Concerns Rise Over Private Credit Defaults as AI Disruption Looms

A few weeks back, UBS Group analysts presented a rather grim outlook for defaults in the private credit sector. Their predictions have since taken a turn for the worse.

Strategists like Matthew Misch indicated that private credit default rates could potentially spike to 15%. This uptick is largely attributed to the disruptive effects of artificial intelligence on corporate borrowers, which is a couple of percentage points higher than the previous month’s expectations.

“What’s new is a more defined catalyst: rapid and profound AI disruption,” the UBS strategists remarked earlier this week.

Direct lenders, who have notably been involved in financing software companies recently, seem particularly vulnerable to the impacts of AI. This situation sheds light on comparisons to the 2008 financial crisis, as it’s estimated these lenders hold around 40% of all loans in the software sector.

Recent alarms have intensified in the $1.8 trillion industry following Blue Owl Capital’s announcement of a permanent closure on one of its funds and asset sales. This resulted in a loss of $2.4 billion in market value, affecting other private credit firms like Ares Management Corporation, Blackstone Inc., and Apollo Global Management.

According to a UBS report, private credit default rates currently sit between 3% and 5%, with signs of distress seen in interest payments in kind (PIK) nearing post-pandemic peaks.

During the iConnections Global Alts conference in Miami Beach, activist investor Boaz Weinstein mentioned that private credit might be the spark that initiates broader issues.

Meanwhile, Danny Moses, known for his role in The Big Short, expressed that the private market’s push towards retail products reminds him of the environment before the subprime mortgage crisis.

Earlier this week, JPMorgan Chase CEO Jamie Dimon reiterated his earlier warnings regarding troubling indicators in the credit market, criticizing certain lenders for, what he termed, “stupid things” that could reflect early signs of a financial crisis.

These warnings resonate deeply with investors, especially as business development companies (BDCs) face pressure to return capital. New Mountain Finance Corp. announced plans to offload nearly $500 million worth of assets at significant losses.

While the company had indicated a need for diversification and financial flexibility, the timing of the sale has raised additional concerns.

Citigroup analysts proposed that BDCs could raise cash through asset sales into loan-backed securities, warning that this could increase leverage substantially while obscuring risks.

Conversely, some experts argue the market’s decline may be overstated. Yuji Maeda from Nomura Asset Management stated that there’s little likelihood of a significant contraction in the private credit market.

Activity in mergers and acquisitions is ramping up after a period of stagnation, which could open doors for direct lenders looking to expand. Additionally, increasing insurance capital is driving growth within this sector.

On Tuesday in Miami, money manager Dan Loeb revealed that his firm, Third Point, plans to launch a business development company on April 2nd, expressing confidence about the market’s resilience amidst current challenges, although he conceded some stress related to software exposure.

“While many loans may indeed encounter impairment, they won’t account for the entirety of the portfolio,” Loeb stated. He added that current asset-liability alignments suggest a bank run scenario is unlikely.

Brookfield CEO Bruce Flatt also noted that the comparisons to the last financial crisis might be exaggerated, given the relatively minor role of the private credit industry in the broader global credit landscape.

Nevertheless, the implications of AI disruption continue to be a pressing worry among investors. Earlier this week, stock prices slid following a Citorini Research report predicting potential double-digit unemployment in the U.S. by 2028 driven by AI advancements.

This concern isn’t confined to private credit alone. UBS strategists have also indicated that, in a dire scenario, the default risk on U.S. leveraged loans might increase by up to 10%, while high-yield bonds could face a 6% rise in default risk. This is a significant uptick from their earlier forecasts of up to 8% and 4%, respectively.

Bob Michel, global head of fixed income at JPMorgan Asset Management, maintained that the leveraged bond market could maintain its momentum as long as the economy remains healthy.

“The worry is that private credit remains unscathed so far,” he mentioned. “A recession would ultimately serve as a cleansing mechanism.”