Private lending market alarms are frequent: behind the official low default rate, the shadow default rate has soared to 6%.

In the 1.7 trillion dollar private credit market, default warnings are beginning to accumulate, prompting at least some analysts to raise concerns about the underestimated risks in one of Wall Street's most profitable businesses. For years, losses have remained manageable as private credit companies have been more patient with borrowers facing difficulties than many other investors. During the pandemic, direct lending institutions often gave companies longer debt repayment grace periods through backdoor negotiations with private equity owners. But this month, several analysts have started to focus on potential pressures, including pressure from lending institutions themselves. While private credit defaults do not have a unified definition, the current market default rate is between 2% and 3%. If so-called "non-accrual loans" (loans that lending institutions expect to record losses for) are included in the statistics, according to a report compiled by Morgan Stanley based on KBRA DLD data, this ratio will rise to 5.4%. The adjusted private credit default rate is roughly in line with the level in the syndicated loan market. Although private credit funds are no longer as popular as before, returns exceeding 8% are still attracting investments. Morgan Stanley data shows that fundraising has slowed down this year, with only $70 billion raised by July 22, accounting for only one-tenth of the total inflow of alternative assets, the smallest share since at least 2015. Morgan Stanley analysts, including Stephen Dulac, wrote in a report this month: "A large influx of funds into this asset class means that capital commitments are happening too quickly," and "underwriting standards are necessarily lowered; losses will be amplified during economic downturns." By allowing borrowers to defer cash interest payments until the debt matures (ultimately resulting in a large lump sum payment), private companies and their lending institutions are able to avoid defaults. S&P Global analyst Zain Bukhari pointed out that another way is to set contract terms at a "lenient" level, making it difficult for institutions to act on early signs of weakness. "The main selling point of private credit is the low default rate," Bukhari wrote in a report this month. "This reputation is built on a narrow definition of default." S&P said that if behaviors such as term extensions and converting cash interest into physical payments are included in calculations, the percentage of borrowers failing to meet debt obligations would be much higher than the current level. Valuation company Lincoln International pointed out in a report this month that defaults may be "masked by a high level of amendment activities," as lending institutions can prevent defaults by adjusting credit agreements. The company's calculation of the market's "shadow default rate" (the proportion of "distressed" physical payment investments to total investments) reached 6% in the second quarter, much higher than the 2% in 2021. The report showed that the official default rate for private credit increased from 2.9% to 3.4% during the same period. More complex is the significant differences in the borrower groups monitored by different credit rating agencies and consulting firms, making it difficult for any institution to fully understand the entire market landscape. Although these differences lead to cognitive dissonance, research from multiple sources seems to be consistent in the direction of defaults: upwards. Morningstar DBRS analyst Michael Dimler stated, "The concentration of borrowers in lower credit rating categories and the recent increase in default rates indicate ongoing challenges." However, some market participants remain optimistic. They believe that lowering interest rates has eased the pressure on highly leveraged companies, and the interest coverage ratios in loan portfolios remain at healthy levels. "Our market research shows that certain industries are at higher risk when interest rates rise, but now that interest rates are falling," said Christopher Bourne, Head of Private Credit for Asia and Europe at Hana Financial Group, "solid companies with strong cash flow can fully withstand the current interest rate levels."