Institutional investors remain committed to private credit despite mounting scrutiny of the asset class, but are becoming more selective around underwriting standards and manager quality.
Private credit is entering a challenging phase. After more than a decade of rapid growth, it is facing rising regulatory scrutiny, concern over underwriting standards and a series of high-profile liquidity and markdown issues. Yet UK institutional investors continue to make allocations, attracted by the prospect of long-term income and diversification into parts of the economy increasingly underserved by traditional banks.
An MSCI report in May found more than 10% of private credit loans globally have now been marked down by at least 50%, a level MSCI said is typically associated with “deep distress or risk of restructuring”. It pointed to higher interest rates as a key factor, placing pressure on heavily indebted borrowers.
The findings come amid a broader wave of valuation cuts across the industry in the US, with Reuters reporting firms including Blackstone, BlackRock and Carlyle marking downs parts of their private credit portfolios in recent weeks, particularly in software-related exposures under pressure from AI.
In February, UK non-bank lender Market Financial Solutions defaulted, echoing the earlier collapses of US borrowers First Brands Group and Tricolor Holdings. The Bank of England’s Financial Policy Committee record in April stated the cases highlighted “high leverage, weak underwriting standards, opacity, overly optimistic valuations and complex structures”.
Ross Morrow, co-founder and executive director at DunPort Capital Management, says: “As the US experience has shown, the liquidity dynamics of certain fund structures warrants close attention. Creating a liquid product from an illiquid asset class is fraught with risk, and we are now beginning to see some of those risks materialise.”
However, he adds that in the lower-mid-market, “discipline has generally held up better in Europe than in the US, largely because there’s less capital chasing the same number of deals”.
The Bank of England is now examining how stress in private markets could spread through the wider financial system, citing concerns around opacity, interconnectedness and liquidity. But for institutional investors, the more immediate question is how to continue prudently investing in the asset class as market conditions become more demanding.
The challenge for investors is to distinguish between funds engaged in disciplined lending and weaker structures that may be exposed by higher rates and worsening economic conditions.
For many large pension schemes, illiquidity is not a flaw to be avoided but a structural characteristic that can support long-term returns if managed appropriately. “We invest in private markets in the knowledge that they are illiquid,” says James Turner, senior investment manager for private credit and private equity at Nest. “We’re not trying to time markets – we’re building diversified portfolios that can perform over long periods.”
If liquidity is the symptom, credit quality is the disease.
Ross Morrow, DunPort Capital Management
Market challenges
The environment supporting private credit through much of the past decade has changed materially. Ultra-low interest rates, abundant liquidity and strong sponsor activity helped fuel rapid growth, particularly in the period immediately after the pandemic.
Patrick Marshall, CIO and head of private credit at Federated Hermes, says that competition for deals in some parts of the market, particularly the large cap market, contributed to increasingly borrower-friendly structures during the years of easy liquidity.
But higher borrowing costs are now putting pressure on companies that raised debt during the more aggressively competitive lending conditions of 2020 and 2021. Turner notes that the greatest pressure is on these older vintages, as origination took place under very different assumptions around refinancing and growth. “Some of the loans written between 2020 and 2022 are obviously under a lot more stress than those being written today,” he says.
Hear how institutional investors are allocating at PMP’s Private Credit Forum in June.
Adds Marshall: “We’re seeing payment-in-kind (PIK) toggles and all sorts of things I haven’t seen in earnest since 2003,” referring to the practice of allowing some interest payments to be added to the principal to support the borrower.”
But this does not necessarily imply a systemic issue; the problems appear to be highly dependent on manager quality, leverage levels and sector exposure.
Dunport’s Morrow believes much of the current stress is appearing “idiosyncratically rather than systemically”, a distinction that makes bottom-up research critical. “Liquidity is the symptom, credit quality is the disease.”
He says investors are likely to see increasing divergence between stronger and weaker managers as refinancing pressures build. “I believe that over the next couple of years there will be a real dispersion in the performance of different managers and different credit funds,” he adds.
Investor demand
For institutional investors, the attraction to private credit is straightforward: it offers floating-rate income, diversification from public markets and access to a broader range of companies and assets.
It also aligns naturally with the long-term investment horizons of large pension schemes. “We’re investing over decades, not for the next six months,” notes Nest’s Turner.
Nest recently announced a £450 million allocation to an evergreen US direct lending fund as part of its broader private markets strategy. Turner says the scheme’s approach is focused heavily on manager selection, diversification and ensuring that liquidity structures match the long-term nature of the master trust’s demographics.
He cautions institutional investors against conflating retail-oriented vehicles that promise relatively frequent redemptions with “fundamentally different” long-term institutional vehicles.
You need to know what’s happening under the bonnet.
Gerald Wellesley, independent trustee
Gerald Wellesley, independent trustee and investment committee chair at the Scottish Widows Master Trust, but speaking in a personal capacity, notes that evergreen vehicles can be well suited to pension schemes if they are properly governed.
He says these structures often align more naturally with the long-term investment horizons of retirement schemes than traditional closed-end funds. “Pension schemes aren’t trying to get in for five years and then take back their money,” he says. “They want to invest for the ongoing accretion of value for members who are in the scheme for potentially 60-plus years.”
At the same time, he acknowledges concerns around transparency and the potential for underperforming assets to remain hidden within evergreen structures for longer periods. “You need to know what’s happening under the bonnet,” he says. “And you need to have a means to monitor that.”
He adds that the key issue is whether trustees receive sufficiently detailed reporting to identify emerging risks before they become more serious problems.
Turner says Nest addresses these governance concerns through the use of bespoke mandates. “Everything we do in private credit is through fund-of-ones that are evergreen,” he says. “That means that we’re not subject to the [exit] decisions of other investors – they can’t affect our mandate.”
He also says the structure also allows allocations to scale gradually over time without forcing managers to deploy capital too quickly in unfavourable market conditions.
While trustees typically support the direction of travel of the Mansion House reforms, some worry that rapid deployment may encourage excessive enthusiasm and facilitate weaker standards.
“There has been a huge push by pension funds to get into private markets,” says Wellesley. “But it’s been due partly to the government pushing and it’s been a bit of a gravy train for the industry, especially in the US. Success can breed greed, which can then breed lower standards.”
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However, he stresses that he is certainly not opposed to private credit allocations. Rather, he believes investors need to become increasingly sophisticated in how they assess governance, structures and manager discipline as the market evolves.
“This is quite early days for most master trusts,” he says. “A lot of work is being done, but is the right work being done in terms of due diligence and prudence? Or is it driven more by commercial momentum to help ensure the trust win the next big insured employer opportunity?”
Wellesley warns that competitive pressure within the master trusts market could encourage schemes to move too quickly; if a significant allocation were later seen as imprudent, the consequences could be long-lasting. “It would be raised in every meeting with a consultant or prospective employer,” he adds.
Concern around standards is echoed by other asset owners, particularly around the complexity of lending structures, greater use of amend-and-extend and the potential for managers to delay recognising problems.
Russell Baird, independent trustee at BESTrustees, says investors need to think carefully about how their liquidity assumptions may be affected by stress.
Baird notes the market has not yet experienced a prolonged period of stress at its current scale, given the enormous growth in assets over the past decade. “There hasn’t really been a stress test because money has generally been flowing in rather than out,” he says. “And it’s very easy to kick problems down the road.”
Governance and transparency
The Bank of England has warned that rapid growth in private markets, combined with limited transparency and growing links between private funds, banks and insurers, could make risks harder to identify. Late last year it launched a system-wide exploratory scenario exercise examining how institutions respond to severe private market dislocations.
Morrow says any resulting regulatory tightening may be justified and prove positive for the market as it matures to become systemically important. “The Bank of England’s increased scrutiny is a natural and appropriate response to the growth of the asset class,” he says.
Marshall adds: “Some large-cap direct lenders are increasingly behaving like banks.”
Heightened scrutiny is just as important at the portfolio level. Wellesley says trustees and investment committees need to devote far more time to manager assessment, structures and operational due diligence than they do for traditional fixed income. “It’s not enough just to allocate to private credit,” he says. “You need to understand exactly what you own.”
Morrow adds: “Managers who have maintained their standards tend to have a clearly defined investment philosophy, the discipline to walk away from a deal, and a strong focus on downside protection.”
“In this asset class, you’re only as good as your worst deal. That is what will ultimately define the performance of your fund. There’s only so long you can ‘amend and pretend’ and push problems into the tail of a portfolio.”
Does it really have the diversification benefits that we give it credit for?
Russell Baird, BESTrustees
Baird questions whether some of private credit’s apparent diversification benefits may partly reflect valuation methodology rather than underlying resilience. As private assets are valued less frequently than public market instruments, there is potential to artificially smooth short-term volatility during periods of market stress.
“Private credit seemed to offer diversification because prices didn’t seem to fall as much as the public markets,” he says, reflecting on the Covid period. “But part of that is just due to the lack of visibility, a time lag, and because it’s valued in-house.”
He stresses that this does not mean private credit cannot aid diversification, but argues that trustees should remain realistic about how valuation processes can affect the appearance of stability. “Is that necessarily a true reflection of reality, or more a result of how it’s valued?” he says. “Does a fund really have the benefits that we give it credit for?”
The interviewees were generally wary about the secular risk to business models presented by artificial intelligence.
Wellesley argues that the market is increasingly having to grapple not just with cyclical downturns and refinancing pressure, but with longer-term disruptions that could fundamentally alter business models over the life of a loan. “What’s AI going to do to the businesses you’re lending to over the next five years?” he says. “That’s a difficult one.”
Trying to time the markets is a fool’s errand.
James Turner, Nest
All interviewees stopped well short of predicting major problems in private credit; instead, they highlighted the same themes of discipline, transparency and manager selection.
Turner says that for large institutional investors, the key is ensuring that liquidity expectations, governance structures and investment horizons remain aligned. “If you’re investing in illiquid assets, you need to structure your portfolio accordingly,” he says.
He also cautions against trying to predict short-term shifts in market conditions. “Trying to time the markets is a fool’s errand,” he says, arguing institutional investors should instead focus on building diversified portfolios capable of steadily deploying capital across different market environments.
Baird also raised a more nuanced concern around liquidity risk. He argues that investor concentration can become a hidden vulnerability during periods of stress, particularly if funds are dominated by investors with similar liquidity needs and governance pressures.
“You need to be aware of who else is invested,” says Baird. “During the gilts crisis, a lot of funds purely had UK DB pension schemes’ money, so everybody was running to the door at the same time.
“The strain on the fund would not be as big with a diversified group of investors, as insurance companies, banks and wealth managers are impacted by different things.”
Private credit is likely entering a far more selective phase, with higher interest rates and slower refinancing activity exposing differences in underwriting quality, leverage discipline and sector selection.
Institutional investors are not retreating from the asset class, but becoming more focused on governance, structures and the quality of underlying managers. The challenge is to identify which managers can continue generating attractive returns as the easy conditions that fuelled the market’s expansion begin to fade.