Goldman Sachs Just Sounded the Alarm on Private Credit. Here Are 2 Things Investors Need to Know.

The private credit market doesn't get much attention from retail investors in ordinary circumstances, but the current market environment is looking increasingly extraordinary.

The private credit market is generally only open to high-net-worth individuals and institutional investors, and typically provides high interest rates to investors for illiquid loans. However, recently, the private credit market has begun looking distressed as it's closely tied to the software industry, and the same nervousness that has led to software stocks falling on fears of AI disruption is causing some investors to mark private loans down, reflecting those risks, and it could lead to a downward spiral.

Goldman Sachs CEO David Solomon commented on these risks in his annual shareholder letter, published on Friday, and said that concerns around private credit, including about underwriting quality and exposure to software that could be disrupted by AI, were a reminder that "the credit cycle has not been repealed," meaning it's at risk of going through a default cycle.

On that note, here are two things investors should know about the private credit market.

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1. Private credit stocks are tumbling

Several publicly traded private credit firms, or business development company (BDC) stocks, have plunged in recent months, and financial giants like Blackstone and Morgan Stanley have capped investor withdrawals to prevent a run on liquidity.

Blue Owl Capital (NYSE: OWL), for example, is down 39% year-to-date, as the company has restricted investor redemptions following high requests, sold $1.4 billion in assets to pay out investors, and fallen victim to a contagion fear in the private credit market, which is the biggest risk here.

If these private loans are no longer performing and the software market sees more AI disruption, there could be a liquidity crisis in the private credit market, which is valued at more than $1 trillion.

2. There's a huge network of risks in the market right now

If the private credit market crashes, there's a risk of another systemic financial crisis like what happened in 2008, and the IMF even warned that banks' exposure to private credit means any fallout could spread to traditional banks.

The private credit crisis is coming at the same time as worries about the AI boom are building. Investors are concerned that hyperscalers are spending too much money on their data center buildouts, essentially spending money that they won't get back, and that AI could disrupt enterprise software, which has already caused valuations in the software sector to plunge.

Finally, the war in Iran and the spike in oil prices have introduced a new level of risk in the stock market. Overall, there's a lot more uncertainty in the market than there was just a few months ago. Investors should stay vigilant and be prepared for a pullback. It's a good time to build cash to potentially take advantage of lower share prices.

Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Blackstone. The Motley Fool has a disclosure policy.