital, said the 556 private credit managers today are increasingly difficult for even high-net-worth RIAs to distinguish, and he urged allocators to examine managers’ underwriting independence, covenant protections and recovery track records.

“Everything is subject to defaults – that’s just part of the game,” Koenig said during the same panel as Herried. “When there’s a default, what happens on recovery? … That’s what really we should be looking at in terms of managers and in terms of trying to interpret all the different managers.”

Covenant breaches are often one of the early signs of stress in private credit, especially in highly leveraged deals, said Art Penn, founder and CEO of PennantPark Investment Advisers.

Leverage that was manageable when money was cheap became harder to sustain as interest rates rose from near zero to around 5%, and many of those borrowers began struggling to service their debt, Penn said, adding that private equity investors are still waiting for liquidity to return, and the payouts keep getting delayed.

“You don’t celebrate when the money goes in. You celebrate when the money comes out,” Penn added.

Barings’ McDonnell said the full impact of the turmoil in software lending could take more than a year to materialize, but that early signs will include elevated customer churn, weaker retention and stagnating or falling revenue.

“It’s not going to be a fall-off-the-cliff scenario. It’s going to be more like a melting ice cube,” McDonnell added.

The risks are particularly acute for software loans underwritten against annual recurring revenue, because AI threatens some borrowers’ SaaS-based business models. Scott McCabe, PennantPark’s head of private wealth solutions, said the firm underwrites against earnings and cash flow instead.

“Revenue doesn’t pay the bills,” McCabe said. “It’s what you have after you pay your expenses that pays the interest on our notes.”

Beyond risks in software lending, rising redemptions have put liquidity pressures on investors’ radar, and Monroe Capital’s Koenig warned that many investors have overlooked the risks of limited liquidity.

“People thought for years there was a hell of a lot more money coming in every quarter than going out,” Koenig said. “This year, people woke up to the fact that hey, sometimes more money wants to go out than comes in.”

PennantPark’s McCabe said fund wholesalers also bore responsibility for telling investors they could get their money back in 90 days without adequately explaining how the mechanism works. Even though such vehicles offer quarterly liquidity, investors should be prepared to hold their positions for 12 to 24 months, he added. “With regards to liquidity in perpetual vehicles, there wasn’t an asset liability mismatch. There was an educational mismatch,” he said.

The gap between perception and reality also extends to portfolio diversification. McCabe warned that much of the capital flowing into direct lending has gone to five large managers, leaving investors who allocate across several of them potentially exposed to the same borrowers.

“Investors think if I put my money with three of those managers, I’m getting diversified exposure. And you’re not. You’re getting a lot of exposure to the same companies and taking portfolio concentration risk,” McCabe said.

Despite those challenges, the shakeout has been a healthy change, Golub Capital’s Tyler Herried said during the panel, because supply and demand are now better balanced than they were last year, when lenders were losing deals to competitors who offered covenant-lite terms or took leverage up another tick.

“This kind of equalization that we’ve seen off the back of the press around software and non-traded BDC flows is a healthy thing for the market,” Herried added.

Barings is seeing the same shift in its deal terms, securing roughly 25 bps more in pricing than a year ago while improving loan structures, McDonnell said. “The risk-reward profile is becoming more balanced for us.”