Morgan Stanley expects the US private credit default rate to reach 8%, and industry giants admit: All valuations are wrong!

Concerns about the private credit market continue to spread on Wall Street.

In a report released Monday, Morgan Stanley analysts pointed out that software industry loans have the highest leverage and lowest coverage in the private credit market, and default rates may approach the peak levels seen since the pandemic.

The report notes that as advances in artificial intelligence continue to disrupt the software industry, software companies' debt repayment ability is weakening, and the default rate for direct loans will climb to 8%. Direct lending is a form of private lending where non-bank institutions (such as asset management companies, private equity funds, insurance companies, etc.) bypass traditional financial intermediaries like commercial banks to lend directly to companies.

Meanwhile, according to The Wall Street Journal, Apollo Global Management co-president John Zito recently used unusually sharp language in a private setting, directly criticizing the “arrogance” prevalent in private markets, noting that private equity valuations are generally distorted and risks far exceed market perceptions.

John Zito pointed out that many software companies acquired between 2018 and 2022 were wrongly valued, and the related private credit faces huge downside and default pressure.

Morgan Stanley: Default rates may rise to 8%, recession probability revised up

Morgan Stanley analyst Joyce Jiang warned in a team report that although the impact of artificial intelligence on the credit fundamentals has yet to emerge, the trend of weak coverage is likely to continue as AI disruptions evolve.

“Coverage” refers to the interest coverage ratio (EBITDA divided by interest expense) for borrowers in the private credit sector. Morgan Stanley believes software companies’ operating profits are already showing signs of struggling to cover their debt interest.

Morgan Stanley data show that software companies are the most heavily weighted industry in the portfolios of business development companies (BDCs), with risk exposure at about 26%. Private credit Collateralized Loan Obligations (CLOs) have a 19% risk exposure to the software industry.

CLO is an asset securitization product, which bundles hundreds of corporate loans (typically leveraged loans) into a resource pool, then issues securities of different risk levels backed by the pool to investors.

Citing PitchBook data, Morgan Stanley noted that 11% of software loans in direct lending will mature in 2027 and another 20% in 2028, creating a concentrated maturity pressure that highly overlaps with the deepening impact of AI.

Morgan Stanley analysts stated:

The credit fundamentals for software loans are under pressure, with the highest leverage and lowest coverage among major industries.

Morgan Stanley analysts noted that cooling retail demand for private credit may drive the investor structure to gradually shift toward institutions and restrain the market's future growth.

As of the end of the third quarter last year, business development companies held $530 billion in assets, with heavy retail investor participation. Their inherent lack of liquidity has triggered widespread concerns about the risk tolerance of less experienced investors.

However, the bank also emphasized that while the overall credit risk is significant, it does not currently constitute a systemic threat.

Software company exposure is the biggest hidden risk

John Zito, co-president of Apollo Global Management, believes that software companies acquired between 2018 and 2022 commonly face three problems: lower revenues compared to similar listed companies, smaller scale, and deals struck at much higher valuations.

He cited the example of Thoma Bravo’s privatization of software company Medallia for $6.4 billion in 2021, noting that the credit situation of this deal "will be worse than market expectations." Multiple Medallia creditors, including Apollo, have already written down related debt.

Zito criticized the logic of using strong performance of listed tech companies to support overall optimism:

Most acquired companies are lower quality than those listed, are smaller in size, and are traded at far higher valuations—anyone saying ‘no problem’ clearly does not truly understand.

He also noted that the AI wave is forcing companies to hurriedly deploy technology before it is truly mature, which will be an early signal for broader economic slowdown, and he stated he believes the probability of a recession is "over 50%", and it is more of a "consumer-confidence-driven recession."

Private equity valuations are generally inflated, transparency is questionable

Zito also raised questions about the cognitive contradictions within the private markets.

He observed that investors are eager to buy private equity secondary market shares, yet are cautious about financing the 80% of private credit for these assets—even though the latter is in a more senior position in the capital structure. He said:

This doesn’t make sense logically, but maybe I misunderstand. Whenever I say this, I’m usually met with blank stares.

On the issue of valuation transparency, Zito made Apollo’s position clear and considers it a competitive advantage:

If you do not mark to market, you will actually lose client trust. We will be the true market leader in marking to market.

He also warned that the next market cycle will be a "major moment" for the private market, and those participants who grew through wealth management channels with an "arrogant" mindset will face a tough test.

Apollo claims its positions are solid, but admits it’s hard to escape unharmed

Despite Zito’s cautious attitude toward overall industry risk, he still sought to support Apollo’s own credit business. He stated that 95% of assets on Apollo’s balance sheet are investment-grade, and its exposure to the software industry is very low.

He predicts that private credit loans issued in the next 12 to 18 months will be "better quality years" in terms of company quality, leverage, documentation terms, and spreads.

However, Zito also admitted that if the economy does fall into a severe recession, Apollo will also find it hard to escape losses:

I am sure we will also be hurt, like everyone else, but I believe we will come out better, and we have enough flexibility to buy quality assets during that period and earn considerable returns.

On redemption management, he favors sticking to a quarterly redemption cap of 5% to protect the interests of existing investors, warning that decisions to meet redemption demands in the short term would be "a very bad decision you will realize a quarter later."

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