Concerns within the private credit market continue to spread on Wall Street. Analysts at Morgan Stanley indicated in a report released on Monday that loans to the software sector carry the highest leverage and lowest coverage ratios within the private credit market, with default rates potentially approaching post-pandemic peak levels. The report stated that as advancements in artificial intelligence continue to disrupt the software industry, the debt-servicing capacity of software companies is weakening, which will drive the default rate for direct loans up to 8%. Direct lending is a form of private lending where non-bank institutions, such as asset management firms, private equity funds, and insurance companies, provide loans directly to businesses, bypassing traditional financial intermediaries like commercial banks. Concurrently, according to The Wall Street Journal, Apollo Global Management Co-President John Zito recently used unusually sharp language in a private setting, stating that "arrogance" is prevalent in the private markets, private equity valuations are widely distorted, and the risks far exceed market perceptions. John Zito pointed out that valuations for many software companies acquired between 2018 and 2022 are incorrect, and the related private credit faces substantial downside and default pressure.
Morgan Stanley: Default Rate Could Rise to 8%, Recession Probability Increased
Morgan Stanley analyst Joyce Jiang warned in a team report that although the impact of AI on credit fundamentals has not yet fully materialized, coverage ratios show a trend of persistent weakness as AI-related disruptions continue to evolve. The "coverage ratio" refers to the interest coverage multiple of borrowing companies in the private credit space. Morgan Stanley believes that the operating profits of software companies are already showing signs of being insufficient to cover their debt interest payments. Data from Morgan Stanley shows that software companies represent the largest industry exposure in Business Development Company portfolios, with a risk exposure of approximately 26%. The exposure of private credit Collateralized Loan Obligations to the software industry also reaches 19%. A CLO is an asset-backed security that pools hundreds of corporate loans, typically leveraged loans, into a portfolio, which is then used as collateral to issue securities of varying risk levels sold to investors. Citing PitchBook data, Morgan Stanley indicated that 11% of software loans within direct lending are set to mature in 2027, followed by 20% maturing in 2028, creating a concentration of maturity pressures that highly overlaps with the timeframe for deepening AI disruption. Morgan Stanley analysts stated that software loans are under pressure in terms of credit fundamentals, exhibiting the highest leverage and lowest coverage ratios among major industries. The analysts also suggested that cooling demand for private credit from retail investors could drive a gradual shift towards a more institutional investor base, potentially restraining the market's future growth. By the end of the third quarter of last year, BDCs collectively held assets totaling $530 billion, with significant participation from retail investors. The inherent lack of liquidity has raised widespread concerns about the risk tolerance of less experienced investors. However, the firm also emphasized that while overall credit risk is significant, it does not currently pose a systemic threat.
Software Company Exposure Seen as Biggest Risk
Apollo Global Management Co-President John Zito believes that software companies acquired between 2018 and 2022普遍 suffer from a triple problem: revenues weaker than comparable public companies, smaller size, yet transacted at higher valuations. Using Medallia, a software company taken private by Thoma Bravo for $6.4 billion in 2021, as an example, he noted that the credit performance of that deal "will be worse than the market expects." Several of Medallia's creditors, including Apollo, have already written down the related debt. Zito criticized the logic of using the strong performance of public tech companies to justify overall optimism, stating that most acquired companies are of lower quality than their public counterparts, smaller in size, and were purchased at valuations far exceeding those of public companies—a point those saying 'no problem' clearly fail to grasp. He also pointed out that the AI wave is forcing companies to deploy technology hastily before it is fully mature, which could be an early signal of a broader economic slowdown. He stated that he believes the probability of a recession now "exceeds 50%" and would likely be a "consumer confidence-led recession."
Widespread Overvaluation in Private Equity, Transparency Questioned
Zito also raised questions about internal contradictions in the private markets. He observed strong investor demand for buying stakes in private equity secondary markets, yet wariness towards the private credit that finances roughly 80% of these assets, even though the latter holds a senior position in the capital structure. He said this seems logically inconsistent, adding that his comments on this topic are often met with blank stares. On the issue of valuation transparency, Zito clearly articulated Apollo's stance, viewing it as a competitive advantage. He stated that failing to mark assets to market ultimately erodes client trust, and positioned Apollo as a leader in true mark-to-market practices. He also warned that the next market cycle will be a "significant moment" for private markets, presenting a severe test for private market participants who have grown within wealth management channels and carry an "arrogant" mindset.
Apollo Claims Robust Positioning but Acknowledges Vulnerability
Despite his cautious stance on overall industry risk, Zito sought to endorse Apollo's own credit business. He said that 95% of the assets on Apollo's balance sheet are investment-grade and its exposure to the software sector is very low. He anticipates that private credit loans originated over the next 12 to 18 months will be of "higher quality" in terms of company quality, leverage, documentation, and spreads. However, Zito also conceded that if a severe recession materializes, Apollo would not emerge unscathed. He expressed confidence that Apollo would fare better than others, maintain flexibility to acquire quality assets during such a period, and generate substantial returns. Regarding redemption management, he advocated maintaining a quarterly redemption limit of 5% to protect existing investors' interests. He warned that decisions made to meet short-term redemption demands often prove to be very poor choices a quarter later.
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