Risk Factors Are Rising in Private Credit, Performance Harder to Predict

Investors have favored the private credit asset class for years as it has grown into a $1.7 trillion market that investors regard as important for everything from portfolio diversification to current income to secondaries. Interest has stayed strong, despite a years-long slowdown in the types of mergers and acquisition deals that were core to private credit financing.

But now, the asset class might be hitting a bit of a speed bump as fundraising has slowed in 2025.

According to data from J.P. Morgan, private credit funds raised $70 billion through July 22, a figure that indicates private credit will likely not beat the $233.3 billion it raised last year. As CIO previously reported, private credit secondaries—both GP-led and LP-led—are also on the rise.

Analysts are a bit divided about what these shifts ultimately mean. On one hand, private credit money managers are sitting on billions of dollars in dry powder and broadly, loans are still performing. On the other hand, default rates are up and questions remain about how private credit as an asset class will fare in a significant market correction. Both private equity and private credit are also showing a greater sensitivity to macroeconomic factors like interest rates, inflation and tariffs than they have in the past, which makes predicting future performance that much harder. Taken together, private credit is showing the signs of a rapidly maturing asset class—which may mean that investors need to adjust their expectations going forward.

Asset-Backed Lending Comes Into Focus

Against this backdrop, the opportunity set in private credit is shifting. Direct lending funds and transactions still make up the bulk of the activity, but investors are taking a closer look at asset-backed lending. Such collateralized strategies can prove to be a diversifier in a portfolio dominated by direct lending.

“We’re in a situation where deal volume is muted on the direct lending side,” says David Scopelliti, global head of private debt at Mercer. “The slowdown hasn’t reached a level where anyone is necessarily worried, but there is an overhang in direct lending. There is more activity happening in structured credit, asset-based finance—areas that are less dependent on the M&A market.”

Scopelliti says that asset-based finance transactions require more work than direct lending in terms of structuring and due diligence, but banks have largely stepped out of the sector and that has created opportunities for private credit managers. “This is really an opportunity set that has been hiding in plain sight,” he says, adding that asset-based lending is typically shorter duration, which can be a positive for investors looking for income with shorter lock ups.

Stephanie Rader, global co-head of alternatives capital formation within Goldman Sachs Asset Management, agrees. “Clients are focused on asset-based finance … the opportunity set is large and the spreads in private markets compared to public markets are attractive right now,” she says. “We expect to see continued growth in this part of the market.”

Risk Factors Increase

Whether as signs of a maturing asset class or a response to macroeconomic volatility, or both, risk factors are increasing in private credit. Default rates have been elevated since the start of the year. Alongside that, private credit managers are beginning to turn to continuation funds to manage performing loans that have been extended and amended past the lifecycle of the original commingled fund in which they were first invested. Continuation funds have grown in popularity over the years and are not necessarily indicators of distress, but they are an indicator that borrowers and managers are pushing out maturities, which, for whatever reason, can be risky.

“When we look at the default index range over the past several quarters, what we are seeing is that it is elevated relative to the past couple of years,” says Timothy Lee, director of private credit – U.S. corporates at Fitch Ratings. “Broadly, issuer quality remains high and loans are performing. Where we see more default activity is in smaller issuers and in C-grade paper.” Lee says in that part of the market the component of transactions are higher risk; the companies are weaker and they may already have other types of financing in play, like bridge loans, which makes the overall debt load higher.

Lee adds that for companies that need more time to pay on existing loans, if they have cashflows and their balance sheets are generally strong, there is still a preference among private credit managers to extend and amend the arrangements, and that is happening without a significant decline in loan quality.

Payment in kind, or PIK, arrangements are also on the rise. According to data from Fitch Ratings, much of that activity has been concentrated within the business development company sector and levels are starting to normalize, but those loans represent a riskier type of financing. For the 32 Fitch-rated BDCs, average PIK income as a percentage of interest and dividend income fell to 7.8% in the second quarter of this year, down from peaks of 8.2% in the first quarter and 8.3% in the fourth quarter of 2024. Those figures are higher than they were in 2024, which can be an indicator of declining credit quality, the ratings agency says.

PIK arrangements offer companies payment relief in the short run, but result in a much larger bill at the end of the loan term, so companies that ask for this option are betting big on their future growth in an uncertain economy.

Mercer’s Scopelliti says much rests on when and how PIK is used. In a high-growth company, if the borrower can reinvest on a short-term basis in the company using cash that would have otherwise gone to loan payments, PIK can be a valuable way to get a bit of flexibility. However, Scopelliti says, if cash paying loans start converting to cash plus PIK, it can be an indicator of default risk, especially if the company is not on a high-growth trajectory. “PIK is definitely something we focus on in our due diligence process with managers because it’s a bit like an IOU at a poker game—it’s not cash on the table.”

Curves Ahead

Forecasting the future in private credit is getting increasingly difficult. After several quarters of high demand, but ultimately slower M&A and other transaction volume, sources are expecting the near term to be more of the same. Even if markets get the September interest rate cut they want, questions linger around inflation and the impact of ongoing adjustments to tariff and other economic policies.

Lenders also appear to be taking steps to tighten terms. Over the past few years, priming, the practice of new loans taking over seniority status in the repayment hierarchy, has come into focus as companies and private equity managers look for ways to restructure their credit arrangements without entering bankruptcy court. Private credit lenders have been willing to participate in so-called liability-management exercises, if it means they can avoid bankruptcy court but that does not mean they are thrilled about it.

Cindy Davis, a partner at law firm Reed Smith, says that as priming becomes a tool that more companies and private equity managers are reaching for, lenders are taking a closer look at their covenants. “We see these cases move forward and once it becomes known that a company got this deal or that deal, others try it. Then lenders move to put something in the documentation saying you can’t do that again. But it’s a bit of a chase,” she says. “It has the most negative impact on minority lenders because they end up with more risk than they anticipated.”

Tags: Alternatives, Private Credit, Private Equity