The Private Credit Debate Isn't Going Away. Here's What Investors Should Know.

There has been a lot of debate about private credit over the past year. Proponents will contend that these investments can generate above-average fixed-income returns over the long run. However, detractors have argued that the sector poses systemic risk to the global economy and could result in significant capital losses for investors.

Here's a closer look at what investors should know about the private credit debate.

Image source: Getty Images.

What is private credit?

The private credit market has risen in prominence over the past decade for two reasons. The capital needs of industry have grown as the economy has expanded. However, traditional lenders such as banks and credit unions have retrenched due to increased regulation and more burdensome capital requirements. That has created a large funding gap that alternative capital providers, such as global alternative investment firms and business development companies (BDCs), are filling.

"At its core, private credit is simply credit," wrote Brookfield Corporation (NYSE: BN) CEO Bruce Flatt in the global investment firm's first-quarter letter to shareholders. Flatt stated that companies like Brookfield are "providing senior capital to asset owners and businesses, in return for a prioritized fixed return." He noted that while structures slightly differ from those in the public markets, "the underlying principles of underwriting, collateral, and discipline remain unchanged. Credit outcomes have always been driven by what you lend against, how you structure transactions, and the discipline applied, particularly when capital is abundant."

Separating fact from fiction

Leading providers of private credit, including Brookfield and fellow giant alternative asset manager Blackstone (NYSE: BX), both defended the asset class during their first-quarter earnings reports. Blackstone CEO Steve Schwarzman spent some time on the company's first-quarter conference call separating the facts from fiction. One falsehood he addressed head-on was the question of whether the asset class posed systemic risk. Schwarzman stated that "the Treasury Secretary, leaders of the Federal Reserve and the SEC, and the heads of numerous financial institutions have now acknowledged they do not see systemic risk from private credit."

Blackstone's CEO also addressed the unfounded concerns about widespread losses across the private credit sector. He started by highlighting that Blackstone has "generated 9.4% net returns annually in our non-investment-grade private credit strategies since inception nearly twenty years ago -- roughly double the return of the leveraged loan market." He noted that, "This track record crosses market and economic cycles, periods of high and low interest rates, and multiple credit default cycles." While he admitted that we're moving into a period of lower base rates and higher expected defaults from historic lows, Blackstone has "designed our funds with these cycles in mind, with low fund leverage, high current income generation, and the equivalent of meaningful reserves for future potential losses." That drives Blackstone's high confidence in its private credit strategy.

Private credit isn't the problem, but this is a concern

Despite the current negative sentiment surrounding private credit, the asset class isn't a problem. However, not all private credit loans are the same. Brookfield and Blackstone primarily lend against secured real assets such as infrastructure and real estate. However, a potential trouble spot in the sector is private credit funds providing unsecured loans to software companies. That's due to the potential for AI disruption. AI could make some software irrelevant or at least compress margins in the sector, making it difficult for these companies to repay their loans.

Brookfield CEO Bruce Flatt wrote in his shareholder letter that the firm has "no material exposure to software in our credit or equity strategies." Instead, it's lending to companies building AI infrastructure, with its loans primarily backed by real assets, such as data centers, energy infrastructure, transmission networks, and digital networks. Meanwhile, software accounts for only about 7% of Blackstone's total investment portfolio, and the firm is working with those companies to help them adapt to AI.

Other players in the private credit market are also stress testing their loan portfolios against AI disruption risk. For example, the largest BDC, Ares Capital (NASDAQ: ARCC), hired a consultant to review its software-oriented portfolio. They found that 85% of Ares Capital's software portfolio has low AI disruption risk. Meanwhile, the 1% at high risk accounted for only 0.3% of its total investment portfolio, while the other 14% at medium risk accounted for an additional 3%, suggesting a low overall risk.

The private credit debate should shift its focus

While some notable private credit bankruptcies have sparked significant debate, the truth is that the sector isn't the issue. There's no systemic risk, and most private credit investments should deliver the anticipated returns. Instead, the debate should shift its focus to software, which is where the main risks lie. Investors should keep a closer eye on funds with exposure to that market, which are at a higher default risk due to AI disruptions.

Matt DiLallo has positions in Ares Capital, Blackstone, and Brookfield Corporation and has the following options: short July 2026 $40 puts on Brookfield Corporation and short June 2026 $90 puts on Blackstone. The Motley Fool has positions in and recommends Ares Capital, Blackstone, and Brookfield Corporation. The Motley Fool has a disclosure policy.