Investors at the Private Credit Gate

Welcome Change

The evolution of institutional direct lending markets for true middle market companies has redefined the availability of capital in the 21^st century. The migration of such lending from banks to a diverse set of institutional hands also reduced net leverage in the banking system by converting bank loans—some of which were implicitly levered ~10x on bank balance sheets—into institutional investments with average leverage level around 0.7x.¹ This is success in syndicating risk and reducing systemic risk by any definition. 

Along the way, investors and certain managers made out handsomely, in large part because the economy has avoided a classic, broad-based credit cycle for nearly two decades.² Therefore, losses have been lower and returns have been higher than would have been expected otherwise.

That combination of ideal circumstances is due to change. If this change is upon us, we consider this an expected—and welcome—phase of the private credit investment cycle. It will allow stronger managers with stringent underwriting standards to generate better returns, potentially attracting more capital. Weaker or troubled managers, unable to raise new funds and unable to reward key personnel, will likely exit the stage, benefitting the broader private credit ecosystem as a result.

The Cost of a Cardinal Rule

Although direct lending investments may be relatively new for some institutions and global wealth investors, the novelty does not negate the laws of finance: credit cycles will still materialize, and all credit strategies that seek to minimize principal loss for a given level of risk generally outperform.

Asset managers who put 20%, 30%, or more of their portfolios in one industry—e.g., enterprise software (Exhibit 1)—ignore the one true “free lunch” in investing—diversification. Lax underwriting and risk management standards are a recipe for problems in any credit-oriented investment strategy.  

Exhibit 1

The Tech and Software Concentration in U.S. BDCs

For many years, enterprise software companies were lucrative investments for private equity (PE) firms. The companies have low capex needs and grew quickly with stable revenue streams and high EBITDA multiples.  PE firms purchased proven companies from venture firms and grew them, often by rolling up competitors.  The PE sponsors subsequently sold the companies to larger competitors or strategic buyers and started the process over again. With high purchase multiples, the companies could carry nominally low levels of debt (e.g., debt-to-enterprise value of 30-40% while debt-to-EBITDA was elevated at 8-10x). PE sponsors—many of which operate direct lending platforms involving their portfolio companies—were writing equity checks of 70% of the purchase price, confident that they could sell at higher valuations amid growing EBITDA and sustainable multiples. The sponsors would make money even if multiples contracted moderately. What could go wrong?

While PE exits were already slow, hence extending the effective life of direct loans, the unprecedent speed and power of AI development put software business models at risk. Anticipating the emergence of AI as an existential risk would have been a great call in hindsight, but exercising proper risk management is a more reliable defense against principal loss (see Exhibit 2 for context). Although concentrated software allocations are not new and remain widespread, the slew of jarring headlines understandably prompted investors to request redemptions from direct lending vehicles.  

Exhibit 2

The Real Credit Issue May Lie in Concentration Risk

Mind the Gate

This brings us to the intersection of private assets, semi-liquid vehicles, and investor behavior. Each firm that created a semi-liquid direct lending vehicle—a business development company (BDC), interval fund, tender offer fund, evergreen private GP/LP fund etc.—started with a lengthy discourse about the vulnerability of such funds to a “run on the bank.” That is, the inherent liquidity mismatch between direct lending investments (around a 3-year average life and illiquid) and semi-liquid vehicles is plain to see, and it was only a matter of time before liquidity was tested and redemption gates were involved. 

Without rehashing the events of the last several months, Exhibit 3 shows the recent history of redemption requests in non-traded BDCs. As these requests have mounted, managers have resolved them differently. One manager successfully pursued a large secondary trade of their full portfolio and consequently redeemed 30% of its fund. Another manager used firm and partner resources to redeem nearly 8% of its BDC, 3 percentage points higher than its contractual obligation. A third manager opted to limit its redemption requests to its contractual 5% requirement, leaving some liquidity-seeking investors standing in the queue before the gate, hoping to pass through in the following quarter. 

Exhibit 3

The Q1 2026 Surge in BDC Redemption Requests

We think the latter example is an important one because it is how the redemption process was contractually meant to work. If the only precedent came from managers who took extraordinary measures to provide liquidity in excess of their contractual obligations, that could have added some moral hazard to the situation and contributed to a less-than-healthy outcome for the market.

Over time, the investment tradeoff between higher investment returns and illiquidity can be worthwhile, provided investors are forewarned of the provisions. Managers’ redemption processes have generally been transparent, including disclosures pertaining to the 5% quarterly redemption threshold. Some investors may feel differently about that liquidity-return tradeoff after recent events, and, if so, the growth of private credit in semi-liquid vehicles could moderate. However, we think investors will adjust and assume a more cyclical pattern of investing, just as they have in the market for floating-rate loan mutual funds over the last 30 years when outflows often exceeded 10% of assets under management (Exhibit 4). That market history suggests that the recent behavior by investors in semi-liquid credit vehicles is expected under challenging conditions.  

Exhibit 4

The Cyclical Pattern of Quarterly Flows into Floating-Rate Mutual Funds 

What’s in a Vintage?

If history is a guide, the 2026 vintage of direct lending loans could be a good one. The natural reaction to a credit cycle and/or mistakes in portfolio construction is to become more conservative. Therefore, some investors may need to be enticed with better terms or higher coupons to allocate new capital within the sector. However, the core institutional appetite for direct lending remains strong, and indigestion within semi-liquid vehicles is more likely to slow growth than reverse private credit’s decade-long run. With these potential reactions in mind, the quality of this year’s direct lending vintage should become clearer over the coming quarters, and investors at the private credit gates will surely be watching.