When managers of private credit funds assure analysts during quarterly calls that "credit health remains strong," a data analysis by the Wall Street Journal reveals that pressure is quietly building within the industry.
According to a report on August 9, analysis of quarterly reports from private credit funds managed by Ares Management, Blackstone, Blue Owl Capital, and Golub Capital shows that loan default rates for these funds have reached their highest levels since at least 2021, while internal risk watch lists are also expanding.
This phenomenon is occurring against a backdrop of the US economy performing relatively well, raising alarms among analysts that if economic growth slows, losses could sharply escalate.
Default Rates Hit Five-Year High, Gap Between Manager Statements and Data
The core business of private credit funds is "direct lending": providing high-interest loans to companies with high debt levels to generate substantial returns. This strategy has attracted significant capital inflows over the past few years, making it one of the hottest asset classes on Wall Street.
However, according to the analysis, the non-performing loan ratio for Blue Owl's funds rose to 2.8% in the second quarter, the highest in at least five years. Funds managed by Ares, Blackstone, and Golub also saw their non-performing loan ratios hit five-year highs, exceeding levels seen during the Federal Reserve's aggressive rate hike cycle in 2023.
In response to external scrutiny, several institutional managers have publicly downplayed the risks. Blue Owl co-CEO Marc Lipschultz stated during a quarterly analyst call, "In our direct lending strategy, credit health remains strong." He added that software companies are among Blue Owl's most profitable borrowers, saying, "Our watch list has not shown any material changes compared to a year ago."
However, Golub Capital co-CEO David Golub offered a more cautious view. He said, "Some media outlets are saying 'the sky is falling,' while some of my peers say 'that's nonsense, there's no problem at all.' Neither statement is accurate. We are clearly in a credit cycle. This cycle is not particularly bad, but there will be winners and losers."
Watch Lists Quietly Expand, Software Loans Become the Biggest Concern
Private credit funds typically maintain an internal "watch list" to track borrowers showing signs of repayment stress. When a company's financial condition deteriorates, it is added to this list, often a precursor to default.
Funds managed by Ares, Golub, and KKR have all reported an increase in the number of borrowers on their watch lists this year, reaching the highest levels since the 2022-2023 rate hike cycle.
Currently, problem loans are concentrated in healthcare and industries impacted by oil prices, such as dental service provider Affordable Care and plastic film manufacturer Loparex. However, what truly worries analysts and fund managers is the risk of defaults spreading to software companies.
The reason is that software company loans account for over 20% of many fund portfolios, and the rapid development of artificial intelligence is disrupting the business models of some software firms, making their debt repayment capabilities uncertain. If a systemic default occurs in this sector, the impact on fund portfolios would far exceed the current issues in healthcare and energy.
Declining Returns, Individual Investors Could Amplify Pressure
Private credit funds have historically offered annualized returns of over 10%, a key selling point for attracting high-net-worth individual investors. Now, even well-performing funds struggle to maintain a 7% annualized return.
A poorly performing fund managed by KKR posted a loss of 6.55% over the 12 months ending in June, compared to a 9.17% loss in the prior 12 months, remaining in negative territory despite a slight narrowing.
The reasons for declining returns are multifaceted: a slowdown in private equity merger activity has reduced opportunities for new high-yield loans; weakening borrower operations combined with falling public bond markets have forced funds to write down the value of loans still paying interest; and a decline in benchmark interest rates has reduced interest income.
Fund managers argue that performance volatility is normal for private credit, given that the strategy focuses on companies with low credit ratings. However, the issue is that many individual investors have never experienced such a downturn cycle in this asset class. If returns remain low or turn negative, they may choose to redeem.
If investors withdraw in large numbers, fund-raising capabilities will be damaged, affecting their ability to provide refinancing for maturing corporate loans—forming a self-reinforcing negative cycle.
Currently, shares of these funds have seen a slight rebound from sharp declines since last year, suggesting that the market has partially accepted managers' optimistic narratives. However, the Wall Street Journal's analysis indicates that pressure from the data has not yet subsided.
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