Goldman Sachs expects U.S. private credit default rates to reach 8%, industry giant admits: All valuations are wrong!

Concerns in 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, with default rates potentially approaching the highest levels since the pandemic.

The report states that as artificial intelligence continues to disrupt the software industry, the debt repayment ability of software companies is weakening, and default rates on direct loans could rise to 8%. Direct lending is a form of private debt where non-bank institutions (such as asset managers, private equity funds, insurance companies, etc.) bypass traditional financial intermediaries like commercial banks and lend directly to companies.

Meanwhile, according to The Wall Street Journal, John Zito, Co-CEO of Apollo Global Management, recently made rare and sharp remarks in a private setting, directly criticizing the prevalent arrogance in the private market, noting that private equity valuations are generally distorted and risks far exceed market perceptions.

Zito pointed out that many software companies acquired between 2018 and 2022 were valued incorrectly, and related private credit faces significant downward and default pressures.

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

Morgan Stanley analyst Joyce Jiang warned in a team report that, although the impact of AI on credit fundamentals has not yet materialized, the ongoing AI disruption shows a trend of continued weakening in coverage.

“Coverage” refers to the interest coverage ratio (EBITDA divided by interest expenses) of borrowing companies in the private credit sector. Morgan Stanley believes that operating profits of software companies are already showing signs of difficulty in covering their debt interest.

Morgan Stanley data shows that software companies are the largest industry focus within the Business Development Company (BDC) investment portfolios, with risk exposure around 26%. CLOs (Collateralized Loan Obligations) related to private credit also have a 19% risk exposure to the software industry.

CLOs are asset-backed securities that bundle hundreds of corporate loans (usually leveraged loans) into a resource pool, then issue securities of different risk levels backed by this pool to investors.

Citing PitchBook data, Morgan Stanley notes that 11% of software loans in direct lending will mature by 2027, and another 20% by 2028, with the concentrated maturity pressure overlapping significantly with the deepening AI impact window.

Morgan Stanley analysts state:

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

Morgan Stanley analysts also noted that cooling demand from retail investors for private credit may drive investor composition toward more institutional participation, potentially restraining future growth of this market.

As of the end of Q3 last year, BDCs held a total of $530 billion in assets, with a large participation from retail investors. Their inherent illiquidity has raised widespread concerns about the risk tolerance of less experienced investors.

However, the bank emphasizes that while overall credit risk is significant, it does not currently pose a systemic threat.

Software companies’ exposure is the biggest hidden risk

John Zito, Co-CEO of Apollo Global Management, believes that software companies acquired between 2018 and 2022 generally face three issues: weaker revenue compared to similar listed companies, smaller size, yet higher valuation.

He cites the example of Medallia, a software company privatized by Thoma Bravo in 2021 for $6.4 billion, noting that the credit situation of that deal “will be worse than market expectations.” Several creditors, including Apollo, have already written down related debts.

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

Most acquired companies are of lower quality than those listed, smaller in scale, and sold at valuations far above those companies—those who say ‘no problem’ clearly do not understand this.

He also pointed out that the AI wave is forcing companies to rush deployment before the technology is truly mature, which could be an early sign of broader economic slowdown, and stated that he believes the probability of a recession has “exceeded 50%”, more akin to a “consumer confidence-led recession.”

Private equity valuations are generally inflated, with transparency in question

Zito also questioned internal perceptions within the private market.

He observed that investors are eager to buy secondary market shares of private equity, yet remain cautious about financing 80% of these assets through private credit, which holds a more senior position in capital structure. He said:

That doesn’t make sense logically, but maybe I’m mistaken. When I mention this, I usually get a blank stare.

Regarding valuation transparency, Zito clearly states Apollo’s stance and considers it a competitive advantage:

If you don’t mark to market, you actually lose the trust of clients. We aim to be the true market leader in valuation based on market prices.

He also warned that the next market cycle will be a “major moment” for private markets, and those private market participants who have grown through wealth management channels with an “arrogant” attitude will face severe tests.

Apollo claims to be well-positioned but admits it cannot be immune

Although Zito remains cautious about overall industry risks, he strongly defends Apollo’s own credit business. He states that 95% of Apollo’s assets are investment grade, with very low exposure to the software sector.

He expects that private credit loans issued over the next 12 to 18 months will be of “higher quality” in terms of company quality, leverage, documentation, and spreads.

However, Zito also concedes that if the economy enters a severe recession, Apollo will not be immune:

I am confident we will suffer some damage, like others, but I believe we will come out better and have enough flexibility to buy quality assets during that period, generating substantial returns.

On redemption management, he favors maintaining a quarterly redemption cap of 5% to protect existing investors, warning that short-term decisions to meet redemption demands could be “a very bad decision after one quarter.”

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