The next thunder on Wall Street? Default warnings surge in the U.S. private credit market

The popular money-making tool on Wall Street—the private credit market—is facing a surge in default warnings. Analysts from multiple institutions are concerned that the $1.7 trillion private credit market's default rate may be underestimated, with the actual default rate significantly higher than publicly available data.

On August 21, reports indicated that several institutions released reports this month highlighting the potential pressures in the private credit market. A report from JP Morgan, based on KBRA DLD data, shows that if non-accrual loans expected to incur losses are included, the market's default rate has risen to 5.4%, roughly equivalent to the default rate in the broader syndicated loan market.

Analysts warn that years of rapid fundraising by private credit funds have led to relaxed underwriting standards, and once the economy declines, they will face excessive losses. Meanwhile, through arrangements like physical payments and loose covenant terms, the true extent of defaults may be "masked."

Despite returns of over 8% still attracting investment, fundraising for private credit funds has significantly slowed. As of July 22, the fundraising scale this year was only $70 billion, accounting for one-tenth of alternative asset inflows, the smallest proportion since 2015.

True Default Risks May Be Underestimated

The definition of default in the private credit market is not uniform, with the publicly available default rate ranging between 2% and 3%. However, the JP Morgan report indicates that if non-accrual loans—loans that lenders expect to incur losses—are included, the default rate would jump to 5.4%.

S&P Global analyst Zain Bukhari stated in a report this month:

"The main selling point of private credit is its low default rate, but this reputation is built on a narrow definition of default. If we include 'selective defaults' such as extending maturity and converting interest payments from cash to physical payments, the proportion of borrowers unable to meet their debt obligations is much higher."

A report from valuation firm Lincoln International shows that the "shadow default rate," calculated by observing the proportion of "bad" physical payment investments to total investments, reached 6% in the second quarter, significantly higher than 2% in 2021.

The firm noted that defaults may be "masked by a large number of remedial activities," as lenders can adjust credit agreements to delay defaults.

Loose Underwriting Standards Pose Risks

JP Morgan analysts, including Stephen Dulake, warned in a report this month:

"The influx of funds into this asset class means too much capital is being allocated too quickly, leading to shortcuts in the underwriting process, and losses will exceed expectations during an economic downturn."

Private companies and their lenders evade cash defaults through physical payment arrangements, allowing borrowers to postpone cash interest payments until the debt matures, ultimately facing a large bill. Another method is to set covenant terms at "loose" levels, making it difficult to act on early signs of weakness.

Morningstar DBRS analyst Michael Dimler stated:

"The concentration of borrowers in weaker credit rating categories is higher, and the recent rise in default rates indicates ongoing resistance."

While different institutions may have variations in specific data, they agree on the direction of the default trend: upward. In addition, the fundraising ability of private credit funds is weakening. Although a return rate of over 8% is still attracting investment, private credit funds are no longer the capital magnets they once were