Beyond 60/40 Ep. 51: Private Credit Myths, Defaults, and Liquidity Reality

In Episode 51 of Beyond 60/40, iCapital Chief Investment Strategist Sonali Basak sits down with Sam Williams, Managing Director and Portfolio Manager at iCapital, to unpack what’s really happening in private credit.

They explore why credit quality remains resilient despite heightened scrutiny, how defaults differ across market segments, and why losses—not headlines—are the metric that matters. The conversation also breaks down the role of PIK (Payment-in-Kind) loans, when they signal flexibility versus stress, and how managers are navigating elevated redemption activity without sacrificing portfolio stability.

With redemptions expected to remain elevated through 2026, learn why liquidity management, portfolio construction, and manager selection matter more than ever.

Transcript

SPEAKER_00 0:04

Welcome to the latest episode of Beyond 6040. I'm Shonali Basick. I am the chief investment strategist at iCapital. And today I'm alongside my colleague Sam Williams, who is a portfolio manager and managing director at iCapital. He oversees a$300 million interval fund focused on the topic of the day, private credit. Sam, thank you for being here with me to talk through some of the challenging dynamics that we're facing right now in the market. If you had to kind of boil it down to one thing, just one thing that it kind of describes what's happening in private credit today, what would it be?

SPEAKER_02 0:40

Wow, that's a really hard-hitting first question. I thought I'd get a colleague's softball to start. Never. Well, thank you for having me, first of all. Um right now I see a market characterized by credit quality and misunderstanding. The perception by investors out there, there are irrational aspects to it. There are rational aspects to it. We can talk some about the rational concerns that we focus on. Um, but a lot of what's going on in the market right now for the largest managers in the space, we're not immune to it. Um, really has to do with a misunderstanding of the quality of credit portfolios, which we continue to believe are very high. Um our analysis of all the data supports that.

SPEAKER_00 1:22

When you're somebody looking from the outside in, I think it's kind of confusing because there are different credit rating firms and other providers who have different default rates across the industry. I find this very confusing because it's anywhere from 2.5% all the way up to 10% across the industry. There are different universes that they're looking at, but how do you sift through that noise to understand what true credit quality looks like today?

SPEAKER_02 1:48

So default rates that are published for direct lending. And when I say direct lending, um, the market could be further segmented into lower middle market, core middle market, and upper middle market. Upper middle market lenders are where we see the most noise about redemptions and otherwise today. They're also the funds that have been the most successful in raising money from the wealth channel. Default rates across those markets differ, and they differ in part because of the loan documentation that underlies all these different investments. Um, in the broadly syndicated loan market, there are no financial covenants, for instance. In most of private credit, particularly those two lower market segments, um, a lot of deals have financial maintenance covenants. So when you go to try and apples to apples compare across the entire credit market, not just private credit, in terms of default rates, you might well be looking at different events that are getting counted within those default rates. Covenant defaults, amendments to avoid covenant defaults, payment defaults everybody would have, and bankruptcy processes would be for broad categories. Um there's some differences in the data. Then you go into the data set where in private credit, particularly in the Corbinal market and below, uh these loans are closely held. There may only be one or two lenders holding the entire facility. Um, and a lot of that data doesn't get reported, and very rarely are those loans rated in a traditional uh sense. So it's a tough thing to look at. What I guide investors towards is usually looking at, especially when they're looking at track records and trying to parse historical default rates, to instead look at losses. Because losses can't be manipulated. It doesn't matter how loose or tight the market documents are. Um losses are really where rubber hits the road and you can discern a manager's quality in their credit process.

SPEAKER_00 3:34

So when you look across the industry, what do trends look like? Are things getting better or worse in terms of credit quality? Because fundamentally, that's kind of the biggest issue that investors would have to grapple with when they're thinking about future returns from this asset class.

SPEAKER_02 3:48

We see very consistent credit quality across the market. One of the things that we're struggling with a lot is that private credit has grown so much over the last five years. Um and we raised, you know, as a market for direct lending only$50 billion last year. Um, with the expansion of private credit, so too of these portfolios have expanded and they're all very, very diversified. It's easy to, if you're a news outlet, go look at a specific example that fits your narrative, whether it's a company that's in default or distress or a fund manager that's made a mistake. Um we're living in a very, very uh scrutinized world right now.

SPEAKER_00 4:26

So there will be defaults.

SPEAKER_02 4:28

Defaults are an actuarial inevitability in this market. So are losses. That's why uh portfolio construction is such a key topic for advisors and investors to bear in mind. This is about manager selection. It's also about fund selection within that manager's complex. But defaults occur. You know, it's it it's the frustrating thing for I think a lot of private credit managers right now is that quality remains high, but there are absolutely going to be examples. When I think about quality and some of the quantitative metrics that we can consider, pick is obviously one that's in a lot of portfolios and a lot of investors' minds. About half the pick that's in the market is what we classify as good pick. Um, not that it's great in my opinion, um, but these would be pick toggle structures where a loan is made with the structure including the ability to pay a portion of interest, not in cash, but in kind. Um, and then there's quote unquote bad pick. Bad pick refers to when a loan is in distress and cash flow is tight, lenders may make an accommodation to allow a portion of interest to be paid in kind in that scenario. You have seen a modest rise in pick and a modest rise from say 40 to 50 percent in normal circumstance to 58% of the total PIC being realized by most private credit funds across the market. Uh, but that in and of itself, I don't think is um is a real damning sign for the quality of portfolios. In general, even within software, which is rightly being scrutinized right now, um, it's an obvious place for investors to look for potential distress. We see a lot of high quality names, particularly in the middle market, um, lenders who did not advance credit based on annual recurring revenue, but instead looked at software companies on the same basis that they look at the rest of their portfolios on cash flow. Uh, those names are performing very well. So it's it's tough to look at the data and draw the conclusion that there are major signs of systemic distress in direct lending funds today. Our fund, as an example, um, which we manage with Audacks, Bain, and Charles Bank. They're the deal origination sources for everything we do in the portfolio, has no outstanding defaults right now.

SPEAKER_00 6:43

Zero defaults.

SPEAKER_02 6:44

Zero defaults. We have no borrowers in distress. It is a fresher portfolio. So everything that we've done has been underwritten with this higher interest rate environment and AI and tariffs all top of mind. But it is still a great um harbinger of uh the quality and the performance of a diverse set of middle market businesses, mostly domestic. Um, and we see free cash flow remaining very strong right now.

SPEAKER_00 7:08

Okay, so zero defaults. And I think, you know, from an advisor perspective, an individual investor who's getting into the space will first ask about defaults. There are a lot of people who struggle with the concept of pick. How do you describe pick to somebody new to the industry? And what does your portfolio look like in terms of pick usage?

SPEAKER_02 7:27

Gosh, you're you're setting me up now, uh almost for too good of a question. We have no pick in our portfolio, zero pick. We also do not invest in anything that has a pick toggle structure.

SPEAKER_00 7:37

Does that mean you disagree with the use of pick in the industry?

SPEAKER_02 7:40

I think that there are upper middle market, um, larger enterprises where in certain circumstances a pick toggle is warranted because more of the underwriting, instead of being based solely on cash flow, is also driven by the enterprise value, which is more established for a company that has$500 million of EBITDA than for a smaller company where you're really looking at forecasted cash flows and whether or not they can service your debt. There's a place for pick toggles. We invest in the core middle market where I don't think it really has a home, particularly if you're trying to remain very conservatively invested. But across all these metrics, this is about risk tolerance. You know, we we deal in probability, um, not in certainty. And returns and risk are obviously highly correlated. So when you see a lender out there that is generating 15% returns on a particular loan, regardless of whether or not it's classified as a senior secured, safe, conservative position loan, um, chances are that there's elevated risk associated with it.

SPEAKER_00 8:40

Okay, so that's the concept of pick a little bit. But again, for somebody new to this industry, how do you describe pick?

SPEAKER_02 8:46

PIC is when a portion or all of the interest payment that you would typically make on a quarterly or monthly basis in cash to your lender is instead added to the principal amount. So you're deferring that payment until the bullet at maturity. It is a tool that is used mostly for companies who, while they may be very valuable and their cash flows may be predictable, um, they may have something like a growth capex project in mind at the outset of a deal. And that growth capex project is going to take up a good portion of cash flows. It will generate returns and future cash flows, but perhaps for a period of time, there are not sufficient cash flows to comfortably service the debt. So lenders will uh allow that company to capitalize a portion of interest rather than paying it in cash to fit the capital structure of that borrower.

SPEAKER_00 9:42

I mean, is there a way to see this as a company being actually more highly levered by using PIC?

SPEAKER_02 9:47

You can look at it that way. There's three main credit metrics that everybody universally looks at. Um they may look at others, but coverage ratios, leverage ratios, and LTV. LTV is the easiest to understand. That is much like the mortgage on a home.

SPEAKER_00 10:04

Loan to value.

SPEAKER_02 10:05

Loan to value. Uh the mortgage on a home, what is the equity cushion that sits junior to the debt investment that the manager is making? LTV, a very hot topic right now as it relates to software, where we've seen enterprise values compress, um, and that cushion of safety for the debt is lower than it was a year ago. Um leverage ratios are the ratios of a company's indebtedness to its cash flow. Uh that is historically the main thing that we have all looked at. And coverage ratios, which are particularly relevant in a high interest rate environment or even a mid-interest rate environment like we have today, and that's the ratio of cash flows to debt service.

SPEAKER_00 10:46

Okay.

SPEAKER_02 10:46

Let's say you had a credit that was great LTV. You know, it's a fast growing company, the private equity sponsor is paying a lot of money for it, a big multiple. You have a conservative leverage ratio, but from a cash flow coverage perspective, that metric may be below. That would be an example of a situation where a pick toggle might make sense.

SPEAKER_00 11:06

So we'll talk more about software, big questions around the industry. But before that, I really think that the biggest thing in the market today is trying to understand what's happening around redemptions and gating. Most funds in this space that are open to individual investors tend to have that 5% limit, but we are seeing this wave of investors really looking to surpass that 5% limit at this point. And we've seen different strategies by different funds. You saw Blackstone come in and redeem or allow investors to redeem beyond that 5%, up to 7.9%. You saw BlackRock take a different strategy and keep that gate at 5%. How do you think about this? What would you do?

SPEAKER_02 11:51

It is case by case, firstly. Um, the narrative throughout 2025 was that a lot of funds, especially the bigger end of the upper middle market, uh, which had raised a lot of money, in particular through the wealth channel, um, was underdeployed. So the capital that they had raised, uh, it was not an easy process, and they were struggling to have deal flow keep up with their deployment requirements. Where we're at now is a natural evolution of that. Inflows have slowed, outflows have increased.

SPEAKER_00 12:21

There was too much money that went into the industry last year.

SPEAKER_02 12:24

I think that that would be a critique of a lot of investors. Um, and I don't think it resulted necessarily in substantially reduced credit quality, but what it did do is compress returns in the market. Where we started the year last year with 10 to 11% being our private credit estimate. Uh we ended the year in the current environment, eight to nine is probably a better bet. So when we look at funds, their liquidity profile has a lot to do with whether or not they decide to exceed their redemption limit.

SPEAKER_00 12:52

So basically all the unused capital.

SPEAKER_02 12:54

Correct. So we did have a number of market participants that were below their target fund level leverage amounts, which means they had excess borrowing capacity, and they may have been operating with a lot of broadly syndicated loans in their portfolio, which are another obvious source of liquidity for these vehicles, and they may have had too much cash on hand. So funding excess redemptions is a relatively easy thing to do in that kind of context. In fact, it right sizes your balance sheet, it probably results in an improved, more pure play private credit portfolio to the extent that those managers sold broadly syndicated loans. All of that said, I'm a very firm believer that these are the word semi-liquid is a dangerous term, right? Investors need to go into these understanding that there are redemption rights on a quarterly basis, you'll be getting interest payments on a quarterly basis or a monthly basis, but that the underlying assets here do not have a vibrant secondary market right now. And the last thing that I want to see any private credit manager do is start to try and pull forward realizations or generate liquidity through asset sales. I think that that's not going to happen anytime soon, but if you look at a prolonged period, a prolonged higher elevated redemption cycle, that's where it could end up. And that's what we want to avoid. Our mission and what we do at the fund I manage is to ensure that the investment program, this very differentiated partnership with access to three managers, underlying deal flow, is not disrupted by anything that happens at the fund wrapper level. I was encouraged by HPS, who is not operating an under-levered fund, right? They had restrained inflows. I think that they did a service to the market by enforcing the 5% limit, which is what they had promised to investors. It's what this market and asset class promised to investors.

SPEAKER_00 14:45

So HPS in a filing called that 5% limit foundational. And you can understand that too, right? If you don't allow, or rather, if you do allow investors to go too far past that 5% limit on a regular basis, then you would risk forced selling of assets. This is an illiquid asset class underlying. So there's really only so much liquidity you can give investors at the end of the day. Why is this so misunderstood, right? This industry is going through a perception change at the moment. And do you think that the fact that we're seeing so many funds surpass that 5% limit creates a reputational issue, frankly, for parts of the industry?

SPEAKER_02 15:28

I think it does. I think that perception matters. I think that um investor and advisor education matters a lot. And I think that there are a lot of people who looked at the massive inflows into this sector and assumed that that would mean no matter what, they'd be able to access that liquidity. That's just not true. You know, the origins of how we get to 20% being a very reasonable number for all of these funds to send out every year is if you look at um an average repayment cycle in direct lending, historical experience tells us that between three and four years is when these loans are refinanced. So if you see between a quarter and a third of your book being returned to you every year, that's somewhere between 25-30% liquidity, that's a sufficient buffer ahead of the 20% that you're promising to investors. So in a wind-down fund, a self-liquidating fund, that would work. I think investors need to understand that. You know, the underlying assets are illiquid. And when you think about risk in your portfolio, it's not just about returns and volatility. Because those are the two areas that private credit really shows its value proposition very clearly, right? These are generally lower volatility loans than the broadly syndicated market. Um, and the returns are a significant premium. So it's a great story in that regard. There's no free lunch. The trade-off to that is the liquidity profile. And so people need to consider liquidity alongside the Sharpe ratio.

SPEAKER_00 16:51

So when you're thinking about what's happening now, as I talk to you at this moment, we're kind of getting towards that end of the window where many funds are closing their first quarter tender offers. That means we're getting a lot of information on what the actual share of purchase requests look like. And we're seeing those in access. We recently published a piece that showed that in a prior example, you can see B REIT, for example, in 2022 took 14 months to get back to 100% redemptions. Um you can compress that timeline a little bit for the for the asset class of private credit, around a year in total. But does that mean that there's gonna be continued, strained sentiment in this industry for a little while longer? We're hitting the end of Q1. What about Q2? Are we gonna see elevated requests through 2Q kind of industry-wide? Um, what does that mean through the rest of 2026?

SPEAKER_02 17:44

I think that, you know, especially in private credit, where we're talking about very conservative individuals leading these funds, right? Everybody has their credit hat on, thinking about worst case. I believe that most managers are planning for elevated redemptions over the course of all of 2026. Okay, doesn't mean that's going to come to pass, but there's also no obvious catalyst for a change in sentiment. It's very difficult to dispel the notion that credit quality is weak when it's strong. You know, all the data supports the continued health of these portfolios. That said, unlike the B-Read example, there are no investor losses that I see as part of this equation thus far. When you read all the headlines, uh nothing points to investors losing money.

SPEAKER_00 18:33

But investors didn't lose money per se in that case. Rates were rising. So the return compression was the worry, from what I remember.

SPEAKER_02 18:40

Definitely, definitely correct. Um and we saw B read play out over what, 15 months?

SPEAKER_00 18:46

14, but yes, yes.

SPEAKER_02 18:48

So maybe we have a similar experience here. Um the the other difference, though, I see vis-a-vis B read is credit funds have access to liquidity in a lot of different ways. Not only is the hold period on average lower for the underlying portfolio, you have uh many funds with about a 50% dividend reinvestment rate out of the current income that those funds generate. Um, credit has the most leverageability of any of the alternative asset classes, perhaps aside from real estate. And all of these credit managers on average, the top 10 are levered about 0.8 right now. The regulatory limit is two times. So that is a massive amount of liquidity buffer that they can um they can rely on. Hopefully, the market throughout this exercise learns more about the nature of these funds and these fund structures.

SPEAKER_00 19:36

Yeah, is there something healthy about this actually, this moment?

SPEAKER_02 19:39

I think the market was ready to test private credit, come hell or high water, right? This was a this was in the waiting. Um, people have seen the growth of the asset class, they always want to scrutinize. And that's fine. I think private credit and it its largest managers stand very ready to meet that test. And yeah, that that's my hope is that as time goes on, the you know, the media coverage and the investor base will become a lot more educated on how this all works and will gain comfort from that.

SPEAKER_00 20:07

Just to hit on the topic of losses really quick, because obviously we've seen defaults here and there. But with private credit, these are hundreds of portfolio companies. And so when you're seeing these individual defaults, people forget that the band of returns across private credit managers is actually quite thin relative to other asset classes. So what does this mean? If you're seeing defaults in portfolios, how much is it really impacting the total return of portfolios? Is it reasonable that you know a 9% portfolio all of a sudden is a 5% portfolio? Or are we talking just a difference of a percentage point or two?

SPEAKER_02 20:43

Aaron Powell Again, going to the historical data, the managers that we work with and the fund I manage, I direct private credit, have an average historical loss ratio of seven or eight basis points. So that means that historically going back 25 years. Um, there's a huge amount of cushion to absorb losses. In addition to which, you know, we're seeing all of this scrutiny of private credit, but if these portfolios really do have distress in them, the implication is that I just walked through an LTV example, right? If you eat through to where the debt is impaired and you do experience losses, that means the equity in each of these companies has been completely wiped out. I don't think people are having the same qualms about private equity right now, but if you're out there and you're really convinced that, you know, whether it's our fund or another manager's fund is going to endure significant losses, you know, more than 10x the historical average, mind you, at even 10x, that's less than a one percentage point impact on the total return, then you really have a very harsh view of private equity.

SPEAKER_00 21:58

So finally, just to get back to Software before we close this up. The software example is interesting because I think when you look on top of this issue from the outside, it's kind of like AI is coming, it's going to eat software, and then you saw the public market drama down, and then the opacity of the private markets, and people get scared. I mean, that's kind of my quick way of wrapping up what's happening on a sentiment level. But what about the reality level? What's actually happening in the software space for these portfolio companies? And is it a real risk, let alone an existential risk for the private credit industry?

SPEAKER_02 22:34

Well, I said before this is a very rational place for investors to look. And in particular, when you dig in on portfolios, in 2022, we saw a significant increase in interest rates. The period immediately preceding that was a relatively competitive environment. A lot of deals cleared at very full leverage on very high enterprise value multiples. And so as that cohort of deals, many of which were tech and were software, has matured, the current interest rate environment creates some real restructuring risk. We've seen a lot of those deals go through halfway restructurings, what we in the industry called liability management exercises.

SPEAKER_00 23:13

The cheap word for it is a meant and extend from what I think.

SPEAKER_02 23:17

That can be one version of it for sure. In a lot of cases, it would involve closing some loopholes in documentation. Maybe the lenders make a covenant modification or some kind of compromise with the sponsor, but whatever it is, the theme of it was that we kind of kick the can and give the existing ownership of the of the business more time to uh improve operations to match the capital structure. That set of deals is now coming to the point where they would be in ordinary course uh refinanced. And so I think you'll see some distress in those names, but it's mostly an interest rate environment question. A lot of those deals were also underwritten on the basis of ARR. And annual recurring revenue-based loans is something that continues to exist in the market today. To me, levering companies, putting debt on companies on the basis of a revenue multiple, no matter how recurring it is, is not what we do in private credit. You know, we look at cash flows, we focus on predictable earnings, not predictable revenue. So to me, those underwritings just fall into the, hey, this is a bad credit philosophy as opposed to something that is specific to software. For the remainder of the SaaS market that private credit has embraced because it has recurring revenue, when there are also recurring cash flows associated with it, those names, by and large, are performing really well. It's mostly enterprise software. Those software companies are deeply embedded with Enterprise America. And I don't think we have yet to see real signs of distress resulting from AI. That's not to say it couldn't occur in two to three years, and I do think that's the time horizon most people are focused on. But as of now, those companies are healthy. We have uh just a couple software names in our portfolio, and I can tell you their performance is on the upper end of the broader portfolio.

SPEAKER_00 25:05

Okay, so let's end on a high note. What would make investors more comfortable with private credit again, writ large?

SPEAKER_02 25:11

I'll be interested to see how Apollo's experiment taking their BDC to daily valuations impacts investor sentiment. Our fund is daily valued already. I think a lot of investors take comfort in being able to recognize that price and understand that it is entirely third-party governed, um, that it has real independence underlying it, and that it is a daily process. We don't wait and allow a large lag to occur prior to.

SPEAKER_00 25:36

It's fairly rare now.

SPEAKER_02 25:38

I think that it will become increasingly prevalent today. Interval funds uh are the only ones who do it writ large, but we'll see how the Apollo experiment goes.

SPEAKER_00 25:48

Very cool. Sam Williams of iCapital. We thank you so much for joining us today on Fion6040, answering the questions that are certainly the top of mind in the market today.

SPEAKER_01 26:03

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