Private credit markets face mounting pressure from regulatory scrutiny, valuation concerns, structural stress, and deteriorating credit quality, making rigorous risk management and transparency essential for investors heading into 2026.
Executive Summary
After a decade of rapid growth and mainstream adoption, private credit faces an inflection point. In recent weeks, the Department of Justice (DOJ) has publicly warned about “creative” marks and divergent valuation practices in private portfolios, while a high-profile SEC inquiry into Egan-Jones Ratings has placed the integrity of private credit ratings under a spotlight¹ ². In parallel, the failure of over-collateralization (OC) tests at a BlackRock private-credit CLO and the subsequent manager fee waiver stand out as structural stress signals³. The aborted Blue Owl fund merger in November — undertaken amid redemption pressures and NAV/price mismatches — exposed the fragility of semiliquid structures when “instant liquidity” meets illiquid assets⁴. Add to this rising defaults, PIK toggles, covenant erosion, and a chorus of market leaders warning of “cockroach”-style hidden risks, and the result is a market where vigilance, discipline, and transparency must replace complacency⁵ ⁶.
These developments do not, in our base case, imply an imminent systemic crisis. But they do elevate tail risks and underscore the need for investors to re-underwrite marks, map liquidity triggers, re-assert covenant discipline, and demand robust valuation governance — especially as 2026 brings a heavier refinancing calendar and more scrutiny of manager practices⁷ ⁸ ⁹.
Key Takeaways
1) Regulatory Scrutiny Is Rising
DOJ warnings and SEC investigations spotlight valuation governance and ratings integrity, underscoring growing regulatory pressure and making transparency, rigorous oversight, and independent validation essential.
2) Credit Quality Is Weakening
Defaults, PIK toggles, and covenant-lite refinancings point to eroding protections and higher tail risk — prioritize senior secured deals and workout-ready managers.
3) Structural Stress Signals
OC/IC test breaches and the Blue Owl merger collapse reveal fragility in semi-liquid structures and liquidity promises — stress-test redemption mechanics and fee diversion risks.
4) Liquidity Mismatches Are Growing
Retail-oriented wrappers and semi-liquid funds introduce structural liquidity gaps — map triggers, model stress scenarios, and reset client expectations around “instant liquidity.”
Ratings Integrity, Valuation Governance, and Regulatory Scrutiny
The DOJ’s public warning about portfolio marks — highlighting divergences across firms and the risk of misrepresentation — is a shot across the bow for private markets, signaling that enforcement is watching valuation governance as a critical weak point¹. In the same vein, the SEC’s ongoing investigation into Egan-Jones Ratings has re-focused attention on conflicts of interest and the broader reliability of private credit ratings, particularly where those ratings condition capital treatment and investment eligibility². Taken together, these signals are reminiscent of the pre-crisis concerns around opacity and incentives in structured finance, albeit in a different market structure, and they argue for triangulation of marks (independent quotes, broker runs, model cross-checks) and documented Level 3 assumptions with credible haircuts.
Level 3 assumptions refer to the valuation inputs used for assets that lack observable market prices. These are typically based on models, internal estimates, or unobservable data, and require careful documentation and justification. Because Level 3 assets are inherently less transparent, investors should ensure that their fund managers provide clear explanations of the methodologies and assumptions behind these valuations and apply appropriate haircuts to account for uncertainty.
Investor Takeaway
Treat ratings and marks as inputs, not truths. Embed explicit validation procedures in manager due-diligence and valuation committees; maintain audit trails and escalation paths when discrepancies appear¹ ².
Structural Stress: OC/IC Test Failures and Semiliquid Fragility
The recent fee waiver offered by BlackRock after a private-credit CLO breached over-collateralization (OC) tests is unusual in credit markets and suggests portfolio stress sufficient to divert cash flows to senior tranches until metrics cure³. OC and IC (interest coverage) triggers are structural safeguards built into credit vehicles such as CLOs. OC triggers require that the value of the collateral (the underlying loans) remains above a certain threshold relative to the outstanding debt. IC triggers require that the interest income generated by the collateral is sufficient to cover the interest payments owed to investors. If these tests are breached, cash flows are redirected from junior tranches (including equity and manager fees) to senior tranches, protecting senior investors but signaling stress in the underlying portfolio.
Though idiosyncratic at the vehicle level, this event shines a light on waterfall mechanics and the sensitivity of equity/fee income to assess breaches — implications that investors should formally model across all private-credit securitizations.
In a separate chain of events, Blue Owl, a major alternative asset manager, attempted to merge a non-traded business development company (BDC) with a listed vehicle amid redemption pressure, only to terminate the deal following widespread concerns about NAV/price gaps and the reality that “instant liquidity” can crystallize a 15%–25% discount to otherwise “steady” private marks⁴. Such episodes emphasize the fragility of semi-liquid private credit structures when market stress tests the promise of smooth NAV.
Investor takeaway
Inventory OC/IC triggers, covenant packages, and redemption mechanics across all vehicles. Always model fee-income loss, cash divert, and gate risks under stress; update client communications to avoid promising instant liquidity in illiquid structures³ ⁴.
Deteriorating Credit Quality: Defaults, PIK, and Weakening Covenants
Default rates among junk-rated private borrowers have climbed with higher rates; when “selective defaults” (e.g., PIK interest, maturity extensions without lender compensation) are included, effective distress measures rise materially⁵. Contemporary analyses capture rising downgrades, greater borrower fragility, and amend-and-extend mechanics that mask stress in headline metrics. Meanwhile, manager practices — including back-leverage, hybrid structures, and covenant-lite refinancings — continue to erode protections and depress expected recoveries if the cycle turns⁷ ⁸.
Complementary enterprise research threads show the share of borrowers with negative free cash flow has increased materially since 2021, with PIK usage and amendments now a non-trivial tailwind to “shadow” defaults, even if headline defaults remain modest⁹.
Investor takeaway
Price covenant-lite deals/funds appropriately; emphasize senior secured, hard-covenant deals with fund managers that have documented workout playbooks. Request and track PIK incidence, non-accruals, and amendments explicitly in portfolio monitoring⁵ ⁷ ⁹.
Liquidity Mismatches and the Retailization Challenge
As private credit continues to democratize, emerging wrappers — ETFs that blend private and public credit — will, by design, rely on public credit to backstop daily liquidity, introducing structural mismatch between equity-leg redemption cycles and illiquid underlying assets¹⁰. Similar semiliquid vehicles (interval funds/non-traded BDCs) have already exhibited queueing, gates, and NAV discontinuities when stress hits. The practical implication is straightforward: liquidity must be mapped, modeled, and conservatively communicated.
Market Sentiment: “Cockroaches” and Public Warnings
Prominent voices have normalized caution: Jeffrey Gundlach, CEO & CIO of DoubleLine Capital, has repeatedly warned that private credit may be the top candidate to start the next financial crisis; he has criticized semiliquid private-credit ETFs as the “ultimate sin”, and flagged structural fragility on national platforms⁶. Jamie Dimon, the CEO of JP Morgan, has reached for the “cockroach” analogy — when you find one problem, more are often nearby — after the Tricolor and First Brands bankruptcies highlighted underwriting and transparency risks¹¹ ¹². Meanwhile, sell-side strategy notes anticipate “bad vintages” coming due in 2026, with shadow lending supplanting banks and raising the odds that private is hit harder than public in a cycle turn¹³.
Parallels to 2007–2008 (What’s Similar, What’s New)
The current set of risks rhymes with — but is not identical to — the structured finance market circa 2007–2008. Then as now, valuation opacity, ratings conflicts, and liquidity mismatches were the accelerants of contagion. Today, proactive regulatory scrutiny is stronger, yet the interconnectedness of private funds, banks, and insurers — through co-lending, warehousing, and insurance partnerships — can transfer or amplify risk in novel ways if stress surfaces rapidly⁷ ⁸. Put differently: transparency and incentives remain the fulcrum; the pipes are different, but the physics of liquidity are unchanged.
Sage Guidance: A Practical Playbook for 2026
1) Re-underwrite ratings and marks. Treat ratings as inputs; triangulate with independent models and quotes; document Level 3 assumptions and haircuts. Escalate discrepancies in valuation committees¹ ².
2) Covenant discipline and workout capability. Favor senior secured structures, hard covenants, and managers with enforcement playbooks; price covenant-lite and amend-and-extend risk appropriately⁵ ⁷.
3) Liquidity mapping. Inventory OC/IC triggers, redemption mechanics, and gate provisions; stress test cash diversion and fee-income loss under adverse scenarios³ ⁴ ¹⁰.
4) Manager transparency. Demand disclosures on back-leverage, warehousing, valuation governance, and audit trails; review conflict policies around internal marks and related-party transactions² ⁷.
5) Portfolio balance. Mitigate single-asset-class credit beta; consider lower-correlated income sleeves (e.g., securitized, ILS) to buttress liquidity and diversification across the cycle⁹.
6) Client communications. Reset expectations around NAV variability, queues/gates, and workout timelines; avoid promising “instant liquidity” for illiquid assets⁴ ¹⁰.
Market History Lessons
The evolution of financial markets is marked by cycles of innovation, exuberance, and, at times, painful correction. Over the past several decades, new asset classes and investment vehicles have repeatedly promised enhanced returns and diversification, only to reveal hidden risks when market conditions changed. The structured finance boom of the early 2000s, for example, brought about the proliferation of complex products such as collateralized debt obligations (CDOs) and structured investment vehicles (SIVs). While these innovations initially delivered impressive performance, they ultimately contributed to the global financial crisis when underlying risks — particularly those related to valuation opacity, liquidity mismatches, and misaligned incentives — became apparent.
History has shown that periods of rapid market growth and product innovation often coincide with a relaxation of underwriting standards, increased reliance on model-based valuations, and a tendency to underestimate the potential for correlated losses. The aftermath of the 2007–2008 crisis underscored the importance of transparency, robust governance, and the need for independent validation of asset values. Regulatory reforms that followed, such as enhanced disclosure requirements and stress testing, were direct responses to these lessons.
Today’s private credit market, with its rapid expansion, increasing structural complexity, and growing participation from non-traditional investors, echoes many of these historical patterns. The emergence of semi-liquid vehicles, the prevalence of covenant-lite structures, and the reliance on internal or private ratings all mirror the dynamics that have, in past cycles, led to both financial success and significant losses for investors.
Sage has been a successful institutional fixed income investor for over three decades and in that time has witnessed many new market developments that have brought both financial success and grim results for investors. We believe it is important for investors and advisors alike to learn from the lessons of market history and maintain rigorous risk management and strong fiduciary standards when dealing with rapidly emerging new markets like that of private credit.
Conclusion
At Sage, we believe the private credit markets remain a vital financing channel and a durable source of yield for sophisticated and well-informed investors. But the mix of DOJ/SEC scrutiny, CLO test events, semiliquid stress, and deteriorating borrower health argues for proactive risk management: re-underwrite valuations, tighten covenants, map liquidity, and enforce transparency as table stakes for 2026. Doing so acknowledges the lessons of 2007–2008 — without assuming a repeat — and will help position investor portfolios to withstand shocks while retaining strategic exposure to an asset class that will continue to shape modern capital markets¹ ³ ⁴ ⁷.
Sources
- Bloomberg video: Private Credit’s Sketchy Marks Get Warning Shot From Top DOJ Cop, Nov 25, 2025.
- Internal correspondence referencing the Egan-Jones ratings probe and conflicts.
- Pensions & Investments, industry commentary on BlackRock private-credit CLO OC breach and fee waiver.
- Bloomberg Opinion Weekend Edition, CNBC, PR Newswire, Alternative Credit Investor, class-action notice on Blue Owl merger termination and NAV/price mismatch.
- Bloomberg Opinion: Private Credit ‘Hysteria’ Will Get Very Real Next Year, Dec 1, 2025.
- Fox Business coverage, Jeffrey Gundlach and Jamie Dimon remarks.
- Moody’s: Private credit innovations are transforming risks in novel ways, Nov 19, 2025.
- Moody’s 2026 Credit Conditions Outlook, Nov 10, 2025.
- Sage Advisory enterprise research, FI Investment Strategy October 2025.
- Moody’s: Private-credit ETFs will use public credit for liquidity, Sep 18, 2024.
- Zacks commentary on First Brands/Tricolor bankruptcies, Oct 27, 2025.
- Fox Business coverage, Jamie Dimon “cockroach” analogy, Oct 18, 2025.
- BofA Equity & Quant Strategy: “cockroaches in private lending” and bad vintages due in 2026, Nov 26, 2025.
- Private Credit Market Pressure and Concerns Summary. Page, Sage Advisory, Dec 2025.
