The private credit market has a growing AI problem

• The issues surrounding alternative manager Blue Owl have thrust private credit back into the spotlight.
• AI-driven disruption, particularly in sectors like software, is increasingly being flagged as a risk.
• New research from UBS laid out a worst-case scenario for private credit.

It's not usually a good sign when a research firm issues a worst-case-scenario forecast. It's even more troubling when that firm adjusts its outlook to be more bearish just two weeks later.

Well, that's exactly what the credit-strategy team at UBS just did. The strategists initially laid out a tail-risk scenario in early February, which included a potential spike in private credit defaults. Then, this week, the firm checked back in to make that forecast more negative.

As with most market disruptions these days, the source can be traced back to the rapid rise of AI. In recent weeks, software has emerged as a particularly vulnerable area, and stock prices sector-wide have paid the price. Those struggles have also thrust a light onto the direct lenders that finance them.

A recent analysis from Bloomberg estimated that 40% of all PE-backed loans are tied up in the software industry. That's a huge percentage, and surely informs UBS's increasingly bearish view on private credit.

Under the firm's worst-case outcome, stress within private credit would then spread to other areas of the bond market, since there's so much overlap amongst borrowers and lenders. And any rise in private defaults would then affect public markets and potentially sap them of liquidity.

The situation "raises concerns about capital adequacy and loss absorption in a downturn, particularly if defaults spike and valuations collapse," UBS said.

Got all that? I swear it's not intended to scare you. It's just that warnings like UBS's are becoming more commonplace.

The most recent flare-up came last week, when alternative asset manager Blue Owl said it would restrict withdrawals from one of its private credit funds geared towards retail investors. Former Pimco CEO Mohamed El-Erian called it a potential "canary-in-the-coal-mine" moment, and said it reminded him of the period right before the financial crisis.

But the potential downside of private credit really burst into the financial mainstream last September, with the bankruptcy of automotive-parts producer First Brands. An autopsy of the company's shoddy finances shined a light on the diligence — or lack thereof — going on in private lending. Industry leaders assured everyone the exposure was limited. But private credit's public image took a hit.

As these risks become more well-recognized, the expansion of private credit is not slowing down. More firms are offering access. More retail investors are getting interested. It may even wind up in your 401(k).

It could work out that heightened recognition of private-credit risk heads off more serious blow-ups down the road. It can only help that lenders are under pressure to tighten underwriting standards. The real question is how much toxic debt is already out there.

If the answer turns out to be "too much," please refer to the UBS scenario referenced above (and say a prayer for my portfolio).