The Shadow Default Rate Is Telling on Private Credit

The real story in private credit is not just gated funds, but the paper inco The Shadow Default Rate Is Telling on Private Credit

KEY TAKEAWAYS

• PIK loans allow borrowers to avoid paying cash interest by adding the interest owed to the principal balance instead. That means lenders can record income even though no cash was actually received.

• PIK loans are not automatically bad, especially when they are part of an original financing plan for a company trying to preserve cash for growth. The danger comes when PIK is added after the fact because a borrower can no longer meet the original terms.

• So-called “bad PIK” has risen sharply, reaching 6.4% of private credit deals versus 2.5% in 2021. That is far above the industry’s reported default rate of roughly 2%, suggesting hidden distress beneath the surface.

• Recent redemption gates at Apollo, Ares, and other major firms are being framed as liquidity events, but the deeper issue is credit quality. Rising PIK usage, weakening coverage ratios, and negative free cash flow are all part of the same story.

• The private credit market grew rapidly because banks stepped back after 2008 and private lenders filled the gap. Now higher rates, crowded competition, and pressure in software-heavy portfolios are exposing which managers were disciplined and which were chasing yield.

MY HOT TAKES

• A lot of private credit performance is starting to look more cosmetic than cash-driven. Reported income is one thing, but paper entries do not pay redemptions.

• The industry’s official default numbers may be understating the real level of stress. Quiet amendments and midstream PIK changes are functioning like a softer, less visible form of default.

• Apollo and Ares are not isolated incidents. They are the visible part of a broader pressure build that has been forming for months across the private credit landscape.

• This is probably not a 2008-style systemic collapse, but that does not make it harmless. Painful and manageable is still painful, especially for investors who thought they owned steady yield and easy liquidity.

• Investors should stop asking only how much a fund yields and start asking how that yield is being generated. In this environment, manager discipline and cash realization matter a lot more than glossy return numbers.

• You can quote me: “That's not a growth strategy, that's a rescue.”
  
  

PIK me up! There is an old Chinese proverb that proclaims, “may you live in interesting times.” Well, my friends, we really do live in interesting times. Now, I am not sure how old that proverb is, but Robert “Bobby” Kennedy, aka RFK, revived it in 1966 but referred to it as an “ancient Chinese curse.” I am still unsure whether it's a blessing or a curse… only history looking back on these times will truly know. Ok, sorry to drop such a heavy one straight out of the gate, but hopefully I peaked your interest. 🤔

The news cycle along with my writing and videos have been chock full of ominous warnings about some very technical economic and financial terms lately. My long-time followers know that one of the tenets on my core life mission is to demystify some of that ambiguity that traditional Wall Street sometimes weaponizes to make you feel… well, dumb. Now, even if you only watched a few of my recent videos or read only a smattering of my notes 😵‍💫, you would know that there is some real trouble brewing in the private credit space right now. Most of you have been around and in the market through the Global Financial crisis which was an eye-opener for most of us. It was, in retrospect, a learning opportunity. We learned that things outside our control can control our financial well-being. More sharply, things “we don’t understand.” Well, we learned a thing or two from that. Most of us are familiar with the implications of rising loan default and delinquency rates at this point. Some of us are aware that those rates are kind of on the rise. But in the private credit world, those may not be as straight forward as we think.

I want to talk to you today about something that most people in finance either don't completely understand or don't want to explain, because the moment you explain it clearly, a few uncomfortable questions start to surface. It's called a PIK loan, and right now it's sitting at the center of a story that's been building quietly underneath all the Apollo headlines you've been watching this week.

Let me start with the plain English version, because… well, that’s what I like to do.

When a company borrows money, the basic deal is simple–you get the cash, you pay interest regularly, you pay back the principal when the loan matures. That's how it's worked since banking was invented. A PIK loan, or Payment in Kind loan, changes that deal in one critical way. Instead of paying interest in cash every quarter, the borrower is allowed to simply add the interest they owe onto the total balance of the loan. In other words, they pay nothing today. The debt just gets bigger! The lender records income on their books–real income, as far as accounting is concerned–but no actual cash changes hands. The borrower essentially says "trust me, I'll pay you everything at the end," and the lender agrees, usually because the alternative is admitting the borrower can't make payments right now.

I want you to sit with that for a moment, because it matters. 😦 The lender is booking income. The investor (you and me) looking at that lender's fund (private credit company) is seeing reported returns. But the cash hasn't arrived. IT’S A PAPER ENTRY only. And the company on the other end of that loan is getting deeper in debt every single quarter without writing a single check.

Now here's where it gets interesting. PIK loans aren't inherently evil. When a high-growth company takes one at the start of a loan to preserve cash for expansion, that's a legitimate financing tool. The problem–and this is the problem we're living through right now–is when PIK gets inserted into a loan midway through, after the original deal was already done. That's not a growth strategy. That's a rescue. It means the borrower couldn't make the payment they originally agreed to make, and rather than call that a default, both sides quietly amended the agreement so the clock could keep running.

That version of PIK, what analysts call "bad PIK," now accounts for 6.4% of all private credit deals, up from just 2.5% in 2021. The official default rate the industry reports? Around 2%! So the number of companies that are technically current on their loans but surviving only because someone quietly changed the terms midway through is more than three times the number of companies that have formally defaulted. That gap is what people are starting to call the shadow default rate.

This is the story underneath the Apollo story. When Apollo's $25 billion private credit fund received redemption requests for 11.2% of its shares last week and could only honor 45 cents on the dollar, most of the coverage focused on the gate itself– the mechanics of being locked out. What got less attention is why investors wanted out in the first place. They're not just reacting to headlines. Sophisticated investors have been watching PIK usage climb, watching interest coverage ratios deteriorate, watching the percentage of borrowers with negative free cash flow reach 40% according to the IMF, and they've been doing the math. Ares followed Apollo just yesterday, gating their own fund under identical circumstances. This isn't two firms having a bad quarter. This is a stress fracture running through an entire asset class.

And here is something the headlines have almost entirely missed. Apollo is not alone. At Ares Capital, PIK payments represented roughly 15% of net investment income last year. At Blue Owl, 16%. Both of those numbers sit above the threshold that industry analysts flag as the warning zone for liquidity stress, and both firms were already there before a single gate went up. Blackstone's flagship private credit fund faced nearly $4 billion in withdrawal requests and had to inject its own capital just to satisfy them. BlackRock restricted withdrawals on its $26 billion dollar HPS Lending Fund. Morgan Stanley got repurchase requests for nearly 11% of its North Haven Private Income fund. Cliffwater saw investors trying to pull 14% out of its $33 billion dollar fund and could only honor 7%. By the time Apollo and Ares made headlines this week, they weren't the beginning of something. They were the latest in a line that had been forming for months. The gates are the part you can see. The PIK levels are what was building underneath, quietly, for years.

I've spent the last several weeks talking about the private credit market in fairly stark terms, and I want to do something a little different today, because I think the nuance here actually matters. The private credit market grew to roughly $3 trillion–with ‘T’--on the back of a genuinely good idea. Banks, constrained by post-2008 regulation, pulled back from lending to mid-sized companies. Private credit stepped into that vacuum and, for a long time, did it well. Yields were attractive, defaults were low, and institutional investors from pension funds to endowments happily allocated. The original sin wasn't the idea. It was what happened when competition for deals intensified, rates stayed high longer than anyone expected, and software companies, which became the single largest sector in most private credit portfolios, started getting squeezed by AI faster than anyone's models had accounted for.

The result is a market that looks healthier in the headlines than it does in the ledger. And that gap–between the reported number and the real number-is exactly the kind of thing that tends to close suddenly rather than gradually.

Here's what I'd want you to think about if you have exposure to this asset class, directly or through a fund. The question isn't whether private credit is in trouble. The question is which managers were disciplined about what they lent against and at what price, and which ones were chasing yield in a crowded market and quietly amending their way through the consequences. Morgan Stanley is projecting default rates could reach 8% in a stress scenario concentrated in software-heavy portfolios. TO BE REALLY CLEAR, that's not systemic collapse. Morgan Stanley themselves said it's painful but not a repeat of 2008. But painful and manageable still means some funds get marked down, some investors wait longer than they expected for their money, and some borrowers who have been rolling their PIK balances higher every quarter finally reach the point where the math stops working.

The investors who come out of this cycle well won't be the ones who panicked when Apollo made the news. They'll be the ones who asked the right question before the news broke: what's actually in this fund, how much of the income is cash versus paper entries, and how many of these loans look the way they do because a company is genuinely growing versus because somebody quietly changed the terms eighteen months ago?

The shadow default rate is already at 6.4%. The gates are already going up. The time to understand what you own is right now, while the market is still giving you the chance to ask the question calmly. Take a deep breath. Put your pencil down–class dismissed. 🤭

YESTERDAY’S MARKETS

Yesterday was a give-back day after Monday's Iran-driven relief rally, with the S&P slipping 0.37%, the Nasdaq dropping 0.84%, and the Dow shedding 0.18%. Not surprisingly, energy was the only sector in positive territory, with Brent crude pushing back above $104 as Iranian state media denied Trump's claims of “productive peace talks.” Also, not surprising, Tech led the selling, with Salesforce off more than 6%, IBM down over 3%, and the software ETF IGV now down 23% year to date. The 2-year Treasury yield spiked more than 11 basis points to 3.94% following a weak auction, a reminder that the bond market is NOT buying the peace narrative either.

NEXT UP

• No major economic releases today, but Fed Governor Stephen Miran will talk today. The last remaining uber-dove will share his thoughts on digital assets. Hopefully we get a bit more from him. Likely as FOMC members love to talk–especially ones in the minority. 😉

• Important earnings today: Chewy, Cintas, Paychex, Beyond Meat, and Jefferies Financial Group.