Breaking: Private Credit Defaults Just Hit a Record High

Private credit defaults have officially reached a record. According to Fitch Ratings, the trailing 12-month default rate across 1,300 U.S. private credit borrowers rose to 6.3 percent in August, exceeding the previous record set only one month earlier. But the most important number may not be that 6.3 percent. It may be 45 percent. That's the share of August defaults caused by stressed maturity extensions, transactions where lenders give borrowers more time because those can't refinance or repay on the original schedule. And that reveals the bigger story. Private credit's rising default rate is colliding with a much wider liquidity issue. Investors are struggling to exit private real estate funds. Real estate funds. Mark Walter's financial network has been coming up more and more. It's attempting to clean up loans inside insurance companies after more than $20 billion of investments were reclassified as affiliated. We'll talk about why that's important. Banks are temporarily financing a $22 billion AI chip deal that may eventually be transferred into the bond market if the bond market will take it. And default stress is rising fastest right where it would in the downswing of a cycle. It's rising fastest among smallest private credit borrowers. These events are all connected by the same underlying factor. For all the talk of resilience, it's macro stress that is pressuring the marketplace. And that's creating unease among investors and therefore leading all of these structures and vehicles to have to find cash, hoping to keep it all together. So start with Fitch's record. The default rate doesn't mean that 6.3% of private credit borrowers simply stop making every payment. Fitch includes several types of default events, including distressed exchanges and maturity extensions. And for the third consecutive month, stressed-induced extensions represented the largest category. They accounted for 45% of August defaults. A maturity extension says the borrower can't complete the original refinancing plan. Maybe rates stayed higher than they were expected to. Maybe the company's earnings never reached the sponsor's forecast or a sale process failed. It could be there aren't willing investors who want to refinance some business at a valuation that protects the existing equity. During easier markets, a private equity sponsor could sell a struggling portfolio company before its debt matured. Another sponsor could buy it, new lenders couldn't refinance it, and everybody could keep going. Today, uncertainty, to use that term, around the economy has weakened deal flow. Buyers and sellers can't agree on prices. IPOs remain selective. Refinancing is suddenly a discussion. So lenders, they have to extend the loan. That avoids an immediate bankruptcy and preserve value if the business eventually recovers. But it also confirms that the borrower can't repay according to the original contract. The default is no longer a single dramatic event. It becomes a rolling negotiation. For the borrower, that extension buys time. But for the lender, it can trap their money in investments that they don't want to be trapped in. A private credit fund expects to receive its principal at maturity and then redeploy that money into a new opportunity, distribute it to investors, or use it to meet other obligations. But when the maturity is extended, cash doesn't arrive. The loan may continue paying interest. It may switch partially to payment in kind interest. That's where the borrower adds interest to the outstanding balance instead of paying cash. Or maybe the lender is forced to reduce the coupon in exchange for additional collateral or some kind of sponsor equity. Each solution can postpone a liquidation, but none of them guarantees liquidity. Houlihan Loki found that during the second quarter, 11.8% of loans on a size-weighted basis elected to pay at least some interest in kind. And that PIK represented 6.3% of total interest dollars. Those numbers aren't overwhelming, though they are starting to really raise some red flags. But PIK illustrates the difference between reported income and cash income. The lender can record interest while receiving less actual cash. That's the hidden consequence of an extension cycle. Losses don't necessarily appear immediately, but cash remains locked inside companies that need more time, more equity, or cheaper financing. PIK's problem is therefore not only rising defaults, it's that rising defaults make an already liquid asset class even less liquid. Before we go on with our video today, let me ask you a question. What if your gold could actually pay you every single month in more gold? That's what today's video sponsor, Monetary Metals, lets you do. And here's how it works. You still own the gold. It's still in your name. It's fully insured. But instead of just sitting there doing nothing, it actually starts working for you. Monetary Metals has built a system that turns idle gold into productive gold, earning real yield, paid in physical gold, not dollars. No selling, no trading, no converting. You keep your gold and every month you get more of it. It's a simple idea, but it solves a big problem. If gold is money, it should act like money, and now it finally can. If you're a long-term gold holder looking for a smarter way to store value, check them out at monetary-metals.com slash Snyder. Again, that's monetary-metals.com slash Snyder. I highly recommend booking a call with them today to see if they're the right fit for you. We thank Monetary Metals for their sponsorship, but now let's get back to the rest of our video. And this macro pressure is coming from both sides of the income statement, starting with most a lot of these loans are floating rate, which means that when interest rates don't go down as people had been hoping, or don't go down nearly far enough, or maybe actually turn around, at least on a temporary basis, it threatens their interest rate exposure. Now normally, a central bank would raise rates because economic growth is strong. At least that's what they've been telling us for the last couple of decades. And in that environment, companies would offset higher interest costs with stronger revenue. But the present situation is, as you know, different. Rates are being pressured by central banker uncertainty, as I went over in yesterday's video. The Fed just hiked its policy rate, even though it doesn't project an inflation problem, but its models can't say so with enough confidence that policymakers would stay on the sidelines. And this lack of commitment has created a detour in the trajectory of market rates, right as macroeconomic concerns are pressing the margins of the economy, both consumers and businesses. For a private credit borrower, that creates a double hit. Energy, labor, other input costs squeeze earnings before interest taxes, depreciation, amortization, all the stuff that's in EBITDA. At the same time, a higher base rate raises the floating rate coupon on the debt that it owes. A business with earnings equal to say, you know, two or three times its annual interest expense has room to absorb that pressure. But a highly leveraged borrower with much thinner coverage just doesn't. And then lenders look at it and say, I don't think I want to extend your loans. And many private credit deals were underwritten when investors expected rates to fall substantially. That expectation became part of the refinancing strategy. Survive the expensive period, wait for cheaper loans, and then refinance later and magically everything would be better. It was a long shot at best, but now it's just another setback and possible question mark to add to the growing list of them. If those just continue to pile up, maybe the maturity gets extended and then the loan enters Fitch's default statistics. And this squeeze from the macro top is not just for private credit to deal with. It is creating imbalances, let's call them, in other parts of the marketplace. We've been going over some of these too. One that we may not think of, real estate. Blackstone is attempting to facilitate a secondary sale for investors in a US real estate fund managed by Blackstone Property Partners, or BPP. The fund has a net asset value of roughly $11 billion, so it's not exactly a small fund here. Investors in open-ended real estate funds may technically be allowed to request redemptions, but the buildings that are owned by those funds can't be sold as quickly as shares of a public company. The cash has to come from property sales, financing, fundraising, or a secondary buyer willing to purchase an existing investor's fund interest. And all those have ground to a halt. And here's the thing. Investors are getting nervous and making more noises about getting their money back. Exactly what we see in private credit. Blackstone has attempted to, let's call it, bribe these flighty investors by reducing management fees for those who keep redemption requests below a specific threshold. Invesco, another one, has explored a tender offer and cut fees in its own US core real estate fund. Now this doesn't say that every underlying property is worthless and it's not a private credit default, but it is evidence of a growing liquidity mismatch being created because investors no longer accept the previous assumptions of a resilient economy creating perpetual fat returns with no risk. That's the downswing in the cycle. It starts by rethinking all those past bubbly assumptions and then getting answers and data from the outside that don't match on the economy while also failing to get answers or any data from those on the inside who always claim there's nothing to see here. When too many investors want out simultaneously, the fund has several choices. Sell assets, which they don't want to do. Borrow money, which they don't want to do. Limit redemptions, what they've had to do. Or offer incentives to stay to keep investors there. Or they can arrange secondary transactions, which is happening more frequently. But secondary market liquidity comes with a price. If existing investors need immediate cash, new buyers can demand a growing discount, even when the fund's official net asset value hasn't moved by the same amount. That is how liquidity pressure turns into more valuation pressure. One thing we have to keep in mind in all this is that the most vulnerable borrowers aren't necessarily those that are going to make headlines. It's just like with layoffs in the real economy. We see when big companies make mass waves of layoffs, but we never see when small companies might let go an employer too. Same thing in private credit or just credit in general. Smaller borrowers in these economic circumstances tend to struggle even more and you never actually hear about it. According again to Houlihan Loki, among borrowers with 10 million to 20 million of EBITDA, 12% of loans are now valued one in eight. In 2023, that figure was approximately 1%. So from 1% to 12%, that's a huge change. And pressure is spreading into the core middle market as well. 6% of loans to borrowers with between 20 and 100 million of EBITDA are below 90% of par, the highest proportion in three years. Among borrowers with more than 100 million of EBITDA, the figure is only 3%. Now different studies produce different default rates because they use different samples, definitions, and weighting methods. And Fitch's 6.3% figure shouldn't be directly compared with the Houlihan Loki market-wide figure that I just cited, even though they measure kind of the same portfolio. But the direction here is consistent across all of them. Stress is concentrated among smaller companies where much of the direct lending operates. Smaller borrowers generally have less diversified revenue, less negotiating power with suppliers, and fewer ways to raise new capital should they really need it. They can also be more dependent on a single private equity sponsor or lending group for the liquidity they've already retained. Fitch identified healthcare, industrial manufacturing as the most stressed sectors in August, each of them recording a 9.9% default rate. And while defaults in the much maligned software industry remain low, investors are saying it's not likely to stay that way, and software is more likely not to become a future source of credit trouble. So you put that together with smaller firms that are already struggling at the margins and in greater amounts, and the credit problem begins to build from all these different sides. And that brings us to what had been one of the most important liquidity sources of the entire credit market cycle, and that is insurance companies. And we've been talking about insurance companies for a little while here, including a couple of specific insurance companies owned by that guy by the name of Mark Walter. Two of them controlled by Mark Walter's TWG Global, Delaware Life, and Clear Spring Life and Annuity, they disclosed more than 20 billion of loans and investments that should have been classified as affiliated but never were, at least not until regulators started poking around. Affiliated doesn't mean fraudulent or worthless. Insurers can make investments involving related entities subject to regulation and disclosure requirements, which were allegedly not followed here. But what affiliation does reveal is potential conflicts, and conflicts that were never disclosed, like I said, until after authorities began looking into the matter. Now, an insurer collects premiums and makes long-term promises to pay off those policyholders, and those premiums are invested to generate the returns required to meet those future obligations. So when the insurer, the asset manager, or the borrower are all connected through some wider business network, the insurer may be financing entities that benefit its owner and not necessarily policyholders. Now, federal authorities have been examining parts of Walter's businesses. No criminal charges have been reported, and TWG itself says investors have not been harmed. The company says it's working with officials to resolve all these inquiries. But the episode demonstrates why disclosure is essential. Insurance capitals become one of the most important sources of funding for private credit and other parts of the credit markets as well. Annuity premiums are relatively stable and can be invested for long periods, making them ideal for funding these kinds of assets that don't trade frequently. The risk appears when affiliated exposure is more concentrated than policyholders, regulators, or ratings agencies ever understood, and why that might have been. Where did that money really go, and for what purposes? TWG has been pursuing transactions intended to clean up scrutinized loans on the insurer's balance sheets. Meanwhile, Walter himself has been forced to reshape parts of his holdings. He agreed to sell the Los Angeles Lakers in a transaction valuing the team at a record $12.5 billion, and he and another partner have held talks about selling their Chelsea soccer stakes to majority owner Clearlake Capital. TWG, of course, has explicitly said it's not conducting a fire sale. That's what they say, but there is no denying the unraveling of the affiliated loans at the insurance companies and the liquidity pressure it is putting on Walter. When regulars question how assets were financed, even valuable trophy holdings can become potential sources of liquidity. Stuff that was never questioned on the way up becomes a need for resolution on the way down. And so back on the credit side of the matter here, interestingly enough, is what Fitch said about software companies, because that may be the part that doesn't, forgive me here, compute. Software has been in the news, valuation, stocks, all that kind of stuff. However, default rates continue to be low, which, again, may not be exactly what you think. Using Fitch's data, the technology software default rate fell, yes, fell from 1.2%, already low in July, to just half that rate, 6 tenths of a percent in August. But that is a backward looking sign of what people might take for resilience, not proof that the sector will remain safe. Software valuations are increasingly being questioned as investors consider which products could be displaced, commoditized, or made less profitable by artificial intelligence. A software company doesn't need to miss an interest payment for that uncertainty to become a credit problem. If a potential buyer applies a lower valuation, its private equity owner may no longer be able to sell it at a price that repays the debt. And if lenders doubt the company's long-term growth, refinancing terms can tighten the theme of this video here. The sponsor may have to inject more equity or accept an extension. That's how disruption moves from equity markets into credit markets. The current default rate says borrowers in the software sector have performed well up to this point. The financing market asks a different question. What will those businesses be worth when their loans actually mature? And, of course, at the other end of the technology marketplace is AI and hyperscalers and the dramatic need for continued capital flowing in. And this is no different, to the point that it's becoming a more visible problem. Call it saturation, crowding out, just regular old limitations. It's another sign that the marketplace is not as pliant and flexible and elastic as it was, say, maybe a year or less ago. A group of 10 banks is providing a $22 billion loan supporting Blackstone and Alphabet's Crux AI cloud venture. That's going finance Google Tensor processing units and will be backed by the chips in Crux AI's customer contract. The banking group is seeking additional lenders through syndication, and some banks are also providing a billion-dollar revolving credit facility. And the $22 billion loan may eventually be replaced with longer-term financing from investment-grade bond investors, which brings up the question, why use banks first instead of going directly to bonds like you're supposed to, like everyone else has been doing so far? But bridge financing contains an assumption. The bridge should eventually lead somewhere. If the bond market becomes more selective, if yields don't come down because spreads are rising, or investors become saturated with AI-related issuance, the banks may have to hold the exposure longer or syndicated on less attractive terms. And the question is why they're doing this in the first place and whether or not they're getting pushback from the marketplace already. And SoftBank offers another signal of that same concern. Its five-year credit default swaps climbed to the highest level since 2023, as traders evaluated the risks surrounding its enormous commitment to open AI. It doesn't mean an AI crash is guaranteed. It means the cost of ensuring some AI-related credit exposure is rising. It is getting tighter. Capital is being pulled toward huge strategic AI projects, while smaller leveraged companies struggle to refinance. Liquidity is not simply disappearing. It is being rationed. That's the point. That's the takeaway. We keep seeing these signs of tightening. And that is where all these various pieces start to really converge. Macroeconomic pressure weakens borrowers. Weak borrowers request extensions. Extensions trap lender capital. Trapped capital limits new lending and distributions. Investors then look for liquidity through redemptions and secondary sales. At the same time, insurance companies face greater scrutiny over where long-term policyholder money has actually been invested. Banks commit billions to AI infrastructure while expecting, or maybe just hoping, bond investors will refinance them later on. Private funds arrange discounted exits for clients who no longer want to wait. None of that proves the private credit is about to collapse. The largest borrowers continue to perform better than the smallest. Many extensions will ultimately be repaid. Secondary markets do provide genuine liquidity. In banks, they routinely use bridge loans without suffering any kind of losses. But the record 6.3% default rate is telling us that the assumptions supporting the boom have changed. The macro forecasts are not holding up. Sponsors may not be able to sell companies on schedule. Funds may not return investor cash as they want. And bridge loans might never reach the bond market like they were supposed to. Private markets are built around the idea that patient capital can wait. The danger begins when too many people need liquidity at the same time. These are symptoms of that tightening. We're led to believe that tightening is some interest rate selection by central bankers. It's not. Real tightening is when money moves more slowly. It goes from being shoveled willy-nilly by everyone from everywhere without question or fail, no one looking at details in fine print, to more cautious, patient, selective, restrictive. And you can see that real and effective tightening in more and more of these places, as well as just as importantly, why that has been taking place. We've gone from bubble fund to now bubble accounting, and then more and more realizing there is going to be a need for bubble cleanup.