Apollo Global Management signage in New York on Dec. 5, 2023.
Jeenah Moon | Bloomberg | Getty Images
Private credit markets are facing fresh uncertainty as AI-driven tools start to pressure software companies, a major borrower group for private lenders.
The software industry came under renewed pressure last week after artificial intelligence firm Anthropic unveiled new AI tools, sparking a sell-off in software data provider shares.
The AI tools, developed by Anthropic, are designed to perform complex professional tasks that many software companies currently charge for, raising fresh concerns that AI could weaken traditional software business models.
Shares of asset managers with large private credit franchises tumbled this week as investors fretted about how AI could upend borrowers’ business models, pressure cash flows and ultimately lift default risks.
Private credit stocks in the past month
Ares Management fell over 12% last week, while Blue Owl Capital lost over 8%. KKR declined almost 10%. TPG lost about 7%. Apollo Global and BlackRock fell over 1% and 5%, respectively. For comparison, the S&P 500 declined by about 0.1%, while the tech-heavy Nasdaq fell 1.8%.
The moves bring to fore a growing unease around private credit market which now has to brace for the impact from AI-driven disruption to the software sector that is heavily exposed to buyouts financed with opaque, illiquid loans, according to market watchers.
Private credit loans to a lot of software companies. If they start going south, there’s going to be problems in the portfolio.
Jeffrey Hooke
Johns Hopkins Carey Business School
“Enterprise software companies have been a favored sector for private credit lenders since 2020,” PitchBook wrote in a report last week following the fallout, adding that many of the largest-ever unitranche (two or more loans combined into one) loans, the favorite structure of the private credit market, have been to software and tech companies.
Software makes up a significant share of loans held by U.S. business development companies, accounting for about 17% of BDC investments by deal count, second only to commercial services, data from PitchBook showed.
That exposure could prove costly if AI adoption accelerates faster than borrowers can adapt. UBS Group has warned that, in an aggressive disruption scenario, default rates in U.S. private credit could climb to 13%, significantly higher than the stress projected for leveraged loans and high-yield bonds, which UBS estimates could come to around 8% and 4%, respectively.
“Private credit loans to a lot of software companies,” said Jeffrey C. Hooke, a senior lecturer in finance at Johns Hopkins Carey Business School. “If they start going south, there’s going to be problems in the portfolio.”
Hooke, however, said that strains in private credit pre-date the latest AI concerns, pointing to issues around liquidity and loan extensions. “A lot of private credit funds have had problems liquidating their loans,” he said, adding that the recent developments has simply added another layer to a sector already under pressure.
This slate of new warnings come on the back of recent concerns in the $3 trillion industry over leverage, opaque valuations and the risk that isolated problems may turn out to be systemic issuesJPMorgan’s Jamie Dimon warned late last year about private credit’s ‘cockroaches,’ cautioning that stress in one borrower can signal more hidden trouble.
“AI disruption could be a credit risk for private credit lenders for some of its Software & Services sector borrowers and perhaps not for others as it depends on which ones are behind the AI curve and which ones are on top of it,” said Kenny Tang, head of U.S. credit research at PitchBook LCD.
Tang added that software and services companies account for the largest share of payment-in-kind (PIK) loans, which refer to arrangements where borrowers can delay paying interest in cash. While PIK structures are often used to give fast-growing companies time to build revenue and cash flow, they become risky if a borrower’s finances weaken. In that case, deferred interest can quickly turn into a credit problem, he said.
Moody Analytics’ chief economist Mark Zandi noted that while it is difficult to grasp a complete assessment of risks in the sector given its opacity, the rapid growth in AI-related borrowing, mounting leverage and a lack of transparency are considerable “yellow flags.”
“There will surely be significant credit problems, and while the private credit industry is probably currently able to absorb any losses reasonably well, this may not be the case a year from now if the current credit growth continues.”
