After years of explosive growth and strong returns, private credit is facing its first meaningful stress test, particularly within direct lending, which has become the dominant segment of the asset class over the past decade. The market has attracted growing scrutiny, with concerns ranging from rising bankruptcies and liquidity pressures in semi-liquid vehicles to the disruptive impact of AI on software companies once considered stable and predictable borrowers. For Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management, the current environment is less a systemic crisis and more a long-awaited normalization process for direct lending.
“Direct lending is going through its first proper credit cycle,” says Pesonen. “Many things are coming together at the same time.” While he acknowledges the challenges facing the asset class, he believes the current environment could ultimately strengthen private credit over the longer term.
“Direct lending is going through its first proper credit cycle. Many things are coming together at the same time.”
Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management.
The Legacy of Easy Money
A significant portion of today’s concerns can be traced back to the exceptionally aggressive deployment environment before and during 2022. That period combined ultra-low interest rates, abundant liquidity, intense competition among lenders, and strong demand from private equity sponsors. The result was a large vintage of loans originated on highly borrower-friendly terms and increasingly stretched capital structures. “Prior to 2022, and during the rate-hike cycle itself, huge amounts of capital were raised across private markets and deployed very aggressively,” recalls Pesonen. “Looking back now, there were many deals with unsustainable capital structures.” Because most direct lending loans are floating rate, the sharp increase in interest rates after 2022 materially changed the financing environment for borrowers. Companies underwritten at near-zero base rates suddenly faced much higher debt servicing costs.
“Prior to 2022, and during the rate-hike cycle itself, huge amounts of capital were raised across private markets and deployed very aggressively. Looking back now, there were many deals with unsustainable capital structures.”
Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management.
On top of the higher-rate environment, Pesonen sees another important source of pressure: software exposure and the rapid rise of artificial intelligence. “There is a strong software and AI loop tied into this,” he explains. Private credit managers heavily financed sponsor-backed software and technology-enabled service businesses under the assumption of stable recurring revenues, high margins, and durable growth. Many of these companies were valued and leveraged at elevated multiples. “Buyout funds loved software because of the growth profile and the market’s positive experience with the sector,” says Pesonen. “But many of these smaller firms needed significant leverage for the buyout math to work.” Because the leverage levels were often too high for the broadly syndicated loan market, many of these transactions ended up in direct lending portfolios instead.
In hindsight, Pesonen believes the concentration toward software now looks problematic, although largely unforeseen. “No one expected AI to arrive with this kind of force,” he says. “Defaults will rise, and they will become meaningful over the next two to three years.” For private credit lenders, the concern is not necessarily immediate defaults, but rather declining enterprise values, weaker refinancing conditions, and highly levered companies struggling in a slower-growth environment.
“Buyout funds loved software because of the growth profile and the market’s positive experience with the sector. No one expected AI to arrive with this kind of force. Defaults will rise, and they will become meaningful over the next two to three years.”
Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management.
Another major concern stems from the rapid growth of semi-liquid evergreen structures, particularly in U.S. private credit markets. Much of the recent negative media attention has focused on these vehicles and the tension between investor liquidity expectations and the inherently illiquid nature of private credit assets. “All the bad publicity has really centered around open-ended evergreen structures with some form of liquidity promise,” says Pesonen.
“All the bad publicity has really centered around open-ended evergreen structures with some form of liquidity promise.”
Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management.
Over the past six to seven years, an estimated $600 billion has flowed into semi-liquid structures, particularly private business development companies (BDCs). Most of these vehicles offer quarterly liquidity, typically capped at five percent of net asset value. “These funds usually have liquid buckets within the portfolio, such as broadly syndicated loans, and if you do the math on the coupons and maturities, under normal circumstances they can meet that five percent liquidity,” explains Pesonen. “But now retail investors are asking for money back and not getting it, which naturally creates headlines.” Still, he argues that the current issues reflect the intended structure of these products rather than a hidden flaw. “This is ultimately what investors signed up for.”
A Long-Awaited Credit Cycle
Private credit has delivered strong returns over the past decade, particularly in direct lending. From 2011 to 2020, direct lending experienced exceptionally favorable conditions: low defaults, near-zero base rates, and spreads of 600 to 700 basis points. The subsequent rise in base rates temporarily pushed all-in yields into double digits, creating what many viewed as the “golden era” of private credit. “In the U.S., people suddenly saw five percent base rates plus six percent spreads and thought this was an incredible business,” says Pesonen. “It was a very attractive period.”
For Pesonen, the current environment represents a necessary step in the maturation of direct lending as an asset class. “I’ve been waiting for this test for quite a while,” he says. “We just never knew what the trigger would be.” According to him, excessive leverage, aggressive deal activity, AI-related uncertainty, and the evergreen liquidity mismatch all combined to create the current situation.
“We need to go through a cycle, get to a more solid footing, and understand that this is just part of that bigger market. But the path there will be painful, and no one really knows how things will unfold or how the direct lenders will deal with it.”
Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management.
Pesonen has long argued that direct lending should not be viewed as fundamentally different from broadly syndicated loans or high yield. “It’s all part of the leveraged finance universe,” he explains. According to Pesonen, the same economic principles apply to direct lending as to the broader leveraged finance market, with smaller companies typically carrying higher leverage. “The default rate should be something more than three percent annualized, whereas in the past they have shown pretty much zero,” he says. “We need to go through a cycle, get to a more solid footing, and understand that this is just part of that bigger market. But the path there will be painful, and no one really knows how things will unfold or how the direct lenders will deal with it.”
At the same time, Pesonen believes the adjustment process may create attractive opportunities elsewhere in private credit. Going forward, he believes opportunities may increasingly shift toward distressed and opportunistic strategies rather than traditional sponsor-backed direct lending.
Lower Returns, Better Discipline
Pesonen expects return expectations for direct lending to moderate over time. Comparing the asset class to the broadly syndicated loan market, he argues that the economics should ultimately converge, although direct lending will continue to command a premium because it finances smaller and more leveraged companies. “Unlevered direct lending should probably settle somewhere in the five to seven percent range,” he says. “With leverage, you can still reach double-digit returns, but the idea of generating 10 percent annually with no volatility and no losses is over.”
Higher interest rates, if sustained, would likely push default rates higher and compress spreads over time. “No economy functions properly when senior debt consistently costs double digits. No corporate can function that way over the long term,” says Pesonen. If higher base rates persist, he expects default rates to rise, while spreads will eventually compress as markets adjust to more sustainable financing conditions. “If money costs too much for too long, it simply doesn’t work,” he explains.
“This cycle is for the better. The market became far too hot, and now we’re finally seeing a necessary cooling period.”
Tero Pesonen, Director for Private Equity and Private Credit at LocalTapiola Asset Management.
Looking ahead, Pesonen expects a more mature and selective private credit universe, with greater differentiation between managers and strategies. “There will be a playoff round among managers,” he says. “Not everyone will survive the next five years.” Still, he believes the ongoing correction is ultimately healthy for the market. “This cycle is for the better,” concludes Pesonen. “The market became far too hot, and now we’re finally seeing a necessary cooling period.”
