“A certain degree of caution is natural,” says advisor.

With all the headlines about problems in private credit markets, investors may be wondering if this means serious problems lie ahead for these assets.

There are currently some weaknesses. These should not be ignored, but some financial advisers say they do not portend widespread failure among private credit funds.

“Some caution is warranted, but the idea that private credit is facing widespread problems is overstated,” said Crystal Cox, a certified financial planner and senior vice president at Wealthspire Advisors in Madison, Wisconsin.

“Some of the pressures you see in the headlines have more to do with market maturation than systemic stress,” Cox said. “What’s really happening is a transition from a young, high-yield market to a more competitive, mature market where manager selection and underwriting discipline are more important.”

Overall, exposure to private credit should be a small portion of the investment, Cox says.

“For most individual investors, a prudent way to enjoy returns without incurring concentrated credit or liquidity risk is to keep it at around 5% or less of the total portfolio,” he said.

Basically, private credit refers to loans made directly to businesses by investment companies. Asset management companies collect money from investors, pool it into funds, and use the cash to make loans to companies. They typically charge higher interest rates in exchange for taking on more risk. Interest rates often fluctuate. In other words, as the benchmark interest rate set by the Federal Reserve rises or falls, the interest rates that borrowers pay and investors earn also rise.

The appeal of private credit includes the opportunity to earn higher returns than fixed income investments in public markets, i.e. government and corporate bonds. But they also come with less transparency, higher fees, lack of liquidity (meaning investors’ money is tied up for longer), and higher risks.

Private credit is “diverse and there are different (lending) strategies,” said Richard Grimm, managing director and head of global credit at Boston investment firm Cambridge Associates. “There are parts of it that are real concerns and portfolios that are a concern, but the vast majority are very cash-producing and have very diversified portfolios.”

The market grew rapidly after the 2008 financial crisis, when stricter banking regulations forced many lenders to move away from riskier loans. Private funds have stepped in to fill the gap, expanding their corner of the broader alternative investment universe to an estimated $1.7 trillion, up from about $500 billion a decade ago, according to a 2024 study by the Federal Reserve.

Most private credit funds are available only to institutional investors, such as pension funds and insurance companies, and wealthy individuals who meet certain asset and income criteria. These funds typically have high minimum investment amounts of $1 million or more, and investors must agree to keep their money for, say, seven or 10 years. Because of its illiquidity and risk, investors receive higher-than-normal interest payments along the way and get their principal back at the end of the period (assuming the borrower does not default).

According to JPMorgan Private Bank, approximately 80% of investors in private credit funds will be institutional investors as of the end of 2024.

Pensions are major investors in private credit, but 401(k) plans typically exclude these assets from their lineup. Cerulli Associates estimates that less than 2% of plans include private assets (including private credit) in their 401(k) through custom target-date funds or similar products. Although it is a small number, we also have a lineup of private real estate.

But last August, President Donald Trump issued an executive order aimed at further encouraging alternative investments in 401(k)s, including in the private market.

Although the timing is unclear, the Ministry of Labor is expected to make a formal proposal soon. The agency submitted the proposed rule for review to the White House Office of Information and Regulatory Affairs on January 13.

There are several other ways for individual investors to invest in private credit. For example, there are exchange traded funds that invest in such funds. There are also business development companies (BDCs) that provide private loans to companies. Both ETFs and public BDCs are traded on exchanges. This means they are generally easier to buy and sell.

There are also some semi-liquid funds available to retail investors, such as interval funds and non-traded BDCs, but these may require minimum investment amounts or investor qualifications.

These funds allow investors to withdraw their funds at specific times (e.g. quarterly) and cap redemptions, usually as a percentage of net assets (e.g. 5% quarterly). If a withdrawal request exceeds that limit, investors may only receive a portion of their desired amount.

“In most cases, they are able to meet these reimbursement requests,” Cox said. “If it’s too much, we can put a cap on it.”

Withdrawal limits are generally intended to balance investor access with the fact that the underlying loans are private and largely illiquid.

It is some of these semi-liquid funds that are making headlines due to high redemption demands from investors who have seen yields fall as overall interest rates fall from 2022 onwards.

Since then, private credit overall still pays out more than the equivalent public debt market, but the additional yield available to investors has been cut in half, according to a study by JPMorgan Private Bank.

“We would argue that some of the increase in redemptions is related to profit taking after nearly three years of meaningful outperformance,” the study said.

Nevertheless, experts are sounding the alarm about the potential for higher default rates in certain areas of the private credit world.

Default rates for transactions involving direct lending are expected to rise to 8% from the current 5.6%, according to new research from Morgan Stanley. Direct lending is just one way private credit funds deploy capital. For example, there are asset-backed loans that use specific assets as collateral and the purchase of non-performing loans.

Defaults are expected to be driven by disruptions in artificial intelligence, concentrated in software and AI-related sectors, according to Morgan Stanley.

“AI trade is disrupting everything, especially software,” Cox said. “That means it (the investment) is riskier at this point.”

Private credit funds that make direct loans have an estimated 26% exposure to software, according to Morgan Stanley.

“What we’re seeing is less of a private credit crisis and more of a broader technology transition, particularly executive selection and structural testing of the impact of AI on software-heavy business models,” said Scott Bishop, CFP, partner and managing director at Presidio Wealth Partners in Houston.