A few weeks ago, analysts at UBS laid out a worst-case scenario for defaults in the private credit sector. Their outlook just became more grim.
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Strategists including Matthew Mish say private credit could see default rates surge as high as 15%, two percentage points more than the firm forecast less than a month ago, if artificial intelligence triggers an “aggressive” disruption among corporate borrowers.
“What is new: a clearer catalyst — rapid, severe AI disruption,” according to the UBS strategists Tuesday.
Direct lenders that took a lead role in financing software companies in recent years now look dangerously exposed to AI’s impact, stirring comparisons to the 2008 financial crisis. Some estimates suggest that the firms have 40% of all sponsor-backed loans tied up in the software industry.
Warnings about the $1.8 trillion industry have been building in recent days, triggered by Blue Owl Capital’s decision to permanently shut the gates on one of its funds and to sell assets. The move sparked a $2.4 billion drop in its market value, and dragged down the shares of other private credit players including Ares Management, Blackstone and Apollo Global Management.
The UBS report published Tuesday noted that private credit defaults are currently between 3% and 5% and that signs of strain such as interest paid-in-kind (PIK) are nearing post-pandemic highs.
Speaking at the iConnections Global Alts conference in Miami Beach, activist investor Boaz Weinstein — whose Saba Capital is seeking to snap up stakes in three Blue Owl Capital funds at a steep discount to their stated value — warned of the “wheels coming off” in private credit.
Money manager Danny Moses, meanwhile, of “The Big Short” fame, said the aggressive push by private markets into retail products reminds him of the years preceding the subprime mortgage crisis.
Earlier this week JPMorgan Chase CEO Jamie Dimon doubled down on his previous warnings of credit market “cockroaches,” lambasting the “dumb things” some lenders are doing and highlighting the similarities to the run-up to the financial crisis.
READ MORE: JPMorgan invests for new age of competition amid AI fears
Asset sale
Warnings like these are hitting a nerve with investors as business development companies, publicly traded direct lenders, come under pressure to return capital to investors. New Mountain Finance announced Tuesday it was offloading nearly half a billion dollars in assets at a haircut of 94 cents on the dollar.
While the firm had telegraphed the move late last year — framing it as a necessary step to diversify, boost financial flexibility, and reduce reliance on PIK income — the timing of the sale adds to the unease.
One way for BDCs to drum up cash may involve selling assets to collateralized loan obligations, Citigroup analysts flagged. Such a move could cause leverage to balloon tenfold while masking risk, they warned.
Still, some argue the gloom is overdone. Nomura Asset Management’s senior investment officer, Yuji Maeda, wrote in a research note that a significant private credit market contraction is unlikely.
M&A activity is picking up sharply after years in the doldrums, offering direct lenders plenty of opportunities to deploy. A surge of insurance capital into private markets is boosting hiring and pay deals in the sector, and fueling a rise in asset-based finance.
Speaking in Miami on Tuesday, money manager Dan Loeb announced plans for his investment firm Third Point to launch a business development company on April 2.
While acknowledging that the private credit market is set to endure some stress from its software exposure, Loeb expressed confidence it would survive the current turmoil.
“The bad news is that a lot of these loans will be impaired, but they don’t make up all of the portfolios that they’re invested in,” Loeb said. “There’s not a run-on-the-bank scenario, because there’s a match between assets and liabilities.”
Credit unease
Financial crisis parallels are also overblown, argued Brookfield’s CEO Bruce Flatt, given the private credit industry’s relatively small place in a much larger global credit market. “This is not a systemic situation,” he told Bloomberg Television Wednesday.
The impact of AI disruption on software, however, remains a major source of concern among investors. Stocks slid earlier this week after a report from Citrini Research outlined a scenario where AI advancements lead to a double-digit U.S. unemployment rate by 2028.
The fallout may not be limited to the private credit market. The UBS strategists also see higher default risk for U.S. leveraged loans of up to 10% — and high-yield bonds of up to 6% — in a worst-case scenario. That’s a rise from estimates of up to 8% for U.S. leveraged loans and up to 4% for U.S. high yield bonds in the previous report.
Leveraged debt markets can keep riding on the coattails of a healthy economy with no major blow-ups, said Bob Michele, global head of fixed income at JPMorgan Asset Management.
“What everyone’s worried about is we haven’t had a shake-out in private credit yet,” Michele told Bloomberg TV Tuesday. “A recession is that ultimate shake-out.”
