Private credit defaults hit 5-year highs as returns slide to 7%

Private-credit loan defaults at funds overseen by Ares Management, Blackstone, Blue Owl Capital and Golub Capital hit their highest levels since at least 2021 in the second quarter, with Blue Owl's nonaccrual rate reaching 2.8 percent, a five-year high.

"Some in the press have been saying 'Oh no, the sky is falling,' and some of my peers at other firms have been saying 'That's nonsense, there's no problem,'" said David Golub, co-chief executive of Golub Capital. "Neither of those is accurate. We are clearly in a credit cycle. It's not a particularly bad one, but there will be winners and losers."

The percentage of defaulted loans in Blue Owl's fund hit 2.8 percent in the second quarter, its highest level in at least five years. Nonperforming loans at Ares, Blackstone and Golub also touched five-year highs, exceeding levels reached in 2023 when the Federal Reserve hiked interest rates, squeezing corporate borrowers and triggering a broad stock and bond selloff. Bad loans so far are concentrated in healthcare companies such as dental-service provider Affordable Care and oil-price-sensitive businesses including plastic-film maker Loparex. Software companies, which make up 20 percent or more of loans in many funds, remain the key risk for analysts and fund managers.

The stress is emerging while the U.S. economy is performing well, a warning sign that losses could jump sharply if growth abates. Fund managers can ill afford more write-downs: private-credit funds that routinely delivered annual returns of 10 percent or more now struggle to reach 7 percent, and an ailing KKR-managed fund lost 6.55 percent over the 12 months through June, a slight improvement from its 9.17 percent loss in the prior period.

Watchlists Grow at Ares, Golub and KKR

Watchlists at funds managed by Ares, Golub and KKR all grew this year, reaching their highest levels since 2022-23, when rising interest rates squeezed corporate borrowers. Longer watchlists suggest more defaults could be brewing. Blue Owl's co-CEO Marc Lipschultz said his firm's watchlist has seen "no meaningful change compared with a year ago," making Blue Owl an outlier among its peers. The divergence between Blue Owl's assessment and the data from its competitors highlights the difficulty of gauging the true health of a market that lacks the transparency of public bond markets.

The watchlist expansion is notable because it is occurring while the broader economy remains solid. In previous cycles, deteriorating loan books typically coincided with visible economic weakness. The current pattern — rising stress in private credit alongside a resilient U.S. economy — suggests the sector's problems may be structural rather than cyclical, tied to the rapid growth of direct lending and the concentration of loans in sectors vulnerable to AI disruption and higher input costs.

Returns Slide From 10% to 7%

The performance decline stems from multiple pressures. Dealmaking by private-equity firms that private-credit funds lend to has slowed, curtailing new lending opportunities. Weaker company performance and a selloff in public debt markets forced funds to write down investments that are still paying interest. Benchmark interest rates have also fallen from peak levels, trimming income on existing loans.

Fund managers say the fluctuations are standard for a strategy that lends to companies with low credit ratings. But many individual investors have yet to experience a downturn in private credit, and if returns stay stuck or drop further, they may walk away. Fewer investors would make it harder for fund managers to raise capital, shrinking the supply of money available to refinance corporate loans when they come due.

While default rates are rising, they remain below previous stress periods such as the height of the Covid pandemic or the 2015 oil-price crash. Losses could abate if interest rates decline and economic activity holds up without pushing inflation higher. The last time nonaccrual rates approached current levels was in 2023, when the Fed's rate-hiking cycle peaked — and the subsequent easing helped stabilize the market.

This article is for informational purposes only and does not constitute investment advice.