Private Credit Is Exploding But There s a Big Problem

Is private credit going to be the cause of the next 2008-style financial crisis? I don't want to be alarmist because clickbait and fear-mongering are really not our style here at Funnels of Finance. But I have to admit, there are a disturbing amount of similarities to the events that led up to the financial crisis in 2008. And I don't want to see a big risk in the market and not tell you about it either. Of course, also, just like 2008, there are a lot of people who may think that they're not exposed to it, but actually could be. So that's what we're going to explore today. So let's start with the basics. What exactly is private credit? Well, it's essentially like the lending version of private equity. Private equity companies raise a bunch of money from ultra-high net worth investors and institutions, and then they invest that money in private companies on their behalf. Private credit companies do the same thing, but instead of investing in private companies, they make loans to private companies. They claim to offer higher return potential, with the trade-off that investors can't just pull their money out whenever they want. Because, of course, these are private companies, so their stocks and bonds aren't regularly traded, and there's not much of a market for them. For someone with $100 million, where this is only 2% of their assets, it makes a lot of sense. Unfortunately, it's not just institutions and the ultra-rich that are investing in private credit anymore. It's everyday investors like you and me. Private credit has become so popular that it's now even bigger than the publicly traded high-yield bond market. The industry has grown about 10x in size since 2008, to over $2 trillion in assets. And that's really the crux of the issue. It's no coincidence that the private credit market really started taking off after 2008. After the financial crisis, the government put in place new regulations that essentially said a much higher portion of banks' lending had to be to safer borrowers. And for each dollar of risky lending that they did, they had to hold much more of a buffer in altersave assets to make up for it. That worked to make the big banks safer, but it did so by pushing the risky borrowers to other places, like private credit. The unfortunate reality is that financial regulation is just basically like a big game of whack-a-mole. When you get rid of the risk in one place, it usually pops up somewhere else. And where might that be? Well, private credit is far and away the top candidate. The similarities are striking. When I think about what caused that crash, it started with an illiquid underlying asset. In the mid-2000s, that was real estate. In the mid-2020s, it's private credit. They both exploded in popularity for similar reasons. People were seeking higher yield for what they perceived as the same or lower risk. In this 2006 BlackRock primer on mortgage-backed securities, you can see some of the key advantages they were touting were high credit quality, attractive yields, and monthly income. Now Blackstone, one of the leading private credit companies, is showing that adding private credit to a 60-40 stock and bond portfolio has historically both increased return and lowered risk in addition to enhancing yield. Sound familiar? Who wouldn't want higher return, higher yield, and lower risk than the alternative, right? Both mortgage-backed securities and private credit exploded in popularity because of that. But the risk turned out to be much higher than people thought. And I think there's a good chance that that could be happening again today in private credit. In the mid-2000s, almost every mortgage-backed security was rated investment grade, meaning BBB or higher. And almost 90% of them were given the highest possible AAA rating, the same rating as the U.S. government. Actually, it's even higher than the U.S. government gets today. In private credit, when you use standard volatility metrics, you're massively underestimating the true risk. That's because private market loans don't get repriced every day like public market loans or bonds do. Think about it. If I asked you how much your investment portfolio was worth, you could tell me exactly because every stock, bond, mutual fund, and ETF that you probably own is publicly traded. And at any given time, you know exactly how much they're worth. Now, what if I asked you about your house? Could you tell me how much that's worth? Probably not. You can get rough estimates from third parties like Redfin or Housing.com or whatever, but you don't really know how much it's actually worth until you try to sell it. So does that mean that its value never changes? No. It's just that you don't see the changes, so its value appears more stable. It's similar with private assets. They're not valued every day, so they appear to be more stable if you just measure price volatility. But that doesn't really reflect the actual change in value underneath the surface. So promises of higher returns and lower risk led to an explosion of popularity, and the explosion of popularity led to depressed lending standards. In the mid-2000s, private-label mortgage-backed securities doubled because home prices were rising and, in CNBC's words, pretty much anyone with a pulse could get a loan. A two-second Google search came up with this perfect example. In today's private credit market, this chart from CR3 Partners shows how lending standards have dropped much in the same way with private credit. Bond covenants are like guardrails to protect lenders that say things like, you have to maintain a minimum amount of profitability, otherwise you have to pay us back sooner before you get yourself into real trouble and can't pay us back at all. Covenant light loans are loans that don't have very many of those kinds of protections for investors. Just like how it became really easy for high-risk borrowers to get money for houses in the mid-2000s, it's become really easy for high-risk companies to get money for their businesses in the mid-2020s. Another outcome of the higher demand was an explosion of securitization, meaning taking a bunch of different loans and packaging them together to sell them to investors. In the mid-2000s, it was usually either a CLO, a collateralized loan obligation, or variations like a CMO, collateralized mortgage obligation, or CDO, collateralized debt obligation. Don't worry, you don't need to remember those. CLO kind of encompasses them all. You can see how in the blue bars at the top, banks held fewer and fewer mortgages on their balance sheets for two reasons. One, they were losing business to non-bank financial institutions, much like how a lot more lending is done by private credit issuers today. And two, they were packaging up the loans into securities like a CLO as soon as they made them and selling them off to investors. That's why you see the second set of blue bars, private label MBS securitization, skyrocket in 2004 to 2007. In the mid-2020s, securitization of private credit isn't quite as rampant as it was back then, but it is growing. Last year, we have the tokenization of a private credit fund by Wisden Street, and now you're seeing ETF versions of private credit funds, including one that invests private credit funds within CLOs. That's right, they're back. But the biggest new risk now might be in BDCs, or specifically non-traded perpetual BDCs. These are essentially new ways for retail investors to access private credit markets that were historically mainly reserved for institutional investors. But the challenge with all these inflows is that there physically aren't that many attractive companies to lend money to. That's how you get to lower and lower lending standards, just like you saw with the rising demand for mortgage bonds in the mid-2000s. One of the key objections to the fears about private credit is that they say it won't impact the banking system that much because it's really just the alter-rich investors who own this stuff and who cares about that. But just like the mid-2000s, the links are a lot deeper than people realize. Back then, banks didn't think they were taking on that much risk because they were just packaging up most of the loans and then selling them off to investors. If the borrower can't pay the loan back, eh, not a problem. Today, you might think the banks aren't exposed, but they are. And how much is kind of hard to tell. That's because post-2008, when lending standards increased for banks, they couldn't make as many of those risky loans without holding significantly more ultra-safe money on their balance sheets in case anything went wrong. So bank lending, the navy blue line, has stagnated, while non-bank lending, the green line, has largely taken its place. Cool. So then banks are less risky now, right? Well, maybe. But what's happened is mainly that banks stopped making loans to the small risky companies directly and instead started loaning money to the big private credit companies, and then they made the loans to the small risky companies. So it was just like the mortgage crisis. On the surface, it seemed like the banks weren't that exposed, but they were, and they are. On the right, you can see that the insurance companies in purple and pension funds in red are also big investors in private credit. Just like the mid-2000s, we're seeing early signs of stress, but investors are still piling in. The New York Times laid out a lot of the risks that eventually caused the crash in this article from 2006, and now we're seeing similar signs of stress in both private equity and private credit markets, which, of course, are largely dominated by the same set of companies. Private equity distribution rates have been plummeting because they can't get out of the companies that they own at the valuations that they paid for them and the valuations that they still claim that they're worth. No one will buy them for those valuations, so they can't sell them and they can't make enough distribution. Last year, Yale was forced to sell billions of dollars of its private equity investments at a loss. They don't like to do that. Then, in the IMF's 2025 Global Financial Stability Report, they show that over 40% of BDC companies have negative operating free cash flow, up from just 25% in 2021. That means, basically, they're losing money, and with the red line, we can see that PIC lending has also risen by about 50% over the past couple of years. A PIC is a payment in kind, which basically refers to when a company can't pay back its debt with cash flows, so they either pay it back with shares of their own company or by just borrowing more. That sounds a lot like what Enron was doing before they went bust, and a rise like that is honestly pretty concerning, and we're starting to see some of these things start to break. Education software company Pluralsight went bust when But you don't go from perfectly healthy to bankrupt in a day. This is the issue with the opaque, private nature of private credit. We simply don't know how deep the problems go, and that is one of the things that is getting investors worried. Not long after Pluralsight went bust, BlackRock lost over $500 million when insurance claims manager Alacrity went safe. Then, two more private credit-backed firms, First Brands and Tricolor also went bankrupt. To be clear, a few bankruptcies wouldn't be that concerning on their own. These are high-risk loans, generally, and sometimes they don't work out, whether in private credit or in the publicly traded high-yield bond market. It happens. But what makes these worse is how recently before their bankruptcies, a lot of them were considered to be completely safe. First Brands was given a clean bill of health in an audit by BDO just six months before it went bust. Only after the bankruptcy did the value of the bonds crash from around par to below 20 cents, so down 80%. Tricolor was a AAA-rated used car dealership and subprime auto lender which packed its loans into AAA-rated securities and sold them off to investors. It went straight from AAA to bankruptcy. If that doesn't remind you of 2008, I don't know what Both First Brands and Tricolor were accused of fraud, so on the one hand, you may say, well, then that's not indicative of wider credit issues at other firms. But on the other hand, you might say, how many more of these were missed because of the relaxed lending standards and opaque nature of this type of business? Can I really trust what they say is safe? That is essentially what Jamie Dimon, the head of the largest bank in the world, was getting at when he said, When you see one cockroach, there are probably more. And he was right, because shortly after, Apollo took a $170 million loss on an Amazon brand aggregator called Perch. And BlackRock completely wrote off a loan to Infinite Commerce Holdings just three months after valuing it at 100 cents on the dollar. And British mortgage company NFS went down. Now we're seeing record redemption requests in retail private credit funds, and unsurprisingly, they're unable to meet those redemptions. And it shouldn't be surprising anyway. A lot of these funds cap redemptions. Investors should know that before investing. It's part of the deal when investing in private assets. But herein lies the problem with expanding into retail and creating all of that false liquidity with tokenization and securitization and all that nonsense. These investors are used to being able to take their money out whenever they want to. But now they're rushing for the exits only to find that the doors are locked shut. So why do so many investors want to pull their money out all of a sudden? Well, the big reason is fears over software exposure. On the left, you can see that BDCs and private credit CLOs have about a quarter and a fifth of their assets in software respectively. And a lot of people fear that software is at major risk of AI disruption. That's why since around the middle of 2025, software in dark red and the big private credit and private equity companies, all in the light colors, have sold off massively while the S&P 500 in black is slightly positive. In addition to AI disruption fears and all their exposure to hardware, these loans are also mostly floating rate, which means they go up when interest rates go up. And some people also fear that it could be even harder for these companies, many of which are already not profitable, to make their loan payments if interest rates on them go up. And a lot of investors are worried about that happening right now because the so-called excursion in the Middle East is going on a lot longer than most people expected, which is pushing up inflation and interest rates. So that brings us to the big question. Is this really going to cause the next 2008 style market crash? Well, it's possible. Like I said, the links are deeper than what most people think, and it's very opaque, so we don't really know. Banks aren't funding these companies directly, but they are funding them indirectly. And if the private credit managers go down or if interest rates rise, either of those could make it harder for these small and mid-sized businesses that they're funding to keep going. And that could have a much wider impact on the economy and jobs market than people think because they invest in many different industries. It's a super opaque market, like I said. So I can't say for sure that that won't happen, but my expectation is that it won't be nearly as bad as 2008. There's one key difference between the mid-2000s and mid-2020s in my mind. In the mid-2000s, about 40% of the new jobs created in the US economy were related to housing. I've also heard 25% before, so I don't know the exact figure, but the point is it was a lot. That meant that not only did people lose value on their homes when the market crashed, but a lot of them also lost their jobs. I don't know how much of the recent job growth has been driven by small and mid-sized companies that are funded by private credit or private equity, but I'm pretty confident it's much lower than 25%. And these companies are in very different industries, so they're not all exposed to the exact same risks. When the mortgage frenzy slowed down, you also didn't need as many loan officers or real estate agents or construction workers or architects, so forth and so on. So a lot of people lost their jobs. Then they lost their houses, and all those houses hitting the market at the same time sent the house values down. Meanwhile, interest rates were going up, so house prices were going down, and the amount that people had to pay for them was going up because a bunch of people invested in mortgage bonds that adjusted with rates. So all of a sudden, they couldn't afford their mortgages even if they did still have their jobs, and it just all snowballed from there. Even if a bunch of software companies do go bust, that's only a quarter of private credit lending, not 100% in one industry like it was in 2008. So could it be bad for private credit investors and lenders? Yes. But will it bring down the economy? I can't say for sure, but my guess is no. That said, investors really aren't getting paid enough, in my opinion, to take on high-yield risk right now, whether that be in private credit markets or in public markets like the high-yield bond market. What you're looking at here is the spread that high-yield bonds are paying over treasuries. So if a treasury bond is paying you 3% and a typical high-yield bond is paying you 7%, the spread would be the difference, or 4% in that case. It's the extra compensation that you're getting for taking on credit risk. And you can see that while it has slightly ticked up recently, it's still incredibly low relative to history. And I don't know if you've noticed, but it doesn't feel like a low-risk time in the markets right now. So I personally don't find any kind of high-yield bond attractive right now. Private credit, public high-yield bonds, BDCs, none of it. If you're looking for a safer place to park some of your fixed income assets until a straight or four moves is opened back up and the big recession risk is off the table, we partnered with Bankrate.com to help you do that. All you have to do is click the link in the description and enter your zip code. It's as easy as that. If you've made it this far, thank you so much for watching. Please don't forget to hit that subscribe button and the like button on the way out, and we'll very much look forward to seeing you in the next one.