The segment of private credit with the worst-looking numbers is not what is worrying investors the most.
Smaller companies are showing the most strain, with 13% of private credit loans in the lower-middle market valued below 90% of their initial value, a marker for a distressed loan, which is an “alarming” sign, according to investment bank Houlihan Lokey.
But those loans are just a “drop in the bucket” of the total dollar amount of direct lending, said Chris Cessna, a director in Houlihan Lokey’s financial and valuation advisory business. Instead, the larger concerns are in an industry that isn’t even seeing distress: software.
“In the software companies, you’re really not seeing any weakness in trailing numbers,” Cessna said. “It’s all about what happens to the business model going forward now that AI becomes a risk.”
Concerns about how AI will impact software firms rattled publicly owned private credit firms in February, as software and related loans make up 28.7% of the total value of loans in private credit interval funds and business development companies, according to S&P Global.
Houlihan Lokey’s fourth-quarter Private Credit Databank report found that 47% of software loans, and 56% by dollar amount, will mature by 2029, when firms will have to either repay the debt or prove they can refinance in the age of AI.
“This presents a complex, two-sided risk for lenders and borrowers alike, as the rapid pace of AI and technological change intersects with refinancing timelines,” the report says.
Small borrowers see distress
Small companies, with less financial cushion to ride out distress, are often the riskiest (and most lucrative) companies to lend to. Unlike large companies with many levers to pull to respond to rising interest rates, tariffs, and supply chain disruptions, or the economic impacts of war, these small companies typically see distress first.
Among the smallest companies, which Houlihan Lokey classifies as sub-$20 million in profit, excluding certain costs, or adjusted EBITDA, only 78% of loans are valued within 3% of their original price, compared to 88% of all borrowers.
As distress ticks up across all levels, do these companies make a canary in the coal mine? Probably not, says Houlihan Lokey. Only 5% of loans in the overall market have fallen to distressed levels, up from 2% in 2023, according to the bank.
“We don’t have any reason to believe that the smaller borrowers would be a leading indicator and that would eventually bleed into the larger borrowers,” said Cessna.
While 4.3% of the loans Houlihan Lokey tracked were in default, that made only 1.4% of the total loan value. Many of these defaults were in smaller companies, which, because of their size, have a lower potential impact on investors.
This lower-middle-market includes lenders that specialize in this area and larger lenders that have decided to cut off loans to smaller borrowers because of the higher returns they offer.
One prominent lower-middle-market specialist firm, Monroe Capital, reported its redemptions rose to 5.4% of net asset value in the first quarter, though these figures are lower than those of some larger BDCs that have recently announced redemptions.
Zia Uddin, president at Monroe Capital, said in a statement to Business Insider that the firm has more than two decades of experience investing in the lower-middle-market, and said the firm views “the current environment as one that rewards careful credit selection.”
“The Houlihan Lokey data points to areas of pricing pressure in the LMM, but from our vantage point, we are still seeing solid fundamental performance across many at the portfolio company level, including healthy interest coverage, and continued strong sponsor support,” Uddin wrote.
Software Loans
Software companies, which have taken a shellacking this year on the public markets, promise more potential disruption. But those loans are actually performing quite well right now.
Of the software companies in Houlihan Lokey’s dataset, nearly 70% achieved revenue growth and EBITDA margin growth year-over-year. Another 75% of the companies have loan-to-value ratios of below 50%, a signal that they’re well capitalized and not borrowing too much.
The actual impacts of AI on software companies remain in the future, though the public market sell-off could hit private valuations as soon as this quarter, the report says.
The real concern will be when the loans are due, with more than half of the money coming due before the next decade. In Houlihan Lokey’s dataset, that’s over $160 billion in loans, a massive wall of maturity that takes up a good proportion of the private credit industry’s entire direct-lending book.
For loans that mature sooner, there’s a “race against time,” the report said, with companies potentially able to refinance before AI drastically changes the industry. Or they may not have enough time to respond to potential disruptions, which can hurt their ability to refinance.
Those with longer-dated maturity have more time to prepare for disruption, but with that time could come more risk: namely, “their entire business model could be fundamentally challenged by more agile, AI-native competitors,” the report said.
But as with anything in private markets, there will always be winners and losers.
“Not all software companies are created equal,” Tim Kang, a managing director in Houlihan Lokey’s financial and valuation advisory business. “There’s probably a tail of software companies where this is a net benefit, but broadly speaking, this potentially could have a big impact, which is why the markets are doing what they’re doing.”
