Concerns in the private credit market continue to spread on Wall Street.
A report released by Morgan Stanley analysts on Monday pointed out that loans in the software industry have the highest leverage and the lowest coverage in the private credit market, with default rates potentially approaching peak levels since the pandemic.
The report indicated that as advancements in artificial intelligence continue to disrupt the software industry, the debt repayment capacity of software companies is weakening, and the default rate on direct loans is expected to rise to 8%. Direct lending is a form of private lending where non-bank institutions (such as asset management companies, private equity funds, insurance companies, etc.) bypass traditional financial intermediaries like commercial banks to provide loans directly to businesses.
Meanwhile, according to The Wall Street Journal, John Zito, co-president of Apollo Global Management, recently made unusually sharp remarks in a private setting, pointing directly to the prevalence of &#34;arrogance&#34; in the private market, with private equity valuations generally distorted and risks far exceeding market perceptions.
John Zito noted that many software companies acquired between 2018 and 2022 are incorrectly valued, and the related private credit faces significant downward and default pressure.
<h2>Morgan Stanley: Default rates may rise to 8%, recession probability adjusted upward</h2>
Morgan Stanley analyst Joyce Jiang warned in the team report that although the impact of artificial intelligence on credit fundamentals has not yet manifested, there is a persistent trend of weakness in coverage as AI disruptions continue to evolve.
&#34;Coverage&#34; refers to the interest coverage ratio of borrowing companies in the private credit sector (EBITDA divided by interest expenses). Morgan Stanley believes that the operating profits of software companies are already showing a trend of being unable to cover their debt interest.
Morgan Stanley data shows that software companies are the most focused industry in the investment portfolios of business development companies (BDCs), with a risk exposure of about 26%. The risk exposure of collateralized loan obligations (CLOs) to the software industry also reaches 19%.
CLOs are asset-backed securities that bundle hundreds of corporate loans (usually leveraged loans) together to form a resource pool, which is then used as collateral to issue securities of varying risk levels to investors.
Citing PitchBook data, Morgan Stanley pointed out that 11% of software loans in direct lending will mature by 2027, followed by 20% maturing in 2028, with concentrated maturity pressure highly overlapping with the timeline of deepening AI impacts.
Morgan Stanley analysts noted:
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The credit fundamentals of software loans are under pressure, with the highest leverage and lowest coverage among major industries.
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Morgan Stanley analysts indicated that the cooling demand for private credit from retail investors may drive a gradual shift in the investor structure towards institutionalization, suppressing future growth in this market.
As of the end of the third quarter last year, business development companies collectively held assets totaling $530 billion, with significant participation from retail investors, and the inherent lack of liquidity has raised widespread concerns about the risk tolerance of less experienced investors.
However, the bank also emphasized that while overall credit risks are significant, they do not currently pose a systemic threat
<h2>Software Companies' Exposure Becomes the Biggest Hidden Danger</h2>
John Zito, Co-President of Apollo Global Management, believes that software companies acquired between 2018 and 2022 generally face three major issues: revenue weaker than comparable publicly listed companies, smaller in size, yet transacted at higher valuations.
He cited the example of Medallia, a software company privatized by Thoma Bravo in 2021 for $6.4 billion, pointing out that the credit situation of this transaction &#34;will be worse than the market expects.&#34; Several creditors of Medallia, including Apollo, have already written down related debts.
Zito criticized the logic of those who use the strong performance of publicly listed tech companies to support overall optimism:
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Most of the acquired companies are of lower quality than those listed companies, smaller in scale, and transacted at valuations far above those companies—those who say 'no problem' clearly do not truly understand.
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He also pointed out that the wave of artificial intelligence is forcing companies to rush deployments before the technology is truly mature, which will serve as an early signal of a broader economic slowdown, and stated that he believes the probability of a recession &#34;has exceeded 50%&#34;, and is more akin to a &#34;consumer confidence-driven recession.&#34;
<h2>Private Equity Valuations Generally Overinflated, Transparency in Doubt</h2>
Zito also questioned the cognitive contradictions within the private market.
He observed that investors have strong demand for purchasing shares in the private equity secondary market, yet remain cautious about financing 80% of these assets through private credit, which holds a more prioritized repayment position in the capital structure. He said:
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This doesn't make logical sense, but perhaps I misunderstand; when I mention this, I usually get a blank stare in return.
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On the issue of valuation transparency, Zito clearly expressed Apollo's stance and views it as a competitive advantage:
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If you don't adjust your books to market value, you will actually lose your clients' trust, and we will become the true market leader in pricing at market value.
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He also warned that the next market cycle will be a &#34;significant moment&#34; for the private market, and those participants who have grown within wealth management channels with an &#34;arrogant&#34; mindset will face severe tests.
<h2>Apollo Claims Stable Positions, But Admits Difficulty in Staying Unscathed</h2>
Although Zito is cautious about the overall risks in the industry, he still strives to endorse Apollo's own credit business. He stated that 95% of the assets on Apollo's balance sheet are investment-grade, and the exposure in the software industry is very low.
He expects that private credit loans issued in the next 12 to 18 months will be &#34;a better year&#34; in terms of company quality, leverage, documentation terms, and spreads.
However, Zito also admitted that if the economy truly falls into a severe recession, Apollo would also find it difficult to remain unscathed:
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I am sure we will also be affected, like everyone else, but I believe we will come out better and have enough flexibility to buy quality assets during that period, accumulating considerable returns for us
On the issue of redemption management, he tends to adhere to a redemption limit of 5% per quarter to protect the interests of existing investors, and warns against decisions that cater to redemption demands in the short term, saying, &#34;After one quarter, you will realize that it was a very bad decision.&#34;
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Morgan Stanley warns that the private credit market has the highest loan leverage and the lowest coverage in the software industry, with default rates potentially approaching peak levels since the pandemic. Apollo Global Co-President Zito pointed out that the valuations of acquired software companies between 2018 and 2022 were generally inflated. Zito believes the probability of a recession has exceeded 50% and criticizes the lack of transparency in private equity valuations

- The private credit market faces concerns as Morgan Stanley reports high leverage and low coverage in software industry loans, with default rates projected to rise to 8%.  
- John Zito from Apollo Global Management highlights significant issues with software company valuations and warns that a downturn is likely, given the disconnect between private equity valuations and market realities.  
- Despite Zito's caution regarding the overall risk, he emphasizes that Apollo's high-quality assets and strategic flexibility will help navigate potential economic challenges effectively.

Morgan Stanley expects the default rate of private credit in the U.S. to reach 8%, and industry giants admit: all valuations are wrong!