Private credit risk: Why credit quality dispersion matters more than default rates

Covenant erosion and the rise of shadow stress

Covenants used to be the early warning system. They are disappearing. Over 90% of broadly syndicated senior loans now carry no meaningful maintenance covenants. In the private credit market, fewer than 10% of loans above $500 million include them.⁶ Middle market deals still have some teeth with nearly half included two or more covenants through Q3 2025, but the direction is unmistakable.

Without covenants, stress does not trigger defaults. It triggers “amendments.” Borrowers negotiate PIK conversions, turning cash interest into more debt. As of Q1 2025, 11% of investments valued by Lincoln International included PIK interest, and 57.2% of that was “bad PIK,” meaning it was added after origination because the borrower could not pay cash. That is up from 36.7% in Q4 2021.⁷ These are not restructurings. They are not defaults. They are credits quietly deteriorating inside portfolios while the headline statistics report all clear.

When your deal pipeline is your conflict of interest

Here is the question nobody in private credit wants to answer honestly: when your biggest PE shop relationship puts a struggling company in front of you for an amendment, and that same firm represents 15% of your annual deal flow, how hard are you really going to push?

Private credit is a relationship business. Most direct lenders source the majority of their deals through sponsor coverage, which are long-term relationships with PE shops who curate which lenders get invited into their transactions. Over the past five years, PE shops have built sophisticated capital markets teams that maintain preferred lender lists and reward cooperative partners with repeat deal flow. The system works beautifully in good times, with ski trip retreats to Telluride, sporting events and concerts. In bad times, it creates a conflict of interest that sits at the very heart of the asset class.

Even end investors recognize how central origination is to the model. A manager’s ability to consistently source deals, both through sponsor relationships and independent channels, is a key determinant in allocator selection. In surveys of LPs, a majority cite origination capability as one of the most important criteria when underwriting a private credit manager, often ranking it alongside track record and fund economics. That creates a reinforcing loop: the same sponsor relationships that drive portfolio construction also drive fundraising success. 

Managers that stay “in the good graces” of large PE shops are more likely to secure repeat deal flow, deploy capital efficiently and raise larger funds. But in stressed scenarios, that dependency raises an uncomfortable question, whether the priority is maximizing recovery on an existing investment or protecting the relationships that sustain the next fund.

Exhibit 2: LP cited determining factors in selecting a private credit manager

As an illustration, when a PE-backed portfolio company starts missing projections, the private credit manager faces two choices that goes far beyond the economics of that one loan.

Proskauer’s 2025 Private Credit Restructuring Year in Review found that restructurings increasingly gravitate toward out-of-court solutions, with change-of-control transactions becoming the go-to mechanism.⁸ Out-of-court is often the right answer. But when the lender, the PE shop and the workout advisor all have reasons to avoid a messy headline, the question is whether losses are being recognized at the pace the credit fundamentals actually warrant or at the pace that keeps everyone’s track record looking presentable.

The fundraising feedback loop

This is where the incentive structure becomes truly perverse. Private credit managers raise capital on the basis of track record metrics: default rates, loss rates, realized returns. A manager who aggressively marks down troubled credits and forces defaults will report weaker near-term numbers than a competitor who accommodates and extends. In a competitive fundraising environment, the most honest manager gets punished.

Read that again. The manager with the most accurate marks may raise less capital than the manager with the most generous amendments. The system is selecting for accommodation, not accuracy.

This dynamic is especially dangerous as private credit enters wealth channels, where advisors and end investors have less experience distinguishing between a low default rate that reflects excellent underwriting and one that reflects a willingness to paper over problems. The infrastructure to make that distinction — such as granular amendment data, PIK conversion tracking and mark-to-market versus mark-to-model analysis — does not exist at scale on wealth platforms today.

These two dynamics — credit quality dispersion and origination dependency — do not just coexist. They reinforce each other. The weakest credits are precisely the ones most likely to receive accommodative treatment, and the managers most dependent on sponsor relationships are the ones with the strongest incentive to accommodate. For wealth platforms building private credit into client portfolios, this means the conventional due diligence toolkit is not adequate.

Here is what needs to change:

Private credit deserves its place in portfolios. The asset class fills a real financing gap in the middle market and offers a compelling return profile. Nobody serious is arguing it should not exist. The argument is about whether the industry’s current practices are adequate for what it is becoming.

Because here is what is actually happening: an asset class built on relationships, information asymmetry and discretionary valuation is being packaged into semi-liquid vehicles and distributed to investors who have none of those advantages. The institutional investors who built private credit understood the trade-offs. They had the resources to conduct independent diligence, the leverage to negotiate transparency, and the sophistication to read between the lines of a quarterly report. The wealth-channel investor buying a non-traded BDC through their advisor does not have those tools. They are relying on the system to be honest with them.

And the system, as currently constructed, has powerful incentives to be something less than fully honest. Not because the people in it are dishonest. Most of them are honest hard-working stewards of capital. However, because the current structure with origination dependencies, the fundraising feedback loops, and the absence of standardized reporting; rewards accommodation over transparency and optimism over accuracy.

For wealth platforms, the choice is simpler and more urgent: build the infrastructure to distinguish between these firms and their less rigorous competitors now, while capital is still flowing in and the stakes feel academic. Because when the cycle turns — and it will turn — the difference between a private credit allocation built on genuine underwriting discipline and one built on accommodative track records will not be a few hundred basis points. It will be the difference between a difficult quarter and a portfolio crisis.

The time to ask the hard questions is when nobody is making you ask them.

Following people contributed to this article:

• Bryan Hui, Executive Director, Strategy and Execution, Ernst & Young LLP.
• Ash S Verma, Manager, Strategy and Execution, Ernst & Young LLP.