Concerns about private credit resurface in the $3 trillion market as software companies face pressures from AI.

Private credit markets are encountering new uncertainties as AI-enhanced tools begin to exert pressure on software firms, a significant borrowing group for private lenders.

The software sector faced increased strain last week when AI company Anthropic launched new AI tools, leading to a decline in shares of software data providers.

The AI innovations from Anthropic are intended to carry out intricate professional functions that many software enterprises presently charge for, which raises fresh apprehensions that AI may undermine conventional software business models.

Shares of asset management firms with considerable private credit divisions suffered this week as investors worried about how AI might disrupt borrowers’ business frameworks, squeeze cash flows, and eventually heighten default risks.

Ares Management dropped more than 12% last week, while Blue Owl Capital fell more than 8%. KKR declined nearly 10%. TPG experienced a loss of around 7%. Apollo Global and BlackRock dropped over 1% and 5%, respectively. In contrast, the S&P 500 declined by approximately 0.1%, while the tech-focused Nasdaq fell 1.8%.

These changes accentuate a growing apprehension surrounding the private credit market, which now needs to prepare for the repercussions from AI-driven disturbances to the software industry that is considerably linked to buyouts funded through opaque, illiquid loans, as per market analysts.

“Enterprise software firms have been a popular sector for private credit lenders since 2020,” PitchBook stated in a report last week following the developments, noting that many of the largest-ever unitranche loans, the preferred structure of the private credit market, have been extended to software and technology firms.

Software constitutes a substantial portion of loans held by U.S. business development companies, accounting for around 17% of BDC investments by deal count, ranking second only to commercial services, according to PitchBook data.

This exposure could be costly if AI adoption accelerates more rapidly than borrowers can adapt. UBS Group has cautioned that, in a scenario of aggressive disruption, default rates in U.S. private credit could escalate to 13%, which is significantly higher than the stress projected for leveraged loans and high-yield bonds, with UBS estimating these could reach approximately 8% and 4%, respectively.

“Private credit financing to many software organizations,” stated Jeffrey C. Hooke, a senior finance lecturer at Johns Hopkins Carey Business School. “If they begin to struggle, there will be complications in the portfolio.”

However, Hooke indicated that challenges in private credit were present before the latest AI-related worries, citing concerns over liquidity and loan extensions. “Many private credit funds have faced challenges in liquidating their loans,” he mentioned, asserting that the recent changes have merely added another layer to an already pressured sector.

This series of new alerts arises from recent worries in the $3 trillion sector regarding leverage, unclear valuations, and the potential that isolated issues might evolve into systemic problems. JPMorgan’s Jamie Dimon cautioned late last year about the ‘cockroaches’ of private credit, suggesting that stress in one borrower can indicate more hidden risks.

“AI disruption could pose a credit risk for private credit lenders for some of its Software & Services sector borrowers and perhaps not for others as it depends on who is lagging in AI and who is ahead,” stated Kenny Tang, head of U.S. credit research at PitchBook LCD.

Tang noted that software and services firms represent the largest share of payment-in-kind (PIK) loans, which refer to arrangements where borrowers can postpone paying interest in cash. While PIK arrangements are often employed to provide rapidly developing companies time to cultivate revenue and cash flow, they become perilous if a borrower’s financial health declines. In such cases, deferred interest can swiftly transform into a credit liability, he warned.

Mark Zandi, chief economist at Moody Analytics, remarked that while it is challenging to grasp a complete evaluation of risks in the sector due to its lack of transparency, the swift growth in AI-related borrowing, increasing leverage, and insufficient transparency are significant “yellow flags.”

“There will undoubtedly be notable credit challenges, and while the private credit industry can probably currently absorb any losses adequately, this might not hold true a year from now if the ongoing credit growth persists.”

Apollo, Blue Owl, TPG, and BlackRock did not promptly address CNBC’s inquiries, while KKR opted not to provide commentary.

Ares Management CEO Michael Arougheti mentioned that the firm’s exposure to software was limited, with software loans accounting for roughly 6% of its total assets and less than 9% of private credit AUM.

He added that Ares primarily lends to successful software firms with robust cash flow and maintains low borrowing levels, which has helped keep problem loans near zero.