For fifteen years the private credit conversation has been about origination: how much capital the asset class could raise, how quickly it could take share from banks, how wide a spread it could earn over the syndicated market, and which wrapper would carry it to the wealth channel. That phase produced a market of roughly 1.5 to 2 trillion dollars by the end of 2024, according to the Financial Stability Board, growing at 13 to 17 percent a year across major jurisdictions. It also produced a client base, across United States offshore accounts and onshore Latin American portfolios, that holds private credit for one reason above all others: income.
The phase that is now beginning is about something else. In August, Fitch’s private credit default rate reached 6.3 percent on a trailing twelve month basis, a record for the series. The Proskauer Private Credit Default Index, covering 716 senior secured and unitranche loans, put the second quarter rate at 2.51 percent. Both are accurate. The gap between them is almost entirely a question of whether a payment converted to payment in kind, or a maturity extended under pressure, counts as a default. Meanwhile Lincoln International recorded 22.3 billion dollars of lender takeovers in the first half of 2026, against 24.2 billion dollars for the whole of 2025, with roughly 70 percent of those companies originally bought out in 2021 and 2022. And on September 16 the Federal Reserve raised its policy rate for the first time since 2023, to a range of 3.75 to 4 percent, reversing part of an easing cycle that private credit borrowers had been counting on to refinance.
This paper makes four arguments. First, the disagreement over default rates is not noise to be averaged away; it describes a market that has chosen accommodation over enforcement, and accommodation defers rather than removes the economic loss. Second, the end point of accommodation is increasingly ownership, which means that a growing share of what sits inside income vehicles is not a loan at all but the equity of a restructured company, valued by the manager and paying no coupon. Third, the academic evidence on creditor control, and on the risk adjusted returns of private debt funds, suggests that the next decade of private credit returns will be determined less by what managers originated than by what they recover, and that recovery is a distinct capability that many lending platforms were never built to provide. Fourth, for the offshore and Latin American corridor, the shift from lender to owner changes the character of what the client holds in ways that matter for income expectations, reporting and, in some structures, tax, and Brazil’s own record wave of judicial reorganisations offers a local preview of the same problem. Section I sets out the measurement problem. Section II addresses the rate reversal. Section III follows the path from amendment to ownership. Section IV examines what an income vehicle holds after a workout. Section V turns to the evidence on recovery. Section VI addresses the corridor. Section VII converts the argument into questions.
Six Point Three, or Two Point Five
The private credit market currently produces two families of default statistics, and an adviser who quotes either without the other is telling a client half the story. The first family measures payment and covenant failure in the narrow sense. Proskauer’s index, which tracks loans with 195.6 billion dollars of original principal, reported a default rate of 2.51 percent for the second quarter of 2026, down from 2.73 percent in the first quarter. Lincoln International, which values a large share of the middle market’s loans each quarter, reported a covenant default rate of 2.7 percent in the second quarter, down from 3.1 percent. On these measures the market looks stressed but stable, and in some respects improving: Lincoln’s portfolio companies grew earnings by 5.6 percent year on year in the second quarter, with 64 percent of them reporting growth.
The second family uses the full rating agency definition, which treats a distressed exchange, a deferral of cash interest or a maturity extension granted under pressure as a default. Fitch’s United States private credit default rate, built on that definition, reached 6.1 percent in July and 6.3 percent in August, the highest level in its history, with fourteen default events in August alone. The composition is the revealing part. In the twelve months to January, Fitch attributed roughly 60 percent of default events to interest deferrals and payment in kind elections, 27 percent to distressed maturity extensions, and only 6 percent to outright uncured payment defaults, with bankruptcies and formal restructurings making up the remainder. In other words, close to nine tenths of what the broad measure counts as default is, by construction, largely invisible to the narrow one.
The Financial Stability Board, in its first comprehensive assessment of the asset class in May, framed the same gap from the supervisory side: outright defaults of around 1 percent, rising to roughly 5 percent once selective defaults are included, a level it described as comparable to the high yield market. It also noted that around 12 percent of private credit loans now carry payment in kind features, that half of those are toggles allowing the borrower to switch from cash to accrued interest, and that the use of a toggle is associated with a one to two percentage point increase in the probability of subsequent delinquency. Lincoln’s own data put payment in kind interest in 11.1 percent of loans in the second quarter, and it isolates what it calls bad payment in kind, where cash interest was converted to accrued interest after the loan was made, presumably because the borrower could not pay. That figure stood at 6.2 percent of all loans, or 55.4 percent of the loans with any payment in kind feature at all.
Neither family of numbers is wrong, and neither is being used dishonestly. The point is that they measure different things. The narrow measure describes how often lenders have been forced to act. The broad measure describes how often borrowers have been unable to meet the original bargain. In a market where lenders are few, relationships are long, and the lender’s own net asset value depends on the mark of the loan, the first number will always run below the second. The distance between them is a measure of how much accommodation is outstanding. In the summer of 2026 that distance is close to four percentage points, and it is growing.
The Rate Reversal
Accommodation is a rational strategy when the lender expects conditions to improve. Extending a maturity for a borrower who cannot refinance today makes sense if refinancing will be possible in eighteen months; converting cash interest to accrued interest makes sense if the borrower’s cash flow is expected to recover, or if base rates are expected to fall enough to restore interest coverage. Much of the accommodation granted through 2024 and 2025 rested, implicitly or explicitly, on the second expectation. The easing cycle that began in September 2025 appeared to validate it.
The September 16 decision changes the arithmetic. The Federal Open Market Committee voted unanimously to raise the federal funds target range by 25 basis points, to 3.75 to 4 percent, citing persistent pressure in energy and consumer prices. It was the first increase since 2023. A single quarter point is modest in isolation, but private credit is an almost entirely floating rate asset class, and the borrowers most dependent on lower rates are precisely those that have already used up their accommodation. The Boston Fed’s analysis of business development company portfolios, published in August, found that the share of loans carrying payment in kind interest rose from about 6 percent in early 2022 to about 10 percent in early 2026, and that in construction it went from under 5 percent to nearly 20 percent. Those borrowers did not plan for a hiking cycle.
The reversal also exposes a structural tension that sat beneath the income story throughout the easing phase. Lower base rates had already compressed the income of lending vehicles. Spreads on business development company loans narrowed by roughly a full percentage point over two years, according to the Boston Fed, even as borrower quality deteriorated, and several of the largest listed vehicles reduced their base distributions in the second quarter, citing lower base rates and tighter spreads. A rising base rate partially reverses that compression for the lender. It does so by transferring the cost to borrowers whose interest coverage is already thin. The income the client receives goes up slightly; the probability that some of that income will be accrued rather than paid, or that the loan generating it will be converted into something else, goes up more.
There is a second channel that receives less attention. Private credit funds are themselves borrowers. Subscription lines, net asset value facilities and portfolio leverage are the main forms of bank exposure to the sector, and the FSB estimated direct bank lending to private credit at around 220 billion dollars on supervisory data, with commercial estimates of 270 to 500 billion dollars. Banks have been tightening. The Federal Reserve added dedicated questions on lending to nondepository financial institutions to its senior loan officer survey for the first time in April, and respondents reported tightening standards across every category of nonbank lender even as demand from private funds strengthened. A lender that is itself facing tighter terms has less room to carry a borrower through another extension, and more reason to resolve the position.
The Keys Change Hands
The path from a performing loan to an owned company is now well worn, and practitioners describe it in almost identical terms. The first response to stress is an amendment: covenant relief, a maturity extension, or a conversion of cash interest to payment in kind. The second is a request for the sponsor to inject fresh equity in exchange for further relief. If the sponsor declines, because the equity is out of the money or because the sponsor’s own fund is near the end of its life, the lenders take control, typically by converting some or all of the debt into equity and installing new governance. Private credit makes this path smoother than the syndicated market does, because a typical direct lending deal has five to seven lenders rather than hundreds, and those lenders tend to negotiate pro rata, inclusive solutions rather than the aggressive liability management exercises that have pitted creditor against creditor in the broadly syndicated market.
What is new is the volume. Lincoln’s figure of 22.3 billion dollars of lender takeovers in the first half of 2026 compares with 24.2 billion dollars for all of 2025. On a straight annualisation, 2026 will produce close to twice the previous year’s total. The vintage concentration is equally telling: around 70 percent of the companies taken over were buyouts completed in 2021 and 2022, at the peak of entry valuations and the trough of interest rates, financed on the assumption that both would persist. Average entry multiples have since come down, to 12.0 times earnings before interest, tax, depreciation and amortisation in the first half of 2026 from 12.8 times a year earlier, which means that the equity cushion beneath many of those loans has been eroded not only by weaker operating performance but by the market’s revaluation of what such companies are worth.
The academic literature suggests that lender control is not, in itself, bad news. The most cited study of creditor intervention, by Greg Nini, David Smith and Amir Sufi, examined United States nonfinancial firms from 1996 to 2008 and found that between 10 and 20 percent of firms report a financial covenant violation in any given year. Following a violation, acquisitions and capital expenditure fall, leverage and shareholder payouts are cut, chief executive turnover rises, and operating performance and share prices subsequently improve. Creditors, in short, can govern. The finding is important and frequently cited in defence of private credit’s covenant heavy model, and S&P’s review of more than 1,400 private loans found that around 90 percent carry financial maintenance covenants, against very few in the syndicated market.
The finding also carries an assumption that deserves to be made explicit. Nini, Smith and Sufi studied creditors intervening through covenants while the borrower remained under the control of its existing owners. A lender exercising a covenant to force a reduction in capital expenditure is acting as a disciplined creditor. A lender that has converted its loan into a controlling equity stake is acting as a private equity owner, with responsibility for strategy, management, follow on capital and eventually exit. Those are different jobs, staffed by different people, and the second is not one that most direct lending platforms were originally designed to perform at scale. Some of the largest managers have built dedicated restructuring and operating teams; many have not, and the distinction rarely appears in a fund factsheet.
What an Income Fund Owns After a Workout
Consider what happens inside a semi-liquid private credit vehicle when one of its loans is converted into equity. Before the conversion, the position paid, or was contracted to pay, a floating coupon of perhaps 4 to 5 percentage points over the secured overnight financing rate, the median spread the Boston Fed observed across business development company portfolios. After the conversion, it pays nothing in cash until the company is sold, refinanced or restored to a capacity to pay dividends. The position is now an illiquid private equity holding, typically a minority or shared control stake in a company that has just failed to service its debt, and its value is determined by the manager’s valuation process rather than by any observable transaction.
Three consequences follow for the client, and none of them is disclosed in the headline distribution rate. The first is income dilution. Every conversion reduces the share of the portfolio generating cash, which means that either the distribution falls or a larger share of it is funded by sources other than portfolio income. The second is valuation opacity. The Boston Fed found that the ratio of fair value to cost across business development company portfolios remained close to 1.0 throughout the period it studied, even as payment in kind usage rose and spreads compressed. Lincoln’s data show where the dispersion actually sits: software loans with loan to value ratios below 35 percent were marked at 99.0 percent of par in the second quarter, while those above 50 percent were marked at 87.1 percent. A converted equity stake has no par to anchor it at all. The third is a change in the risk the client holds. The client selected a senior secured lending strategy for its position in the capital structure. After a workout, part of that client’s exposure sits at the very bottom of the capital structure of a company with a demonstrated history of distress.
This is not a reason to treat restructured equity as worthless. Lenders who take control at a sensible valuation, with operating capability and patient capital, can and do earn attractive outcomes; the reorganised equity of a company with a viable business and a repaired balance sheet can be worth more than the loan it replaced. The point is narrower. An income product that accumulates equity positions is gradually becoming a different product, and the change is happening through the ordinary operation of the strategy rather than through any decision the client or adviser made. It is the same phenomenon this series examined in the context of evergreen liquidity buffers: an allocation decision made on the client’s behalf, invisible unless someone looks through to it.
There is an academic result that frames the issue precisely. Isil Erel, Thomas Flanagan and Michael Weisbach, using a cash flow based method to construct replicating portfolios for private debt funds, found that the typical fund produces a positive abnormal return gross of fees, a positive abnormal return when measured against a debt benchmark alone, and an insignificant abnormal return net of fees once both debt and equity benchmarks are applied. The middle finding is the important one. Private debt fund returns contain equity risk. In benign conditions that risk is expressed as a modestly higher yield. In a workout cycle it is expressed literally, as equity on the balance sheet. The workout does not create the equity exposure; it reveals the exposure that was priced into the loan from the start.
Recovery Is the Return
If accommodation defers losses and ownership crystallises them, then the variable that will separate private credit outcomes over the next several years is not the default rate under any definition. It is the recovery rate, and the default statistics that dominate the public conversation say almost nothing about it.
The historical evidence on recovery is favourable to private credit, with important qualifications. Practitioners have generally cited average recoveries in direct lending of 65 to 70 percent, rising toward 75 percent when a handful of pandemic affected names are excluded, and S&P’s review of middle market collateralised loan obligations found defaulted loans exchanged at around 80 cents on the dollar. That compares with average first lien recoveries in the syndicated market of around 75 percent historically, 70 percent for covenant light first lien loans since 2009, and roughly 60 percent in liability management exercises, where disfavoured lenders have suffered impairments of around 70 percent. The covenant package and the small lender group are the reasons private credit has historically recovered more: lenders see trouble earlier and can act together.
The qualification is that recovery depends on what stands behind the loan, and what stands behind private credit has changed. The Bank for International Settlements, in its September Quarterly Review, documented that technology firms’ share of direct lending roughly doubled from about 22 percent in 2010 to more than 44 percent in 2025, with outstanding loans to the sector rising from about 22 billion dollars to more than 1 trillion dollars. Direct lenders, the authors noted, specialise in lending against recurring revenue and intangible assets, which suits software businesses well while they perform and leaves little to seize when they do not. The share of technology borrowers with negative earnings nearly doubled, from 23 percent before 2020 to 46 percent after it, leverage among profitable technology borrowers tripled, and the dispersion of loan spreads narrowed, which the authors read as a sign that risk may not be adequately priced. The Boston Fed found internet and software companies at around 20 percent of the median business development company portfolio, with some portfolios above 30 percent.
The software default rate itself is currently low: Fitch put it at 0.6 percent in August, against 9.9 percent in both healthcare and industrial manufacturing. But a low default rate in an asset light sector is not the same as a low loss rate, because the loss given default in such businesses can be very different from the historical average. At least one senior executive at a large alternative credit manager has publicly estimated that recoveries on failed software loans could fall to 20 to 40 cents on the dollar if artificial intelligence undermines the underlying business model, and credit strategists have observed that senior secured status provides less protection in an asset light company than in an asset intensive one. Nobody knows whether that scenario will materialise at scale. What is clear is that the historical recovery statistics on which the asset class’s loss experience rests were generated by a portfolio with a materially different sector mix, and that the default rate is the wrong number to watch for this particular risk.
The practical implication is that recovery capability, meaning the people, processes and capital a manager can bring to a distressed position, has become a primary source of return dispersion rather than a back office function. A manager that can take control of a company, replace management where necessary, fund a turnaround and sell the business at a sensible time will produce materially different outcomes from one that can only extend and hope, even if both originated loans of identical quality. That capability is rarely tested in a due diligence process built during the origination phase, because for most of the past decade it was rarely needed.
The Americas: Income Bought Offshore, Ownership Delivered
For the offshore and Latin American channel, private credit occupies a particular place in client portfolios. It has been the most natural first step into private markets for clients accustomed to fixed income, because it speaks the language of yield, is denominated in dollars, and has been delivered through semi-liquid vehicles and feeder structures that resemble the funds clients already understand. As earlier papers in this series noted, alternatives, real assets and cash together account for only around a tenth of the average moderate model portfolio in the corridor, and private credit has been the most heavily used route into that sleeve. The client in Monterrey, São Paulo, Bogotá or Santiago who bought a senior secured lending fund for monthly or quarterly income is exactly the client most exposed to the transition this paper describes, and least likely to have been told it was possible.
Three features of the corridor sharpen the issue. The first is the income expectation itself. Latin American investors are accustomed to high nominal yields in local currency, and dollar private credit was often positioned as the dollar equivalent of a local fixed income allocation. A product whose cash yield gradually declines as more of the portfolio becomes non paying equity, while its reported net asset value holds near par, can produce an awkward conversation precisely because the reported numbers will not obviously explain what has changed.
The second is the character of what is held, which in some structures has tax consequences that differ for non United States investors. Interest paid by a United States borrower to a foreign lender can generally qualify for an exemption from withholding tax, which is one reason offshore feeders into United States direct lending funds work as they do. Equity is treated differently. Dividends from a reorganised company do not carry the same exemption; restructured equity in an operating business organised as a pass through can generate income effectively connected with a United States trade or business; and a lender that becomes a significant shareholder of a borrower can, depending on the structure, affect the treatment of the interest it continues to receive on any remaining debt. Fund managers address these issues through blocker entities and careful structuring, and most large platforms serving offshore clients have done so for years. But the issue is real, it arises precisely when loans become equity, and it is a fair question to ask of any vehicle sold to non United States clients. Nothing in this paper is tax advice, and the specific treatment depends on the structure and the investor.
The third feature is that the region has its own version of the same cycle running at the same time, and it offers a useful lens. Brazil recorded 977 requests for judicial reorganisation, or recuperação judicial, in 2025, involving 2,466 companies, according to Serasa Experian. The number of filings rose 5.5 percent, the number of companies involved rose 13 percent, and agribusiness accounted for 30.1 percent of cases. Serasa’s analysts highlighted that filings are becoming larger and more complex, with each one grouping a growing number of linked corporate entities. Judicial reorganisations outnumbered extrajudicial agreements by roughly sixteen to one, while bankruptcies fell 19 percent. Brazil’s insolvency framework was substantially modernised in 2020, introducing debtor in possession financing and allowing creditors to propose their own reorganisation plans, but the process remains court supervised, slower and less predictable than the consensual out of court workouts typical of United States direct lending. Brazilian credit funds, including the receivables funds this series discussed in August, are learning the same lesson as their United States counterparts, in a more formal venue and at higher local interest rates: the value of a credit portfolio in a stress cycle depends on the enforceability of the lender’s rights and on the lender’s capacity to use them.
For advisers serving the corridor, the comparison is instructive in both directions. Brazilian and other Latin American families are often more familiar than United States retail investors with the experience of a lender becoming an owner, because the region’s corporate history contains more of it. They may also have direct experience of how long and how costly that process can be. That familiarity is an asset in the client conversation, provided the adviser has done the work to explain how the same dynamic plays out inside a dollar private credit fund.
The Questions That Separate Lenders from Owners
The argument of this paper reduces to a set of questions that any adviser, private bank or distribution platform can put to a private credit manager this quarter, and that a manager serious about the wealth channel should be ready to answer.
On measurement, ask for the portfolio’s default and stress experience under both definitions: payment and covenant defaults, and the broader measure that includes payment in kind conversions after origination, distressed maturity extensions and amendments that reduced cash interest. Ask what share of current portfolio income is accrued rather than paid in cash, and how that share has moved over the past eight quarters. A manager that tracks only the narrow measure is telling you how it thinks about the problem.
On ownership, ask what share of the portfolio’s fair value is now held as equity received in a restructuring, how many portfolio companies the fund or its affiliates control, and how those positions are valued, by whom, and how often. Ask whether restructured equity is held in the same vehicle as performing loans or transferred elsewhere, and on what terms. Ask what the distribution policy assumes about the cash yield of the portfolio, and what happens to the distribution if the share of non paying positions doubles.
On capability, ask who runs workouts: whether the manager has a dedicated restructuring team, how many people it has, what its record is on companies taken over in previous cycles, and whether it has operating partners capable of running a business rather than merely monitoring a loan. Ask how the manager behaves in a lender group, whether it has participated in non pro rata liability management transactions, and whether its loan documents protect it against being on the wrong side of one.
On exposure, ask for the portfolio’s share in asset light sectors, particularly software, and for the manager’s own estimate of recovery in a scenario where a business model fails outright rather than merely underperforms. Ask about the vintage profile, specifically the share of loans originated in 2021 and 2022, which is where the takeover data say the stress is concentrated.
On structure, for non United States clients, ask how equity received in restructurings is held, whether blocker entities are used, and whether conversion of a loan to equity can change the tax treatment of income for the feeder or its investors.
On fees, finally, ask whether incentive fees accrue on income that is accrued rather than received, and whether management fees are charged on the manager’s own valuation of restructured equity. These are ordinary features of the asset class, not accusations, but their interaction with a rising share of non paying, manager valued positions is exactly the kind of detail that determines a client’s net outcome.
None of this is a case against private credit. The asset class’s core proposition, that senior secured lending to the middle market with strong covenants and a concentrated lender group can earn an attractive return relative to its risk, remains intact, and the academic evidence on creditor control suggests that lenders willing to govern can add real value. The argument here is that the proposition was always partly a bet on recovery, and the market has now reached the part of the cycle where that bet is settled. The origination phase rewarded scale, distribution and speed. The workout phase will reward managers who know how to own what they lend against, and advisers who understood the difference before their clients asked.
Sources
- Fitch Ratings, as reported by James Langton. «U.S. Private Credit Defaults Rise: Fitch» (August 2026 trailing twelve month default rate, sector rates). Investment Executive, September 14, 2026. https://www.investmentexecutive.com/news/research-and-markets/u-s-private-credit-defaults-rise-fitch-4/
- Funds Society. «U.S. Private Credit Default Rate Continues to Climb» (Fitch PCDR composition by default type). March 2, 2026. https://www.fundssociety.com/en/news/alternatives/u-s-private-credit-default-rate-continues-to-climb/
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- Financial Stability Board. «Report on Vulnerabilities in Private Credit.» May 6, 2026. https://www.fsb.org/uploads/P060526.pdf
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- Nini, Greg, David C. Smith, and Amir Sufi. «Creditor Control Rights, Corporate Governance, and Firm Value.» Review of Financial Studies 25, no. 6 (2012): 1713 to 1761. https://academic.oup.com/rfs/article-abstract/25/6/1713/1595112
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