Private credit has had one of the most remarkable institutional ascents of the post-2008 era. The asset class — broadly defined as direct lending and other non-bank credit arrangements between institutional investors and corporate borrowers — grew from roughly $500 billion in assets under management in 2015 to over $2 trillion by 2025. Blackstone, Apollo, Ares, Blue Owl, and dozens of other managers built institutional credit franchises that now touch pension funds, sovereign wealth funds, insurance companies, and an expanding list of retail-accessible vehicles through BDCs and interval funds.
The growth story was compelling and largely validated: when public bond markets fell sharply in 2022 as rates rose, private credit portfolios marked flat or slightly positive because they are floating-rate instruments (interest income rises with rates) priced on infrequent mark-to-model schedules rather than daily market prices. Institutional investors who had allocated to private credit saw lower volatility in reported returns, collected higher current yields than public investment-grade bonds, and benefited from covenants that gave lenders more control over problem credits than public high-yield bonds typically allow.
That story is true as far as it goes. It does not go as far as the subsequent rush of capital into the asset class implied. The combination of rapid growth, covenant loosening, higher-for-longer interest rates, and increasing complexity in the underlying exposure warrants a more careful look at what risks have accumulated in the $2 trillion stack.
Mark-to-Model: The Volatility That Has Not Arrived Yet
The most significant structural feature of private credit that investors need to understand is that reported returns and actual economic performance can diverge substantially until a credit event forces a realisation. Private direct loans are not traded on an exchange. They are valued by the lending manager, typically quarterly, using models that incorporate interest rates, comparable transaction multiples, the borrower’s financial performance, and the manager’s judgment about credit quality.
This is not inherently dishonest — it is the nature of illiquid private markets. But it has two consequences that investors should take seriously. First, reported returns in private credit appear smoother than the actual economic risk of the underlying loans because mark-to-model valuations lag reality. A deteriorating borrower shows up in the loan’s value only when the manager decides to write it down, which happens more slowly and more gradually than a public bond price would reflect the same deterioration. Second, the absence of price discovery means that the market-clearing price for private credit — what someone would actually pay to buy these loans today — is unknown until someone tries to sell, which most LPs are contractually prevented from doing for years.
The implication: private credit’s low reported volatility during 2022 to 2024 reflects the asset class’s accounting features as much as its underlying economics. If the same borrowers had issued public high-yield bonds rather than taking private direct loans, those bonds would have reflected their credit stress in real time. The private loans are priced by the people who own them, on schedules they control, using assumptions they select. That is a feature when markets are stable and a significant risk when they are not.
Covenant Lite Crept Into Private Credit Too
One of the original selling points of private credit was its covenant package. Unlike broadly syndicated loans (where lenders compete to provide capital and borrowers extract terms), direct lending was supposed to involve tighter maintenance covenants — financial tests that a borrower must pass quarterly — which give lenders early warning of deteriorating credits and the ability to intervene before value is permanently impaired.
That differentiation has eroded. As capital flooded into private credit and managers competed for deal flow, covenant packages were progressively loosened. The industry term “covenant-lite” — which refers to the weaker covenant structures that emerged in broadly syndicated loans from 2013 to 2019 — has increasingly applied to direct lending transactions as well. Deals that would have had three or four maintenance covenants in 2016 frequently have one or none in 2024 and 2025.
This matters because maintenance covenants are the primary early-warning and control mechanism that lenders use to manage deteriorating situations. When a borrower breaks a maintenance covenant, the lender can negotiate amendments, extract fees, tighten terms, or in extreme cases accelerate repayment. Without covenants, lenders have fewer levers to pull until the borrower is in actual payment default — which means less recovery of value in a restructuring because the situation has typically deteriorated further before anyone can act.
The loosening happened gradually and competitively, driven by the same dynamic that loosened public leveraged loan covenants a decade earlier: too much money chasing too few acceptable deals, with each manager slightly relaxing terms to win the transaction. The aggregate result is a private credit market that is structurally less protected than its reputation for careful direct lending implies.
Higher-for-Longer Rates as a Double-Edged Variable
Private credit is a floating-rate asset class. When base rates rose from near-zero to over 5 percent in 2022 and 2023, private credit lenders collected dramatically higher interest income. A private credit portfolio yielding SOFR plus 500 basis points went from yielding roughly 5.5 percent to yielding over 10 percent as SOFR rose. For lenders, this was a windfall.
For borrowers, it was the opposite. Private credit borrowers are typically private equity-owned businesses with significant leverage — EBITDA multiples of 5x to 7x or higher in many cases. The same rate increase that boosted lender income simultaneously raised interest expense for those borrowers by multiple percentage points annually. A business that was servicing its debt at 6 to 7 percent interest suddenly owed 10 to 12 percent, with no change in its underlying operating performance required to trigger stress.
The Fed’s constrained cutting path means that this elevated interest expense environment persists longer than borrowers may have originally modelled when they took on the debt. Many private equity-backed businesses that took direct loans in 2021 and 2022 anticipated a refinancing environment by 2024 or 2025 that has not materialised at terms that reduce interest burden meaningfully. The extend-and-pretend dynamic — where managers roll loans rather than recognise impairments — has become visible in the vintage cohort data for 2021 and 2022 originations.
The fiscal backdrop matters at the margin too. Sustained fiscal expansion keeps term premium elevated and makes the rate normalisation that private equity borrowers need for comfortable refinancing more distant than it might otherwise be. That is a second-order effect, but directionally adverse for the credit quality of the most leveraged borrowers in the private credit stack.
The Denominator Effect and Capital Allocation Reality
When public equity markets fell in 2022, private assets — which are not marked down commensurately — became a larger percentage of total institutional portfolios than investors had targeted. A pension fund targeting 20 percent private markets exposure suddenly found itself at 25 percent as public equity fell and private marks held flat. This “denominator effect” caused many LPs to slow new commitments to private credit as they tried to rebalance toward target allocations.
That pressure has eased as public markets recovered in 2023 to 2025, but it highlighted a structural feature of private credit allocations: they are sticky in ways that can become problems. An LP that committed $500 million to a private credit fund in 2021 cannot exit that position at will. The lockup periods are typically five to ten years. If the LP needs liquidity, it must access the secondary market — where private credit fund stakes are sold at discounts that vary widely depending on the credit quality of the underlying portfolio and overall market conditions.
The secondary market for private credit fund interests has grown, but it is still thin relative to the size of the asset class. Bid-ask spreads on fund interests can be 10 to 20 percent or more of NAV in stressed environments. Investors who relied on private credit’s high reported yields and low volatility without fully pricing in the liquidity premium — the compensation for accepting a multi-year lockup — may find that the effective yield was lower than it appeared once liquidity costs are factored in.
What the Stress Scenarios Look Like
The risks in private credit are not evenly distributed across the asset class. Infrastructure-adjacent direct lending, real asset-backed credit, and investment-grade private placements carry substantially less risk than the sponsor-backed leveraged buyout direct lending that most institutional investors associate with “private credit.” The risk conversation needs to be segmented.
The segment that warrants the most scrutiny is the private equity-backed direct lending market for mid-market and upper-middle-market US and European businesses. These are the deals most affected by covenant loosening, leverage levels, and rate sensitivity. In this segment, payment-in-kind (PIK) rates — where interest is added to the loan balance rather than paid in cash — have risen across multiple managers’ portfolios. PIK is not inherently a distress signal, but rising PIK rates across a portfolio indicate that borrowers are conserving cash, which is consistent with businesses under margin pressure from higher interest costs.
A realistic stress scenario does not require a recession. It requires only that a meaningful fraction of 2020 to 2022 vintage private credit deals fail to refinance at acceptable terms by 2026 to 2027, forcing restructurings that crystallise losses currently sitting in marks that have not been adjusted. The losses would then flow through to LP capital accounts over 2027 and 2028, with the standard eighteen-month to two-year lag between economic event and reported portfolio impairment.
What Institutional Investors Should Be Doing Differently
The case for private credit as an asset class is not eliminated by these risks. Floating rate exposure, illiquidity premium, and covenants — even weakened ones — still provide genuine portfolio benefits in the right context. The problem is not private credit as a concept; it is private credit as deployed at scale, with loosened protections, in a higher-for-longer rate environment, with portfolios valued by managers who have strong incentives to delay impairment recognition.
Institutional investors with significant private credit allocations should be conducting vintage year analysis — understanding specifically what credit risk profile, what covenant package, and what rate sensitivity their 2020 to 2022 vintage loans carry, separately from their overall AUM figures. They should be stress-testing their liquidity assumptions: if they need to access capital from their private credit allocations before the fund term, what is the realistic secondary market discount and timeline?
They should also be interrogating manager practices around PIK, extension requests, and covenant amendment frequency — all of which are leading indicators of credit stress that should show up before formal impairment. The managers who are most transparent about these metrics in a deteriorating environment are also typically the ones best positioned to manage through it.
Private credit at $2 trillion is too large and too heterogeneous to be treated as a monolithic risk. The right question is not whether the asset class is dangerous but which parts of it, in whose hands, with what underlying borrower quality and covenant protection, are carrying risks that reported returns are not yet reflecting. That question is harder to answer than the quarterly statements suggest — which is precisely why it deserves to be asked more carefully.
