Private Credit's Faulty Formula: Credit Over Capability
- Delanta Frink
- 12 minutes ago
- 4 min read
A wave of concern is sweeping through the private credit market, a once-celebrated corner of finance. What was hailed as a resilient alternative to traditional bank lending is now showing significant strain, particularly among Business Development Companies (BDCs) and similar funds. The model, which involves providing high-interest loans to small and medium-sized enterprises (SMEs), is facing a critical test. Critics argue that its fundamental approach resembles "vulture capital" more than productive investment, leading to a growing portfolio of troubled loans. This article examines why this model is failing, where it went wrong, and what it signals for the future of corporate lending.
The Promise and Mechanics of Private Credit
Born in the aftermath of the 2008 financial crisis, the private credit market emerged to fill a void. As banks retreated from riskier middle-market lending, non-bank lenders—including BDCs, private credit funds, and direct lenders—stepped in. The pitch was compelling: investors would earn attractive, steady yields (often 8-12%+), while businesses would gain access to flexible, albeit expensive, capital without the stringent covenants of public markets.
The typical model is straightforward:
The Target: Small-to-medium-sized companies, often with $10 million to $500 million in revenue, that may not qualify for or desire traditional bank loans or bond issuance.
The Offer: Senior secured loans with floating interest rates (e.g., SOFR + 6-8%). These rates are significantly higher than bank loans, justifying the perceived higher risk.
The Screening: A heavy, often primary, reliance on quantitative metrics: historical cash flow, leverage ratios, and credit scores. The underwriting process can prioritize strong "paper" financials over deep operational due diligence.
The Cracks in the Foundation: Why the Model Is Stumbling
The current slump is not merely a product of higher interest rates. It exposes structural flaws in the underwriting philosophy of many funds.
1. The Vulture Capital Parallel: Feeding on Financial Distress, Not Building Value
The comparison to vulture capital is apt in its mechanics, if not always its intent. The model often profits from a company's need for capital rather than its potential for growth. By targeting firms that are stable enough to service high debt but not strong enough to secure cheaper financing, lenders extract substantial yield from financial engineering rather than value creation. The high interest payments can suffocate a company's ability to reinvest in innovation, talent, or expansion, trapping it in a cycle of debt servicing.
2. The Fatal Flaw: Screening for Credit, Not for Capability
The core failure is an over-reliance on backward-looking financials. A strong balance sheet from the past two years says little about a management team's vision, a product's competitive moat, or a company's adaptability to market shifts. This process misses two critical elements:
Operational Health: Is the business model sustainable? Is the industry in decline? Does leadership have a credible plan?
Growth Trajectory: Is the capital being used to fuel genuine expansion, or is it merely patching over short-term cash flow issues or financing a dividend recapitalization for private equity owners?
This credit-centric screening creates a portfolio of companies that look qualified on paper but may lack the fundamental resilience or growth potential to withstand economic stress.
3. The Debt Vehicle Dilemma: Capital Flow Over Company Health
In the worst cases, some companies become mere "debt vehicles." Capital is advanced, often to portfolio companies of private equity sponsors, primarily to generate fee income for the lender and show distribution yield to shareholders. The long-term health of the borrowing company becomes secondary to the appearance of capital deployment and yield generation within the fund. This misalignment of interests ensures that when the business cycle turns, these highly leveraged companies are the first to falter, as they were built for debt service, not durability.
The Consequences: A Mounting Pile of Problem Loans
The results of this flawed approach are now evident. Default rates in private credit are rising. BDCs are increasingly setting aside larger provisions for loan losses and marking down the value of their portfolios. The Wall Street Journal and Financial Times have reported on "zombie" companies in private credit portfolios—firms that can barely cover interest payments, surviving only because lenders, wanting to avoid write-downs, extend and amend loans rather than force a restructuring.
This creates a dangerous illusion of stability. Unlike public markets where prices adjust daily, private loan valuations are often smoothed, delaying the recognition of losses and potentially masking the true scale of the problem.
The Path Forward: A Return to Fundamentals
For the private credit model to be sustainable long-term, a fundamental recalibration is needed:
Operational Due Diligence: Lenders must integrate rigorous assessments of management quality, market position, and operational scalability alongside financial analysis.
Alignment of Interests: Structures should reward lenders for the successful deployment of capital that leads to enterprise value growth, not just for the act of lending at a high rate.
Transparency and Valuation: More frequent and realistic mark-to-market valuations would provide earlier warning signals to investors and reduce the risk of a sudden, systemic shock.
The current slump in private credit is a necessary correction. It serves as a stark reminder that capital is most productive when it is patient, discerning, and aligned with the creation of real economic value. The funds that survive and thrive will be those that move beyond being mere providers of expensive debt and become true partners in building resilient businesses. The era of easy yield from financial engineering is closing; the next chapter must be written by lenders who can distinguish between a good credit and a good company.
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