Private Credit's Slow-Motion Reckoning
Why the fastest-growing corner of finance could be the next to crack
“If in the first act you have hung a pistol on the wall, then in the following one it should be fired. Otherwise don’t put it there.”
— Anton Chekhov
Shadow banking has a problem, but I want to set the record straight since this quote is going viral which everyone’s overreacting to. That ‘19,000’ number is likely inflated as there’s probably a fair amount of independent sponsors & search funds included. The real number is probably within the 10,000-14,000 range which is still a lot.
The rise of private credit and other niche strategies like continuation funds, broadly speaking, are the latest examples of this. We’re in a situation where too much capital is chasing too few deals and sectors like technology & business services crowd out capital that other industries sorely need.
I think it’s worth noting that this is ‘book talk’ from KKR, APO, etc as they want LP $ floating away from buyout only shops to large, diverse managers that specialise in a range of asset classes including private credit. Smaller PE funds aren’t as diverse and primarily focus on a single strategy and/or asset class that makes up the bulk of their returns.
Private credit has become the $2.1 trillion gun hanging on the wall of our financial system. Everyone can see it. No one’s quite sure when it goes off. For now, lenders are partying like it’s 2006 and the credit markets are wearing noise-cancelling headphones.
Act I: Loading the Weapon
After 2008, banks got religion about risky lending. Basel III regulations meant traditional lenders retreated from anything remotely dodgy. But companies still needed money, and institutional investors still needed yield. Enter private credit: the unregulated shadow banking system that promised to split the difference.
The growth has been absurd. The US market doubled in five years to $1.25 trillion. McKinsey projects another $5-6 trillion could shift into the nonbank ecosystem by 2035. That’s big enough to be systemic.
The Structural Flaws
Private credit funds increasingly offer daily or monthly redemptions while holding assets that take years to sell. This violates Finance 101: don’t promise overnight liquidity on illiquid assets. When redemptions accelerate, you get gating or fire sales. Neither ends well.
Covenant protections that gave lenders early warning signs have been systematically stripped away. Payment-in-Kind (PIK) arrangements let borrowers defer cash interest by adding it to principal, the financial equivalent of paying your credit card with another credit card. This creates a vicious feedback loop where struggling companies avoid immediate pain by making future defaults both more likely and more severe.
Unlike public markets, private credit is marked-to-model, not marked-to-market. Problems fester unseen until they explode. Recovery rates are now estimated at 20-30 ~50 cents on the dollar versus 70 cents historically. Meanwhile, the top 20 managers control over one-third of industry capital. When everyone moves at once, diversification becomes correlation risk.
Most dangerously, private credit is floating-rate. Companies that borrowed expecting rates to fall are now squeezed. Cheap zero-rate debt now costs 8-10% to roll over. Many simply can’t afford it, creating zombified firms surviving on PIK and prayer.
Act II: Default Rate Theater
The warning signs multiply, sending mixed signals, perhaps the most dangerous situation of all.
The Proskauer Default Index showed defaults rising to 2.71% in Q2 2024, then declining to 1.76% in Q2 2025. Yet Fitch reported 5.0% defaults in August 2025. This disparity suggests different players are seeing different realities.
The industry’s dirty secret: “selective defaults” are five times more common than reported defaults. These economically painful events get classified as anything but “default” - amendments, restructurings, covenant waivers - preserving the illusion of stability. The sponsors are quite literally forcing an “amend and pretend.”
The BDC Reality Check
Want to see how private credit actually performs? Look at publicly traded Business Development Companies (BDCs) that can’t hide behind mark-to-model accounting.
Blue Owl Capital (OBDC) reported non-accruals jumping from 0.4% in Q4 2024 to 0.8% in Q1 2025, while NAV per share declined from $15.26 to $15.14. Management celebrates “continued resilience” while non-accruals double. That’s creative spin.
Blackstone Secured Lending (BXSL) maintains a remarkably low 0.1% non-accrual rate with a 98.7% first lien senior secured portfolio. Their Q3 2024 credit rating upgrade from Moody’s to Baa2 made them one of only two publicly traded BDCs with that distinction. If you’re exposed to private credit risk, at least be at the top of the capital structure with actual collateral.
But even the “good” BDCs report stress. The ICE BofA US High Yield OAS sits at 3.18% as of October 2025, compressed but ticking up. Credit spreads are widening across the board.
The Cockroaches Emerge
Jamie Dimon warned:
“When you see one cockroach, there are probably more, and so everyone should be forewarned.”
Let’s count them.
Tricolor collapsed spectacularly in September 2025. They’d been writing auto loans to people without driver’s licenses or social security numbers—undocumented immigrants, in plain terms. Bloomberg reported a fight over 100,000 car loans. It’s The Big Short but for cars, NINJA loans repackaged. By itself, Tricolor won’t bring down the system. But six cockroaches later, the pattern becomes impossible to ignore.
Carvana’s recovery from $3.55 to $240 looks impressive until you examine the loan book. Hindenburg Research documented systematic fraud: $800M+ in related-party transactions, title fraud across states, and aggressive securitization masking loan deterioration. Their playbook is to originate subprime auto loans (FICO <620), immediately securitize into ABS, book gains on sale, use cash to originate more loans. Delinquencies are spiking as used car prices normalize. Over $20 billion originated since 2020, substantial portions held by insurance companies, pension funds, and private credit funds.
PrimaLend is the next domino. Bloomberg reported unpaid creditors eyeing bankruptcy as the subprime auto lender struggles to meet obligations. The numbers: ~$2.5 billion originated lifetime, ~$800 million outstanding, delinquency rates spiking to 12-15%, creditors owed $150-200 million unpaid, warehouse credit lines pulled. A classic death spiral. Word on the street is that PrimaLend have just gone bannkrupt (which I called about 4 days prior) due to the firm defaulting on their debt.
Adler Pelzer, a global auto parts supplier with €1.2B revenue, carries €850 million in leveraged loans and bonds. Fitch affirmed a ‘B-’ rating in August 2025, noting weak automotive production, leverage over 6x Net Debt/EBITDA, and negative free cash flow. In October 2025, hedge fund Sona Asset Management and Apollo shorted Adler Pelzer bonds. When distressed debt specialists short your bonds, the game is over. The firm faces a refinancing wall of ~€400M maturing 2026-2027. At current spreads, refinancing costs 12-15% annually—€48-60M in interest the company can’t afford. I think there’s a ~60% probability of bankruptcy by the end of 2026.
Standard Profil, an Austrian auto parts supplier, completed a creditor takeover in July 2025 through a debt-for-equity swap that wiped out shareholders. Senior lenders received 95% of new equity. Junior lenders got 5%. Existing equity holders: zero. This demonstrates the debt-to-equity pipeline becoming standard procedure. It also obscures true default rates; a debt-for-equity swap isn’t classified as “default” even though the economic substance is identical to bankruptcy. I don’t think their debt burden is sustainable relative to its current cash flow generation capacity as in 2024, their total revenue decreased by 7.1% year on year to €461.1 million and the company’s EBITDA normalized to €56.6 million, down 43.0% compared to €99.4 million in 2023 & their refinancing risk is still high (source).
First Brands: The Mess That Got Messier
Then there’s First Brands Group. As Debt Serious detailed (here and here),
at least 517 CLOs held First Brands loans. The ad hoc group providing DIP financing included 81 lenders. Can you imagine that group call?
The $4.4 billion DIP facility comes with SOFR + 1.55% cash plus 8.45% PIK.
First Brands’ debt was rehypothecated several times over, obscuring ownership and control. You don’t want to be the last guy holding 10 cents on the dollar CLOs.
At least nine publicly traded BDCs held First Brands debt, believing they had diversified exposure. There’s actually 15 BDC’s involved, some aren’t on this list. Total BDC exposure according to the picture above is ~$136 million across first and second lien debt. First lien holders mark at 94-95% of par. Second lien holders at 89-90%. When restructuring completes, second lien will be lucky to recover 40-50 cents. Those 10% markdowns are wildly optimistic.
These BDCs thought they were diversified across different middle-market credits. Instead, 517 CLOs also held First Brands, meaning everyone owned the same distressed borrower through different vehicles. This is exactly what happened with subprime mortgages in 2008.
If nine BDCs have $136M in First Brands exposure, and hundreds of middle-market companies face similar distress, aggregate BDC exposure to zombified borrowers could be $20-30 billion. BDCs mark these at 85-95% of par. Reality is probably 40-60% recovery, if you’re lucky. That’s a $10-15 billion hole in the BDC sector alone.
Apollo and Diameter were the only adults in the room, shorting this flaming turd into oblivion. Kudos to them (I guess it was through a long CDS position?), but I won’t let them off the hook either as they’ve probably got bad debts on their books that we don’t fully know about.
The Regulatory Blind Spot
The Fed cheerfully suggests that “redemption and fire sale risks posed by private credit seem to be low, largely due to its long lock-up periods.” This confidence would be more reassuring if it accounted for the $500 billion in bank credit lines backing private credit funds.
The Investment Advisers Act of 1940 provides the primary regulatory framework, a regime spectacularly unsuited to today’s complexity. A 2024 court ruling even overturned proposed enhanced oversight, ensuring the industry remains self-regulated just as selective defaults surge. Regulatory capture isn’t accidental. It preserves the illusion of low default rates that keeps capital flowing.
Act III: When Does It Fire?
As I stated in the beginning, lenders are still dancing to the music but what happens when it stops? Three scenarios ahead:
Scenario 1: Soft Landing (Unlikely)
Economic resilience allows companies to stabilize. PIK arrangements provide breathing room instead of compounding disaster. Selective defaults plateau, rates decline, corporate cash flows improve. This requires several unlikely alignments and asks private credit funds to voluntarily strengthen covenants, essentially giving up competitive advantages that fueled their growth. Don’t hold your breath.
Scenario 2: The Gun Fires (Most Likely)
A catalyst triggers a liquidity crisis: mass redemptions, high-profile defaults, or regulatory action. Funds forced to sell into illiquid markets trigger fire-sale pricing. The statistical illusion of low defaults shatters as selective defaults transform into genuine ones.
The $500 billion in bank credit facilities activates as a transmission mechanism, pulling regulated banks directly in. With global banks having extended credit equivalent to 25-30% of global private credit AUM, the contagion pathways are already built.
Recovery rates of 20-30 cents versus historical 70 cents amplify losses. The concentration of capital among top managers means coordinated responses amplify rather than dampen systemic stress.
Scenario 3: Managed Decline (Fantasy)
Regulators and industry participants successfully defuse the bomb through coordinated intervention: enhanced disclosure, mandatory liquidity buffers, stress testing. Current regulatory frameworks offer little hope. Recent court rulings have reduced regulatory authority. The political economy works against this; private credit thrives on regulatory arbitrage.
The Bank Exposure Nobody Discusses
Banks have become inextricably linked to private credit through regulatory arbitrage. They structure exposures as subscription credit facilities and warehouse lines to bankruptcy-remote vehicles, allowing lower regulatory risk weights under Basel III. Unlike crypto (which regulators propose 1,250% risk weights for), private credit facilities often receive investment-grade treatment despite backing portfolios where over 40% of borrowers have negative free cash flow.
The interconnection runs deeper. Banks hold equity stakes in private credit funds, provide FX and interest rate hedging, and offer banking services to fund portfolio companies. When selective defaults become actual defaults, losses cascade through multiple touchpoints simultaneously.
Perhaps most perversely, the regulatory blind spots that allow private credit to flourish are precisely what make bank exposure dangerous. Banks can’t properly underwrite or monitor risks they’re not allowed to fully see. When crisis hits, they’ll discover they’ve been systematically under-reserved for losses hidden in plain sight.
Watching the Trigger
There are key indicators to watch out for in Act III, some of which may already be happening, for example: accelerating redemption rates from private credit funds offering daily liquidity, increasing PIK conversion as cash interest becomes unsustainable, regulatory moves to enhance oversight, stress in bank funding markets supporting private credit operations, and credit card delinquencies and HELOCs starting to underperform.
In a non-recourse mortgage market, if you lose your job, you’ll logically gobble up as much home equity as you can. When those loans underperform, we may see a proper shake-out.
The Lesson We Should But Won’t Learn
Private credit isn’t inherently dangerous, contrary to popular belief, as they fill an important gap for businesses that may struggle to get loans from banks but execution matters as well.
The gun is loaded. The trigger is sensitive and everyone can see it except those who placed it there.
Tricolor won’t bring down the financial system. First Brands won’t be another Lehman. Carvana and PrimaLend’s ABS implosions won’t spark contagion by themselves.
But if we shrug them off too lightly, do we risk ignoring the real lesson? It’s not only about structures or ratings, but about discipline, skepticism, and humility in the face of risk.
People who think/say that any single domino will trigger a crisis are more than likely missing the point. It’s whether markets have learned anything from 2008 at all.
In classic dramatic fashion, every element introduced in Act I must find resolution in Act III. The only remaining question is not whether the gun will fire, but when, and who will be standing too close when it does.
My vote is soft lending. Marked-to-model will allow us to kick the can down the road, so things won’t hit all at once (unlike BSL).
Excellent piece, really thought provoking. You lay out the slow-burn risks in private credit very clearly, especially around liquidity, mark-to-model behaviour, and incentives.