Private Credit: Tricks of the Trade

Soundbite: Construction and Industrial loans were flat for 2025, while loans to Non-Depository Financial Institutions (NDFI) grew an astonishing 50% last year, from $1.2 trillion to $1.8 trillion. Private credit has never had to deal with a true liquidity crisis, and most investors had put the First Brands and Tricolor defaults behind them. The massive equity losses in software stocks have reminded investors not to forget Jamie Dimon’s cockroach warning that future defaults in private credit are coming. 

What many investors do not realize is the extent to which private loans are compromised through manipulation. In what is becoming regular industry practice, accounting tricks are occurring with higher frequency that artificially inflate income. Loan modifications avoid classifying underperforming borrowers as in default, and there has been an increase in bringing in new creditors to stabilize a troubled company that often pushes original lenders down in the capital structure.

These practices are analogous to commercial banks extending the maturity of troubled loans to avoid classifying loans as nonperforming that would require a write down and reporting a loss. Such “adjustments” mask deteriorating portfolio conditions and act as a veneer over a troubling lending portfolio. This uncertainty should result in lower valuations for risk assets to compensate investors.

These manipulations by private equity sponsors and their portfolio companies enhance the profile of deteriorating private credit conditions. As general economic conditions worsen, creating false impressions by postponing defaults will create a bigger problem down the road. Papering over problems to buy time will elevate risk premiums in the private and public markets, increasing the potential of a larger dislocation down the road. Underperforming companies will not be able to go public, and, in a worst-case scenario, may force portfolio unwinds resulting in losses on private equity investments and private credit lending. Just because there are blind spots in private credit does not mean that signs of distress do not exist, but unfortunately, we will not see it until it is too late. Many institutional investors are unaware, and retail investors who come in to buy every dip are certainly doing so without understanding the full picture.

There are three main areas where illusions are created in the private credit markets.

The first is the increasing tendency to adjust EBITDA for one-time exceptional expense items, adjustments that are now exploited by aggressive accounting practices that have become normalized. In a recent interview, Oaktree Managing Director Raghav Khanna discussed that these adjustments “are increasing in number and becoming recurring in nature.” Some of these adjustments can inflate profits by an additional half of what would have been reported following more conservative GAAP accounting.

Secondly, there are “shadow defaults” where a borrower is unable to generate sufficient cash flow to meet its debt obligations. In that case, the private credit lender is not paid back fully in cash but in more debt. This is known as Payment in Kind (PIK), and the strategy eliminates the private equity sponsor that owns the borrower from reporting a blowup, and allows the lender to avoid  reporting a default. However, the loan is past due, and technically in default. The unpaid interest is added to the loan principle, meaning the creditor has now extended additional credit to a company that failed to service its original obligation. This “solution” burdens the borrower with even more debt in the hope that business conditions improve. If they do not, then the borrower will end up defaulting on an even larger amount of debt.

According to Oaktree Capital Management, the frequency of converting unpaid coupons into  PIK stabilized after peaking in 2024. However, if the economy slows down, this practice will only accelerate across the industry, as it has become widely accepted. This brings up another issue: because the banks are essentially lending blind, they must take the PE sponsor at its word that PIK arrangements are not decreasing the likelihood of collecting future interest income.  

The third area involves an industry euphemism called a liability management exercise or transaction (LME or LMT). While it sounds harmless, it is treacherous for original lenders. An LME is initiated by the private equity sponsor and the portfolio company’s management team, who moves assets that were originally part of the collateral package. This transaction benefits the sponsor and the borrower by attracting new lending, but for existing creditors their collateral package has shrunk, reducing expected recoveries in the case of a restructuring and effectively pushing them down the capital structure.

Again, as this form of financial restructuring is becoming more commonplace, it raises the risk of faster bank write-offs if a recession occurs. Commercial banks that lent to the original creditors suddenly find that their private credit customers’ ability to recover their private loans has deteriorated, as they have been subordinated to new lenders brought in by the PE sponsor.  

The bottom line is that when private equity and credit portfolio firms cannot pay debt, the commercial bank’s lending position is compromised. Banks are often unaware of their true exposure under these circumstances, and the general investing community is certainly left in the dark. As conditions get worse, these troubled companies become more leveraged, exacerbating the downturn once the distress is finally revealed.

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Is Software Having a Going Out of Business Sale?

Soundbite: Software stocks peaked in Q3 2025 relative to the S&P 500, and since November,  have cratered on concerns that customers will migrate their business to AI-native companies. Investor anxiety over public software companies spilled over to private credit because many private credit companies have heavy portfolio concentrations in that industry. Making matters worse, many of the deals were booked at peak enthusiasm, so the worry is that even with conservative loan-to-value ratios, private credit could be sitting with excessive losses. We believe the worry is well-founded but overdone, at least in the short run.

Software, and specifically Software as a Service (SAAS) companies, are undergoing a dramatic rerating of their terminal value, which is bad news for private software lending. Additionally, hyperscalers’ never-ending need to issue debt (given their cash flow is increasingly consumed by capital spending) is creating stress in public investment grade credit markets. We noted in Pave’s Substack on Friday that high yield spreads may finally be breaking higher.

We have been consistent in our view that tight credit spreads have kept a floor under the equity market. Therefore, if spreads continue to rise, equity investors may be losing a vital pillar of confidence. Simultaneously, markets are contending with risks in private markets stemming from the aforementioned overweight exposure to software firms.

Ok, how do we measure the risks going forward?

1. We are monitoring the Fed’s H.8 report on Assets and Liabilities of Commercial Banks, focusing on loans to nondepository financial institutions (NDFIs). There are pressures pushing loan officers to expand lending, and NDFI lending is the fastest growing area for them. If lending begins to stall or even contract, as banks potentially sell a portion of their private credit loan portfolio, then the withdrawal of liquidity could signal an air pocket ahead in risk assets.
2. We are tracking the software ETF IGV relative to broad equity indices as a critical risk measure. There is a degree of hysteria in the air, but markets should stabilize once investors reduce their exposure sufficiently. We expect to see that stabilization reflected in a snapback in IGV/SPY.

SAAS companies will not be going the way of the horse-and-buggy anytime soon, in the same way that quantum computing will not be breaking public Bitcoin passwords this year. That said, while the problems mentioned above will continue to dog equity investors in the hyperscalers and software companies, private credit transactions—assuming they were executed at conservative loan-to-value ratios—have built-in shock absorbers. This does not mean that the current disruption ends well, but the group may first trace out an extended period of volatile range trading as part of a broad topping process. 

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SLOOS: According to Plan

Soundbite: The Senior Loan Officer Opinion Survey (SLOOS) for Q4 showed great concern by large banks over the threat from non-depository financial institutions’ (NDFI) considerable lending activities. We believe that big banks are planning to increase their loan income to fund AI outlays, and the push for new business could compromise lending standards to win more business. As we wrote last week, this push to expand their loan portfolio is occurring as the Fed and Treasury are ensuring that bank regulators encourage growth and reduce their regulatory oversight. Despite renewed concerns over private credit, commercial banks expect loan demand to increase, and they are prepared to compete against private lenders and also plan to continue to lend to them.

We expect lending to stay buoyant as banks determined to increase their loan portfolio interact with supervisors who are being directed to promote growth. The combination, however, is a recipe for increasing default risk.

The following line from the report stood out: “Among banks that reported having eased C&I loan standards or terms, all cited more aggressive competition from other lenders as an important reason for doing so.” Additionally, of those banks expecting to ease standards in 2026, “major net shares cited an increase in competition from other lenders as important.” We have been pushing the idea that private credit firms have forced banks to adopt more aggressive lending practices. Thanks to this report, you do not need to take our word for it, simply listen to the banks. Among those institutions easing lending standards, “aggressive competition” was unanimously mentioned as the most important reason for doing so.

The positive news from the SLOOS Q4 report was that large and middle-market firms increased their demand for commercial and industrial (C&I) loans, with expectations that firms of all sizes will increase their loan demand in 2026. Commercial Real Estate loan demand is also picking up, and large banks are easing CRE standards.

It appears banks will favor business over consumer lending. The consumer showed weaker demand “across most categories of residential real estate loans” as well as auto and other consumer loans. On a relative basis, credit card demand was solid, potentially revealing a liquidity shortfall among working families. Supporting that view, banks reported stronger demand for home equity loans but not mortgages. Banks may be contending with their own version of a K-shaped economy: businesses remain confident, while consumers appear increasingly constrained. 

Looking ahead, most banks forecasting increased loan demand in 2026 expect it to be driven initially by declining interest rates, followed by the expectation for "higher spending or investment needs due to more favorable income prospects.” Notably, 80% of large banks said the higher loan demand would not be driven by a “shift to your bank from other nonbank sources because [they] become less attractive.” For banks tightening standards, none did so because they encountered “less aggressive competition from other banks or nonbank lenders.” From all angles, the private credit industry is perceived as a formidable competitor.

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What to Look for This Week

(All times E.S.T.)

1. Wednesday, February 13 at 8:30 a.m. Consumer Price Index for January (The BLS collects this data and was delayed by the quick government shutdown last week). Core CPI was 2.6% in November and December, the lowest since March 2021. The Cleveland Fed Inflation Now service expects 2.45% in January, and the same for February. The February data will be released the week before the next FOMC meeting on March 16-17. The volatile Used Cars and Trucks component came in at a depressed 1.6% vs 3.6% in November, suggesting this line item alone could boost CPI if it reverts toward trend. Shelter inflation merits attention because it rose 3.2% in December, above November’s 3.0% reading.
2. Tuesday, February 10 at 8:30 a.m. Employment Cost Index for Q4. The trend has been lower, with the Wages component peaking 4 years ago at 1.4% quarter-over-quarter. Q3 wages grew at a 0.8% growth rate on a quarterly basis, matching the lowest level in 5 years, so a drop below there without any jump in Compensation would be welcome news for wage inflation—for the market and the FOMC.
3. Thursday, February 12 at 8:30 a.m. Existing Home Sales for January. Existing home sales have been rising consistently since the 2025 low in June at 3.95 million units. December strongly exceeded expectations with the sharpest increase in almost two years to a 4.35 million annualized rate. The increase caused an 18% drop in inventory in just one month to 3.3 months of supply, but median prices still are trending down. It is possible that home prices are reaching attractive levels, which is why this data release has our attention.

Wednesday, February 11 at 8:30 a.m., the delayed Nonfarm Payroll report is released for January. The Semiannual Benchmark Revision will be released: August 2024 it was -818k, February 2025 -598k, and August 2025 it was -911k.

The Benchmark Revision number could be the most important release of the month.

Now that the government’s Bureau of Labor Statistics has returned to its normal cadence, we will be focused on the unemployment rate. A move up to 4.5% in January could set up a Sahm Rule recession signal as early as April IF the unemployment rate continues a rise of 0.1% per month.

FOMC Voters Speaking: Governor Christopher Waller starts the week on Monday, February 9 at 1:30 p.m. on Digital Assets. Governor Stephen Miran is speaking twice that day, at 2:30 p.m and 5:30 p.m. Two of the new 2026 voters, regional Fed Presidents Beth Hammack from Cleveland and Lorie Logan from the Dallas Fed, speak Tuesday, February 10 at 1:00 p.m. and 2:00 p.m, respectively. One speech we will scrutinize is Vice Chair for Supervision Michelle Bowman’s talk Wednesday, February 11 at 10:15 a.m., after January Payrolls. Later that day at 8:00 p.m., President Logan speaks again. Governor Miran follows up on Thursday, February 12 at 7:05 p.m. with his third speech of the week. 

Quarterly Treasury Auction: $100 bln in Treasury notes: 3-year on Tuesday, February 10 and 10-year on Wednesday, February 11. Thursday February, 12 an additional $25 billion 30-year bonds will be auctioned.

Earnings: Monday, February 9 before market, Apollo Global Management (APO) should contain positive comments about their private lending practices but look for any cautionary note. Tuesday, February 10 before market, Ferrari N.V. (RACE) to see how the highest part of the K-shaped economy is faring given geopolitical concerns. Tuesday after market, Robinhood Markets, Inc. (HOOD) could lend insight into speculative sentiment. Wednesday, February 11 after market, Cisco Systems, Inc. (CSCO) and AppLovin Corp. (APP). APP is critical to see how the stock reacts after earnings. Good results that are sold into would suggest further underperformance for software. By contrast, we would look for a firm tone to suggest stabilization. Thursday, February 12 after market Applied Materials, Inc. (AMAT) could be a pivotal earnings release and conference call.

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By Peter Corey

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