Reassessing Risk, Discipline, and Return in an Overcapitalized Asset Class
Private credit has expanded dramatically over the past decade, emerging as a dominant source of capital in corporate finance. As of 2024, the global private credit market surpassed $1.7 trillion in assets under management (AUM), according to Preqin, with forecasts projecting a rise to $2.5 trillion by 2027. Initially positioned to fill gaps left by post-crisis bank retrenchment, private credit now plays a central role in leveraged lending, particularly in the middle market.
However, the rapid scaling of this asset class has coincided with increasing signs of discipline erosion. Covenant protections have weakened, spreads have tightened, and deal sizes have grown significantly. These developments suggest a crowding effect in which excess capital supply begins to distort underwriting quality and investor expectations. This post outlines the structural shifts underway and evaluates whether private credit remains appropriately priced for the risks it assumes.
The Institutionalization and Scale of Private Credit
Private credit’s rise is largely attributable to regulatory constraints on banks following the 2008 global financial crisis and subsequent implementation of Basel III, which limited bank exposure to leveraged lending. Non-bank lenders, particularly private debt funds, filled the gap. The direct lending subset alone accounts for more than $650 billion globally.
This expansion has been catalyzed by institutional investors, primarily pension funds, endowments, and insurance companies, seeking higher yields in a low-interest rate environment. Between 2015 and 2023, the average institutional allocation to private credit doubled from approximately 4 percent to over 8 percent, based on surveys conducted by Mercer and BlackRock.
Declining Credit Protections and Spread Compression
As capital inflows intensified, competition among lenders resulted in the weakening of traditional credit protections. According to Covenant Review, over 75 percent of U.S. middle market unitranche deals in 2023 were covenant-lite, up from just 35 percent in 2018. In addition, first lien leverage multiples have risen, with S&P Global reporting a median of 5.4x EBITDA for sponsored middle market deals, compared to 4.7x five years prior.
Simultaneously, the yield premium once associated with private credit has diminished. The average spread on new direct lending deals in the U.S. fell from 675 basis points in 2020 to 525 basis points by the end of 2023, even as base rates rose. This suggests that investor demand is absorbing tighter pricing without commensurate increases in risk-adjusted returns, particularly in the context of weaker underwriting standards.
Structural Risks in Workout Scenarios
A key argument in favor of private credit is the presumed ability of lenders to control outcomes in distressed scenarios through bilateral engagement and senior secured status. However, as deal structures become more complex, often involving multiple lender tranches, NAV-based facilities, or co-investor syndication control dynamics can be diluted.
Moreover, the size of unitranche loans has expanded significantly. PitchBook data indicates that by 2023, over 25 percent of new unitranche issuances exceeded $1 billion. These larger deals increasingly resemble syndicated loans in structure but do not benefit from the same levels of secondary liquidity or regulatory oversight associated with broadly syndicated loans.
The result is a paradox. Lenders hold senior claims but face practical constraints on enforcement, particularly when borrower distress is met with limited refinancing options or misaligned sponsor incentives.
The Illusion of Stability and the Role of LPs
Another dimension of risk lies in how private credit is perceived by institutional allocators. The asset class is often marketed as offering equity-like returns with bond-like volatility, due in part to the absence of daily pricing and the relative illiquidity of fund structures. However, this stability may be illusory.
During periods of market stress, valuation marks tend to lag public market movements. In 2022, as high yield bond indices fell over 15 percent, many private credit funds marked NAVs down only marginally. This lag creates a smoothing effect that may understate volatility and overstate diversification benefits in portfolio construction models.
Additionally, while most private credit funds offer quarterly or semi-annual liquidity, the underlying loans are not easily sold. If a macroeconomic shock or rate-induced default cycle were to occur, LPs may find that redemption queues are frozen, with no practical exit until asset realizations materialize.
Anticipated Market Adjustments
Several shifts are already underway. Larger asset managers such as Ares, KKR, and Apollo are consolidating market share, leveraging economies of scale, and implementing risk management frameworks that smaller platforms may not sustain. Regulatory scrutiny is also rising. The U.S. Securities and Exchange Commission (SEC) has issued new rules aimed at enhancing transparency in private funds, including mandates around fee disclosure and side-letter arrangements.
On the demand side, institutional allocators are beginning to distinguish between core direct lending strategies and opportunistic or structured credit products. This may lead to revised underwriting standards, increased demand for covenants, and tighter fund structures.
Private credit is now a core allocation for many institutional investors, with significant influence over corporate financing and capital formation. Yet its continued success will depend on whether the asset class can evolve from a capital-supply-driven market to one grounded in risk-sensitive underwriting and transparent governance.
As liquidity remains constrained, rate volatility persists, and macroeconomic pressures build, the test will be whether private credit delivers not only contractual yield but also real resilience. The crowding dynamic, once a symptom of success, could become a structural liability if left unaddressed.
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