What private credit’s challenges with AI can teach investors about the importance of due diligence

The private credit market has been under heavy scrutiny in recent months as AI disruption has turned into a growing risk for the industry’s meaningful loans to software companies.

Private credit refers to direct lending from non-bank financial institutions to middle-market businesses—including software and many other types of companies—which has helped fill a void in business lending created by the retreat of banks in the years since the Global Financial Crisis (GFC). This form of private lending has grown roughly four-fold over the last 15 years.

Exhibit 1: Private credit asset growth has accelerated within the last decade

Data for 2024 are as of Q2. Source: Board of Governors of the Federal Reserve System, Preqin and LSEG

Today, though, investors have become increasingly concerned with the fact that many private credit funds have significant exposure to software company loans. The rapid growth of agentic AI capabilities in software development now puts some of these loans at greater risk of default over the coming years as the business models of software companies come under scrutiny.

We believe there’s much more to these developments than straightforward AI disruption. Private credit’s challenges can offer valuable lessons about the risks of fast-growing asset classes, decisions about fund structures and, ultimately, the importance of setting expectations and conducting clear-eyed investment manager research.

An appealing opportunity…

We saw initial appeal in private credit in the years following the GFC when it was a much smaller asset class with attractive characteristics. Investors could find higher credit spreads—or compensation for credit risk—and stronger investor protections than comparable credit investments in the traditional bond market, which we’ll call public credit.

At the time, private credit was accessible primarily in the form of closed-end drawdown funds, which is the go-to fund structure for private market investments. This structure helps align the interests of long-term investors with investment managers through multi-year commitments of capital. This long-term focus alleviates the need for managers to identify opportunities under time pressure or sell investments to meet redemptions.

…Grown too quickly

As time passed, and private credit assets grew rapidly, cracks began to emerge. We believe one of the overarching red flags arose from the influx of relatively untested investment managers seeking to capitalize on the interest.

In specific terms, most of the points of caution we identified arose from what have been called the seven worst words in the investment world: too much money chasing too few deals.¹

• Private and public credit spreads converged, with private credit eventually offering lower compensation for credit risk and limited compensation for its illiquidity amid competition for deals.

• Competition and pressure to deploy investor capital led to less disciplined loan-level underwriting—that is, research on the borrower’s business and financial strength—and deteriorating investor protections.

• Private credit fund portfolios became increasingly concentrated in loans issued by companies which, in turn, were owned by the private equity firms sponsoring the fund.

Putting manager assumptions under the microscope

We believe it’s crucial to have clear expectations about the outcomes we’ll face if everything goes right as well as if something goes wrong. This helps investors avoid surprises.

To that end, concerns about the influx of managers that had never been through a credit default cycle were borne out in loan underwriting that assumed business-as-usual conditions rather than any adverse scenarios.

We also took issue with claims that private credit offered lower defaults, stronger protections, and better loss recoveries than public credit.

• The lack of a genuine private credit default cycle means there was not enough history to validate the claim of lower defaults.

• Furthermore, private credit is focused on smaller companies that are likely to be more vulnerable in a downturn.

• Lastly, many of the loans were to companies in the services sectors—like software—with little hard-asset collateral, which would challenge recoveries in a default.

Heading for the exits

Knowing when to say “no” to an opportunity is one of the most critical abilities investors should possess, in our view. The evidence clearly did not accumulate in favor of private credit, and we’ve been monitoring the situation carefully.

In recent years, private credit managers have increasingly begun to launch interval funds with periodic liquidity windows. We believed this created an additional layer of risk in adverse scenarios when the flood of investor capital flows could reverse and redemption demands soar.

We’re now seeing a “dash for liquidity” resulting from the AI disruption narrative, and investors in these funds are finding themselves gated—or limited—in redeeming as much from these funds as they’d like.

Keeping the door open

A “no” under ordinary circumstances can become a “yes” for appealing temporary opportunities. After interest rates climbed in 2022, private credit portfolios came under pressure amid rising borrowing costs and reduced lending appetite. We’ve found that some of the most attractive investment opportunities arise during relatively short windows of market stress. In this case, the tightening of credit conditions meant that lenders gained the leverage to select from high-quality loans and demand appealing pricing.

Clear-eyed manager research makes all the difference in successfully capitalizing on tactical opportunities. In this case, investors needed to identify skilled managers that could balance the intriguing yields on offer against the work required to conduct strong underwriting and deep knowledge of target companies and industries, all in the context of a spike in market stress.

Longer term, we believe the right manager, pursuing a thoughtful strategy, can also succeed in private credit despite our reservations. Managers with track records that date to the early years of the market, and that conduct worst-case underwriting, will likely be more prepared for the risks when credit stress arises. These types of strategies, enacted in a closed-end fund structure, can offer managers flexibility to find attractive entry points for investment opportunities that meet their criteria.

We’ve been seeing signs of stress in private credit since 2025—namely in the form of “kicking the can” by delaying loan interest payments—and we remain cautious. Still, while it’s too early to say, opportunistic managers may eventually encounter a rich opportunity set at attractive valuations in these types of loans.

 

 

 

 

1. Oaktree 2018