Private credit’s software blind spot raises new fears for $3 trillion industry

Private credit markets face new uncertainty as AI-based tools begin to put pressure on software companies, a major borrower group for private lenders.

The software industry came under renewed pressure last week after artificial intelligence company Anthropic unveiled new AI tools, sparking a selloff in shares of software data providers.

The AI ​​tools developed by Anthropic are designed to perform complex business tasks that many software companies currently charge for, raising new concerns that traditional software business models could be undermined by AI.

Shares of asset managers with large private credit franchises fell this week as investors worried about how AI could upend borrowers’ business models, pressure cash flows and ultimately increase default risks.

Ares Management fell more than 12% last week, while Blue Owl Capital lost more than 8%. KKR decreased by almost 10%. TPG lost about 7%. Apollo Global And black rock fell more than 1% and 5%, respectively. For comparison, the S&P500 fell by around 0.1%, while the technology sector Nasdaq fell 1.8%.

The moves highlight growing unease around the private credit market, which must now prepare for the impact of AI-driven disruption on the software sector, which is heavily exposed to buyouts financed by opaque and illiquid loans, according to market observers.

“Enterprise software companies have been a favored sector for private lenders since 2020,” PitchBook wrote in a report last week following the fallout, adding that many of the largest unitranche loans (two or more loans combined into one), the preferred structure in the private credit market, have been made to software and technology companies.

Software accounts for a significant portion of loans held by U.S. business development companies, accounting for about 17% of BDC’s investments in terms of number of transactions, second only to business services, according to PitchBook data.

This exposure could prove costly if AI adoption accelerates faster than borrowers can adapt. UBS Group has warned that in an aggressive disruption scenario, US private credit default rates could rise as high as 13%, significantly higher than the expected stress for leveraged loans and high-yield bonds, which UBS estimates could be around 8% and 4% respectively.

“Private loans to a lot of software companies,” said Jeffrey C. Hooke, a lecturer in finance at the Johns Hopkins Carey Business School. “If they start moving south, there will be problems in the portfolio.”

Hooke said, however, that private credit strains predate the latest AI concerns, pointing to issues with liquidity and loan extensions. “Many private credit funds have had difficulty liquidating their loans,” he said, adding that recent developments have only added another layer to an already stressed sector.

This series of new warnings follows recent concerns in a $3 trillion industry Last year, JPMorgan’s Jamie Dimon warned of the “cockroaches” of private credit, warning that stress in a borrower can signal other hidden problems.

“AI disruption could pose a credit risk to private lenders for some of its software and services sector borrowers and perhaps not for others, because it depends on who is behind the AI ​​curve and who is above it,” said Kenny Tang, head of U.S. credit research at PitchBook LCD.

Tang added that software and service companies account for the largest share of payments in kind (PIK). loans, which refer to agreements allowing borrowers to delay paying interest in cash. Although PIK structures are often used to give fast-growing businesses time to generate revenue and cash flow, they become risky if a borrower’s finances weaken. In this case, deferred interest can quickly turn into a credit problem, he said.

Mark Zandi, chief economist at Moody Analytics, noted that while a comprehensive assessment of risks in the sector is difficult to grasp due to its opacity, the rapid growth of AI-related borrowing, rising leverage and lack of transparency are considerable “red flags.”

“There are sure to be significant credit problems, and while the private credit sector is probably currently able to absorb any losses reasonably well, this may not be the case in a year’s time if current credit growth continues.”

Apollo, Blue Owl, TPG and BlakRock did not immediately respond to questions from CNBC, while KKR declined to comment.

Michael Arougheti, CEO of Ares Management, said the company’s exposure to software is limited, with software loans accounting for about 6% of its total assets and less than 9% of private credit assets under management.

He added that Ares primarily lends to profitable software companies with strong cash flow and keeps borrowing levels low, which has helped keep problem loans near zero.