When it comes to private credit, 'some caution is reasonable,' advisor says. What to know

As headlines swirl about trouble in the private credit market, investors might wonder whether it means significant problems lie ahead for these assets.

Right now, pockets of weakness exist. Those shouldn't be ignored, but they don't foretell a broad-based meltdown among private credit funds, some financial advisors say.

"Some caution is reasonable, but the idea that private credit is on the verge of widespread trouble is overstated," said certified financial planner Crystal Cox, a senior vice president for Wealthspire Advisors in Madison, Wisconsin.

"Some of the pressure you're seeing in headlines … has more to do with a maturing market than systemic stress," Cox said. "What's really happening is the shift from a young, high-return market to a more competitive, mature one where manager selection and underwriting discipline matter a lot more."

Overall, any exposure to private credit should be a small share of your investments, said Cox.

"For most individual investors, keeping it to no more than about 5% of the overall portfolio is a sensible way to access the benefits without taking on concentrated credit or liquidity risk," she said.

At its core, private credit refers to loans made by investment firms directly to companies. Asset managers raise money from investors, pool it into funds and use that cash to loan to businesses — generally charging higher interest rates in exchange for taking on more risk. Often, the interest rate floats, meaning that as the benchmark rate set by the Federal Reserve rises or fall, so do the rates paid by borrowers and earned by investors.

The appeal of private credit has included the opportunity to earn returns that may be higher than in debt investments in the public market, i.e., government and corporate bonds. However, it also comes with less transparency, higher fees, a lack of liquidity — meaning an investor's money would be tied up for a lengthy period — and higher risk.

Private credit is "diverse, with lots of different [lending] strategies," said Richard Grimm, a managing director and head of global credit for investment firm Cambridge Associates in Boston. "There are real pockets of concern, portfolios of concern, but the vast majority are highly cash generative and have a highly diverse portfolio."

The market grew rapidly following the 2008 financial crisis, when tighter banking regulations prompted many lenders to pull back from riskier loans. Private funds stepped in to fill that gap and have since expanded into an estimated $1.7 trillion corner of the broader alternative investment world, up from about $500 billion 10 years ago, according to 2024 research from the Federal Reserve. 

Most private credit funds are available only to institutional investors — pension funds and insurance companies, for example — and wealthy individuals who meet certain asset and income criteria. These funds typically have high minimum investments — $1 million and upward — and investors must agree to have their money locked up for, say, seven or 10 years. Due to that illiquidity and risk, investors receive higher-than-usual interest payments along the way and get their principal back at the end of the term (assuming the borrower doesn't default).

About 80% of investors in private credit funds are institutional, as of the end of 2024, according to J.P. Morgan Private Bank.

While pensions are major investors in private credit, 401(k) plans have generally excluded these assets from their lineups. Less than 2% of plans have incorporated private assets — which includes private credit — in their 401(k)s via custom target-date funds or similar offerings, according to an estimate from Cerulli Associates. A small number also offer private real estate in their lineup.

However, last August, President Donald Trump issued an executive order aimed at encouraging more alternative investments in 401(k)s, which includes the private markets.

A formal proposal is expected soon from the Labor Department, although the timing is uncertain. The agency submitted a proposed rule for review to the White House's Office of Information and Regulatory Affairs on Jan. 13.

Retail investors have several other ways to invest in private credit. There are exchange-traded funds that invest in such funds, for example. There are also business development companies, or BDCs, as they're known, which make private loans to companies. Both ETFs and public BDCs trade on an exchange — meaning they are generally easy to buy and sell.

Then there are some funds that are semi-liquid, including interval funds and non-traded BDCs, available to retail investors, although they may come with minimum investments or investor qualifications.

These funds allow investors to pull money out at certain times — for example, quarterly — and typically cap redemptions at a percentage of net assets, such as 5% per quarter. If withdrawal requests exceed that cap, investors may only receive part of the amount they wanted.

"Most of the time they can fill those redemption requests," Cox said. "If they get too many, they can cap them."

Limiting withdrawals generally is intended to balance investor access with the fact that the underlying loans are private and largely illiquid.

It's some of these semi-liquid funds that are grabbing headlines, due to high redemption requests from investors, who have watched yields fall as overall interest rates have eased since 2022.

Since then, while private credit overall still pays more than comparable public debt markets, the extra yield that investors get has been cut in half, according to research from J.P. Morgan Private Bank.

"We'd argue part of the rise in redemptions is related to taking profits after almost three years of meaningful outperformance," the research says.

Nevertheless, experts are sounding the alarm about the potential for higher default rates in certain parts of the private credit world.

Among deals involving direct lending, defaults are expected to rise to 8%, up from the current 5.6%, according to new research from Morgan Stanley. Direct lending is just one way that private credit funds may deploy their capital; there's also asset-backed lending — where particular assets are used as collateral — and buying distressed debt, for example.

The defaults are expected to be driven by artificial intelligence disruption with concentration in software and AI-adjacent sectors, according to Morgan Stanley.

"The AI trade is disrupting everything … specifically software," Cox said. "So that's a riskier [investment] at this juncture."

Software exposure among private credit funds that do direct lending is an estimated 26%, according to Morgan Stanley. 

"What we're seeing is less a private credit crisis and more a manager-selection and structure test [in] a broader technology transition, particularly around AI's impact on software-heavy business models," said CFP Scott Bishop, a partner and managing director with Presidio Wealth Partners in Houston.