Private credit is showing increasing signs of stress, despite comments to the contrary from some of the largest fund managers that are trying to put a year of turmoil behind them.
Recent quarterly reports from funds overseen by the industry's big players showed that loan health and investor returns are worsening, according to an analysis by The Wall Street Journal.
Among funds overseen by Ares Management, Blackstone, Blue Owl Capital and Golub Capital, loan defaults touched their highest level since at least 2021. The funds' stocks trade on public exchanges, requiring them to regularly update shareholders on their investments.
Blue Owl, Blackstone and other investment firms have said fears gripping the relatively new market are overdone, and that their loan portfolios are doing well.
"Some in the press have been saying 'Oh no, the sky is falling,' and some of my peers at other firms have been saying 'That's nonsense, there's no problem,'" said David Golub, co-chief executive of Golub Capital. "Neither of those is accurate. We are clearly in a credit cycle. It's not a particularly bad one, but there will be winners and losers."
Rising defaults
Private-credit funds invest money from clients in high-interest loans to heavily indebted companies, a strategy called "direct lending." Until recently, the hefty returns the funds delivered made them one of the hottest flavors on Wall Street.
Then, investors grew alarmed by several high-profile defaults caused by alleged frauds, and by loans made to software companies at risk of disruption by artificial intelligence. Many individuals who had been sold the funds asked for their money back.
Fund managers such as Blue Owl, Blackstone and KKR dismissed the panic as media hype, saying fund performance tells a different story.
"Across our direct lending strategy, credit health remains strong," Blue Owl's co-CEO Marc Lipschultz said on his firm's quarterly call with Wall Street analysts.
The percentage of defaulted loans in Blue Owl's fund hit 2.8% in the second quarter, its highest level in at least five years. Nonperforming loans at the three other funds also hit five-year highs, exceeding levels reached in 2023 when the Federal Reserve hiked interest rates, squeezing the finances of corporate borrowers and triggering a wide stock and bond market selloff.
So far, the bad loans are cropping up primarily in healthcare companies, like dental-service provider Affordable Care, or businesses affected by higher oil prices, including plastic-film maker Loparex. The worry for analysts and fund managers is that defaults might spread to software companies, which make up 20% or more of the loans in many funds.
While default rates are rising, they remain below previous periods of heavy stress, such as the height of the Covid pandemic or the oil-price crash in 2015. Losses could abate if interest rates decline and economic activity remains robust without pushing inflation higher.
Watching the watchlists
Software companies are among Blue Owl's most-profitable borrowers, Lipschultz said on the recent analyst call. "We have seen no meaningful change in our watchlist compared with a year ago."
That makes his firm an outlier.
Funds keep watchlists of borrowers they lend to showing signs of trouble. The fund managers use internal analysis and outside consultants to assign ratings signaling whether those borrowers are meeting expectations and seem likely to keep paying their debts. When a company's performance fades, they are added to those watchlists.
Private-credit funds managed by Ares, Golub and KKR all reported increases this year in the number of borrowers on watch for deteriorating performance. For those funds, the lists are at their highest levels since 2022-23, when interest rates were rising, the Journal's analysis shows.
Longer watchlists suggest more loan defaults could be brewing. The stress among private-credit borrowers is occurring while the U.S. economy is performing well, a possible warning sign that losses could jump sharply if growth abates.
Where's the beef?
Private-credit investment firms can ill afford more write-downs because the performance of their funds is already suffering and their stock prices have only just started to recover from sharp selloffs that started last year. A modest rebound in the shares suggests the market is buying into the optimistic view delivered by top fund managers.
Private-credit funds routinely delivered annual returns of 10% or more in years past, a key factor in their ability to raise money from wealthy individuals. Now, even the stronger funds are struggling to deliver 7%. An ailing fund managed by KKR lost 6.55% over the past 12 months through June, a slight improvement from its 9.17% loss in the prior period.
Profits are declining for a variety of reasons. Dealmaking by private-equity firms that private-credit funds lend to has slowed down, curtailing the number of lucrative new loans to be made. Weaker performance by the companies they lend to and a selloff in public debt markets forced funds to write down investments that are still paying interest even as defaults climbed. Benchmark interest rates have also fallen from peak levels, trimming the income funds make on their investments.
Fund managers say the performance fluctuations are standard in private credit, which focuses on lending to companies with low credit ratings. But many individual investors have yet to experience such a downturn and if returns stay stuck or even drop, they may walk away.
Fewer investors mean it would be harder for fund managers to raise money, shrinking the supply of capital to refinance existing corporate loans when they come due.
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