Private credit default rates could rise to 8% as AI-driven disruption weakens software sector fundamentals, with high leverage, looming debt maturities, and rising investor redemptions adding pressure
Private credit markets are bracing for a fresh wave of stress, with default rates in direct lending projected to climb to around 8 per cent, according to a new note from Morgan Stanley, as artificial intelligence-driven disruption reshapes the software industry.
While the impact of AI on private credit has not yet been “material,” underlying vulnerabilities — particularly in software-linked loans — are building rapidly, analysts led by Joyce Jiang said. Elevated leverage levels and weakening cash-flow coverage could push defaults close to peaks last seen during the pandemic.
“Credit fundamentals of software loans are challenged, with the highest leverage and the lowest coverage ratios across major sectors,” the strategists noted, adding that defaults, which had stabilised in recent quarters, are likely to rise again as AI-led disruption accelerates.
Software sector at the centre of risk
The warning comes as global credit markets grapple with the implications of AI on business models, especially in software, a sector long favoured by private credit investors for its predictable revenues and high margins.
Over the past decade, alternative asset managers have significantly increased exposure to software firms. According to Morgan Stanley, the sector now accounts for roughly 26 per cent of business development company (BDC) portfolios. Exposure is also substantial in private credit collateralised loan obligations (CLOs), at around 19 per cent.
The concentration has heightened concerns that any sustained disruption to software revenues — particularly from AI-led automation and competitive pressures — could have outsized effects on credit performance.
Maturity wall adds to pressure
A key near-term risk is the so-called “maturity wall” facing software borrowers. Morgan Stanley estimates that 11 per cent of direct lending loans to software companies will come due in 2027, followed by another 20 per cent in 2028, citing data from PitchBook.
This front-loaded refinancing cycle could prove challenging if market conditions tighten or if lenders grow more cautious toward the sector, potentially leading to higher refinancing costs or an inability to roll over debt.
Investor unease and fund pressures
Rising anxiety around the sector is already being reflected in investor behaviour. Redemption requests in private credit funds have increased, prompting some managers to impose withdrawal limits.
Recently, Morgan Stanley and Cliffwater LLC capped withdrawals from their multi-billion-dollar private debt funds after investors sought to redeem amounts exceeding standard quarterly thresholds.
Risks seen as contained, not systemic
Despite the rising stress, Morgan Stanley’s strategists emphasised that risks in private credit are unlikely to trigger broader financial instability.
Business development companies — key vehicles that allow retail investors to access private credit — held about $530 billion in assets as of the third quarter of last year. While this has raised concerns about retail exposure to illiquid assets, analysts believe the risks are largely contained within the segment.
They added that a moderation in retail demand could shift the investor base more towards institutional players, potentially slowing the rapid growth seen in private credit markets over the past decade.
Still, with AI reshaping industries and a heavy refinancing cycle looming, the outlook for private credit — particularly in software — is becoming increasingly uncertain.
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