After frequent defaults in U.S. private credit, PIMCO warns: The industry faces a "full-scale default cycle"

PIMCO, according to Pacific Investment Management Company, has analyzed private credit risks. After the 2008 financial crisis, direct lending institutions saw record-breaking financing, leading to relaxed underwriting standards. Now, stress testing is underway. Analysts Lotfi Karoui and Gabriel Cazaubieilh stated in a report to clients on Friday:

“Like all mature leveraged finance sectors, direct lending will eventually face a comprehensive default cycle — testing its ability to withstand industry-specific shocks and macroeconomic impacts.”

In recent months, concerns about defaults have increased due to high-profile corporate bankruptcies and worries that direct lending funds are overly sensitive to software companies potentially disrupted by artificial intelligence.

This unease has recently been most evident among investors in Business Development Companies (BDCs), a type of closed-end private debt fund aimed at retail investors. As many cautious BDC investors request redemptions, BlackRock and Blue Owl, among other alternative investment firms, have restricted withdrawals.

These investors are increasingly aware that they cannot always withdraw funds from so-called semi-liquid funds. While these funds offer quarterly redemptions, they impose limits if certain thresholds are reached.

They noted, “Although the risk of a true ‘bank run’ on these investment vehicles is generally low due to clear contractual redemption limits and the fund managers’ control over cash flows, semi-liquidity does not mean full liquidity. Investors still need to assess their liquidity needs and their tolerance for restricted access to funds.”

They also pointed out that an overexposure to software assets in direct lending portfolios could limit performance relative to publicly traded stocks and other private credit products. Additionally, Pimco analysts highlighted that direct loan funds do not compensate investors for long-term capital lock-up.

PIMCO was among the earliest critics of private credit, which has now grown into a $1.8 trillion industry. As direct lending strategies’ financing volumes surge, the asset management firm has adopted an opposite approach, identifying issues emerging among companies supported by private credit. The firm, with a history of about 55 years, originally a bond giant, now manages approximately $2.3 trillion in assets.

However, Pimco analysts wrote that these concerns should not affect the outlook for private credit overall. The scope of private credit extends beyond direct loans and BDCs. They pointed out some “channels” they find valuable, including asset-based financing, which they say can offer “investment-grade” risk levels.

Last year, Pimco raised over $7 billion for an asset-based financing strategy, including its first funds specifically designed for insurance companies and high-net-worth individuals.