For months, the alternate lending sector known as private credit – a $3 trillion mammoth – has been top of mind and tongue for bank officials, money managers and investors.

The high-yield lending system ballooned following the 2008 financial crisis, when stricter regulations led banks to pull back from providing debt to mid-sized companies. Early investments came from private equity firms and alternative asset managers flocking to put up loans for borrowers locked out of traditional financing.

Today, private credit is drawing about as much scrutiny as it did capital over the last 15-some years.

Between pressure from rising interest rates that increase default risks, surging investor withdrawals and hefty exposure to a software sector vulnerable to artificial intelligence disruption, the once-booming market is under heat.

How much of it is warranted? Depends on who you ask.

Last fall, JPMorgan Chief Executive Jamie Dimon warned of bad debt from subprime lenders and the risk of private credit market collapse in an economic downturn.

“When you see one cockroach, there are probably more,” Dimon told analysts during the bank’s third-quarter earnings call in October. The bug in question was auto parts supplier First Brands, whose bankruptcy exposed a hoard of off-balance sheet and private, non-bank financing.

To find some of the biggest private credit players Dimon warned of, Angelenos need not look further than their own backyard.

Century City-based Ares Management Corp. runs some of the market’s largest business development companies – vehicles for retail access into private credit, historically reserved for institutional investors like pension funds.

The investment manager is parent to Ares Capital Corp., a public BDC with a market-leading $31.2 billion in total assets, and the newer but rapidly scaling Ares Strategic Income Fund, a non-traded BDC.

ARCC’s share prices have tumbled 14% in the last year while ASIF has fielded rising withdrawal requests – the ripple effects of private credit unease, much of which stems from investor concerns over AI’s threat to the software companies that make up roughly a fifth of their investment portfolios. But fund managers have assured investors and analysts they have the situation under control.

“We feel very, very confident that we have our arms around our existing exposures,” Ares Chief Executive Michael Arougheti told investors and analysts during the firm’s February earnings call. “We feel very confident that the types of software businesses that we’ve invested in have meaningful characteristics that will protect them.”

Ares declined to provide further comment for this story.

Software bets

Software-as-a-service has long been a key portfolio concentration for private credit, which provided fast access to capital and fueled much of the acquisitions and investments technology companies undertook after the pandemic. Lenders favored SaaS companies for their stable subscription revenues, high margins and low capital expenditures, driving record lending, according to a Morningstar report.

S&P Global estimates BDCs’ exposure to software and related sectors like IT services and health care technology at roughly 29%, compared to 16% for the bank-led broadly syndicated loan market.

Software’s outsized role in private credit portfolios has raised questions about how disciplined underwriting has remained as capital has flooded in – especially to non-traded BDCs, which grew 46% between third-quarter 2024 and the same time last year.

Some of that worry comes from private credit players themselves, like Armen Panossian, co-chief executive at Brentwood-based Oaktree Capital Management and head of the company’s public BDC, Oaktree Specialty Lending Corp. OSLC has a below-average software exposure at 17%, according to a Dec. 31 regulatory filing.

“Any time that in a short period you get meaningful inflows and cash drag creates a big problem for returns – you do see excessive risk-taking,” Panossian said in an interview on Bloomberg Television in late March. “That’s true in credit, that’s true in private credit – and we’ve seen that over the last five, six years.”

Under pressure to deploy and maintain returns, fund managers stretched further into software, a field dominated by asset-light businesses now facing disruption risk as “good enough” AI-enabled substitutes develop, Fitch Ratings analysts say.

“These sectors could see intensified competition and pressure on pricing and margins as AI lowers barriers to entry and reduces development costs,” the credit rating agency warned in a recent report.

Shares of publicly traded SaaS companies took a beating in early February as markets woke up to the risk of AI disruption in what JPMorgan strategist Aaron Mulvihill called an “abrupt and indiscriminate sell-off.” Slowing growth is feeding investor fears on companies like enterprise software giant Salesforce, whose stock prices fell 31% in the last six months.

Falling valuations or narrower margins could increase defaults on private credit’s SaaS loans. Fitch Ratings estimates that 15% of the software companies in the institutional leverage loan universe might soon have trouble making interest or principal payments.

During the earnings call, Arougheti said Ares sees “no change” to its earnings growth projections, which are ted to expectations for managed asset growth and profitability, from AI risks. Private credit loans are meant to be relatively safe because they are “senior secured,” meaning companies have to repay them before other kinds of debt.

Some analysts are nonetheless concerned about how much funds will recover if particularly asset-light software borrowers default. In a report, strategists at Allianz Research warned lending to companies with little to no tangible assets “provides less downside protection than in asset-intensive sectors.”

Worry that AI disruption might lead to lower-than-expected returns or defaults is likely the primary force driving investors out of private credit funds, said USC finance professor and former PIMCO portfolio manager Stephen Moyer.

“People say, ‘Oh my gosh, maybe they’ve got problems in their portfolio,’ and try to recover their investment before those loans default,” Moyer said.

Caution creeps in

From his work with distressed or transitioning companies at FTI Consulting, Amir Agam has gleaned that the software stock sell-off was “a little bit of an overreaction,” given that the risk of displacement is nothing new. Though AI is a faster-moving threat than typical competition, fund managers aren’t quite sharing in that panic, Agam said.

“People aren’t necessarily running and fire-selling off all their software companies,” said Agam, the consultancy’s west region senior managing director and co-leader of turnaround and restructuring. “What it is doing is making people more hesitant to transact or at least transact in high multiples.”

More hesitancy means more discernment in loan quality and the level of vulnerability a SaaS company has to AI, Agam said. That’s how easily key revenue streams might be supplanted.

As a practice, private fund managers open their loan books to re-evaluate terms and assess risk. Given potential AI disruption, Ares, Oaktree and Santa Monica-based Clearlake Capital say they’re doing what they always do to protect their returns and investors’ interests.

But estimating revenue impact can be more challenging when the scope and timing of AI’s incursion is as uncertain as it is, said Steve Spitzer, partner and managing director at consulting firm AlixPartners.

“I think that’s what’s really driving concerns around valuation, because people don’t have a good sense of exactly how disrupted these companies are going to be,” Spitzer said.

Digging moats

Arougheti projected confidence in Ares’ resiliency. He said his team was “spending a lot of time” looking at the small number of portfolio companies that might be vulnerable.

“I’m not going to say our portfolio is entirely clean,” Arougheti said.

Features that insulate a company from AI risk include the use of proprietary data and positioning in an industry vertical with strict regulations that heighten barriers to entry, said Spitzer, whose turnaround and restructuring team helps clients build protective “moats.”

In the absence of these foundational characteristics, Spitzer asks: “Are there ways to fortify their business or re-platform their business so they can create some additional barriers to entry that will help prevent AI disruption?”

Building up durability is a key exercise for Woodland Hills-based enterprise software company BlackLine Systems Inc.

Though its stock recently tumbled alongside other publicly traded SaaS firms, with shares down 36% in the last six months, Chief Financial Officer Patrick Villanova said the company is shielded from a major AI shake-up.

BlackLine, which scaled with help from a private equity investment realized in 2019, sits on a trove of customer data. It also announced a business model shift away from seat-based pricing in early 2025, which previously stunted revenue growth.

“The better our technology gets, and the better the AI within our technology gets, the less professionals you’re going to need within your department,” said Villanova, who has seen improved efficiency “cannibalize” the company’s number of users.

Under a new platform pricing model, BlackLine has started charging clients for their overall use of its accounting software. The move contributed to a 10% jump in annual recurring revenue in last year’s fourth quarter – a result Villanova sees as proof the company’s outlook is more positive than markets have made out.

“The longer we sustain that the demand is there and that our AI-enabled platform is growing at stronger rates, you slowly erode or defeat the narrative that is out there,” Villanova said.