Undercurrents of Risk in Private Credit: Default Rates at Top Funds Hit Five-Year High, Software Loans Emerge as Major Concern

As managers of private credit funds assured analysts during quarterly conference calls that "credit health remains robust," a data analysis by The Wall Street Journal revealed that pressure within the industry is quietly accumulating.

According to a report by The Wall Street Journal on August 9, an analysis of quarterly reports from private credit funds under ARES Management LP, Blackstone, Blue Owl Capital, and Golub Capital BDC found that loan default rates for these funds have reached their highest levels since at least 2021, while internal risk watchlists are expanding in tandem.

This phenomenon has raised alarms among analysts against the backdrop of a generally resilient U.S. economy—should economic growth slow, losses could expand sharply.

Default Rates Hit Five-Year High, Divergence Emerges Between Manager Statements and Data

The core business of private credit funds is "direct lending": issuing high-interest loans to highly leveraged companies to generate substantial returns. This strategy has attracted a massive influx of capital in recent years, once becoming one of Wall Street's hottest asset classes.

However, analysis shows that the non-performing loan ratio for funds under Blue Owl Capital rose to 2.8% in the second quarter, the highest in at least five years. Non-performing loan ratios for funds under ARES Management LP, Blackstone, and Golub Capital BDC also touched five-year highs, exceeding levels seen during the Federal Reserve's aggressive rate-hiking cycle in 2023.

Facing external skepticism, managers at several institutions publicly downplayed the risks. Marc Lipschultz, Co-CEO of Blue Owl Capital, stated during a quarterly analyst conference call, "Credit health remains robust in our direct lending strategy." He also noted that software companies are among Blue Owl Capital's most profitable borrowers, adding, "There have been no material changes to our watchlist compared to a year ago."

However, David Golub, Co-CEO of Golub Capital BDC, offered a more cautious perspective. He said, "Some media outlets are saying 'the sky is falling,' while some of my peers say 'this is nonsense, there are no problems at all.' Neither characterization is accurate. We are clearly in a credit cycle. This cycle is not particularly bad, but there will be winners and losers."

Watchlists Quietly Expand, Software Loans Become the Biggest Concern

Private credit funds typically maintain an internal "watchlist" to track borrowers showing signs of repayment stress. When a company's operating conditions deteriorate, it is added to the list, which is often a precursor to default.

Funds under ARES Management LP, Golub Capital BDC, and KKR all reported an increase in the number of borrowers on their watchlists this year, reaching the highest levels since the rate-hiking cycle of 2022–2023.

Currently, problematic loans are concentrated in the healthcare sector and industries impacted by oil price shocks, such as dental service provider Affordable Care and plastic film manufacturer Loparex. However, what analysts and fund managers are truly concerned about is the spread of Default Risk to software companies.

The reason is that loans to software companies account for more than 20% of many fund portfolios, and the rapid development of artificial intelligence is disrupting the business models of some software firms, creating uncertainty regarding their debt-servicing capabilities. If systemic defaults occur in this sector, the impact on fund portfolios would far exceed that of the current healthcare and energy sectors.

Declining Returns, Individual Investors May Amplify Pressure

Private credit funds have long provided annualized returns of over 10%, which was their core selling point for raising capital from high-net-worth individual investors. Today, even better-performing funds are struggling to maintain annualized returns of 7%.

A poorly performing fund under KKR recorded a loss of 6.55% in the 12 months ended June this year, a slight narrowing from the 9.17% loss in the previous 12 months, but it remains in negative territory.

The decline in returns is driven by multiple factors: a slowdown in private equity M&A activity has compressed opportunities for new high-yield loans; weakening operating performance of borrowing companies, coupled with a decline in the public bond market, has forced funds to write down loans that are still paying interest; and the fall in benchmark interest rates from their peaks has also reduced interest income.

Fund managers state that performance volatility is normal for private credit, given that the strategy focuses on companies with lower credit ratings. However, the issue is that many individual investors have never experienced such a downturn cycle before. If returns remain sluggish or even turn negative, they may choose to redeem their investments.

If investors withdraw capital on a large scale, the funds' ability to raise capital will be impaired, thereby affecting their ability to provide refinancing for maturing corporate loans—this will create a self-reinforcing negative cycle.

Currently, the share prices of these funds have seen a slight rebound after significant declines since last year, suggesting the market has somewhat accepted the managers' optimistic narrative. However, The Wall Street Journal's analysis shows that pressure at the data level has not yet subsided.