The massive influx of new capital coming into the private credit market through life insurers and business development companies (BDCs) could lead to an erosion of quality and returns, Adams Street Partners has warned. 

Jeffrey Diehl, head of investments at Adams Street, argues in new research that this rapid growth puts significant pressure on the investment teams responsible for deploying that capital. According to Diehl, these so-called “hyperscalers” could take their investors “on an undetected ride of forced deployment, which we believe is likely to increase credit risk and erode returns.”  

Among the rapidly expanding pools of private credit assets are BDCs, which large private credit managers have been using to offer high-net-worth investors access to the asset class. Because these evergreen vehicles bypass complex tax and cash management issues, offer immediate yield, and provide liquidity if needed, they’ve become popular with wealthy individuals, amassing $128 billion in assets, with most (72 percent) concentrated in the top six products from publicly listed firms. Life insurers have added to this growth by channeling general account capital into private credit.  

Having been the primary clients of private credit managers for so long, institutional investors have regulated those managers’ scaling ambitions. However, with some publicly traded private credit managers holding rapidly growing wealth and insurance pools that already dwarf their institutional assets, that soft regulatory power has been significantly diminished. 

This lack of institutional oversight of BDCs means that managers are left to self-regulate their scale — when they have little incentive to do so. As assets grow, so does the pressure to deploy that capital. Diehl argued that this urgency leads to looser underwriting standards, such as weaker covenants, higher leverage, and less rigorous borrower vetting.

Adams Street reported that the last eight quarters of filings from large BDCs with the Securities and Exchange Commission showed an erosion of credit quality, even without having visibility into underlying borrower financials. In addition, credit rating firms have been increasingly reporting on rising defaults. This deployment pressure at the largest BDCs has also begun to create overlapping portfolios, which could ripple through the portfolios of multiple large BDCs if problems surface with private credit loans. 

The asset manager estimated that the managers of the four largest perpetual BDCs must invest an average of $23 billion a year to keep their funds fully invested. The largest private BDC, meanwhile, is estimated to invest $43 billion a year, representing more than a quarter of the annual U.S. direct lending market. To put that into perspective, that annual level of deployment would be materially larger than the biggest ever commingled drawdown private credit fund. 

In an email, Diehl told Institutional Investor that allocators should be “very selective in which PC [private credit] managers they use.” Specifically, they should dig into deployment scaling over time across all managed pools, managers’ alignment of interest with their investors vs. their stockholders, and the fundamentals and valuations of the underlying portfolio companies.  

“If an investor is already exposed to a hyperscaler and wants to reduce exposure, they could try to redeem shares in a BDC or look to sell PC fund LP interests in the secondary market,” he added.