Canary in the Coal Mine?

Overview:

Recent high-profile bankruptcies of companies partially financed with private credit have sparked questions about whether these cases signal broader credit concerns. Many are wondering if they are the “canary in the coal mine.” Our view: these are isolated casualties of bad business fundamentals and excessive leverage, combined with inadequate lender due diligence and fraudulent conduct. A toxic cocktail, to be sure, but not a systemic warning sign.

In this Diversify Outlook, we examine what went wrong in these headline-grabbing cases, explore the rapid evolution of this once-nascent asset class, and explain why rigorous due diligence and manager selection are more critical than ever. We also assess the fundamental health of the broader private credit market and make the case for why the asset class remains attractive.

What Happened:

Recent bankruptcy filings from First Brands and Tricolor have raised questions about the potential for widespread credit issues. First Brands was an automotive parts company with an aggressive rollup strategy f inanced by mountains of debt, including potentially double pledged collateral and $2 billion of "off-balance sheet" loans that were unaccounted for. Tricolor was a national chain of "buy here/finance here" car dealerships. A 2025 filing revealed that roughly two-thirds of Tricolor's borrowers lacked a credit score and over half didn't even have a driver's license. Tricolor appears to have also double pledged collateral. The Department of Justice is investigating allegations of fraud against both companies.

Referring to these bankruptcies, Jamie Dimon, CEO of J.P. Morgan, whose penchant for risk management has made his bank the biggest and arguably the best on Wall Street, said on their recent Q3 earnings call: "When you see one cockroach, there are usually more." His comments have fueled broader concerns, with some now drawing parallels between recent private credit issues and the 2008 global financial crisis (GFC), similar to how many are comparing today's AI-fueled equity market to the late-1990s tech bubble.

However, today's credit climate is very different than the cracks that were forming in 2006-2007. The GFC was born from excessive leverage, the wholesale abandonment of prudent lending standards, and non-existent capital buffers. Those conditions are largely absent today, in our view. Sometimes loans are simply given to bad actors or bad companies that go bust. Our conclusion: these are routine credit events, not the canary in the coal mine.

Diversify’s Take:

Market Share Gains:

Private credit is the practice of providing privately negotiated loans and other debt financing to companies. Unlike public debt, like bonds, private credit instruments are not issued or traded on an open market. Rather, each loan is a unique agreement between the lender and the company requiring financing.

Private credit has experienced explosive growth following the GFC. In its aftermath, stricter regulations and reduced risk appetite forced banks to tighten their lending standards. This contraction in bank credit created a f inancing gap, leaving many companies unable to secure the capital needed to fund their operations. Nonbank lenders, operating through private credit vehicles, emerged as a critical alternative source of capital.

Since then, the market share of private credit has climbed steadily, outpacing the growth of other fixed income asset classes and transforming from a niche alternative into a mainstream component of the credit markets. Shown below using data from Preqin, private credit AUM has ballooned from $250 billion during the GFC to $2.2 trillion today, a CAGR of nearly 14%.¹ Remarkably, in recent years, the asset class’s AUM eclipsed that of its publicly traded counterparts (high yield bonds and leveraged loan), which both stand around the $1.5 trillion AUM mark today.

Manager Selection and Due Diligence:

Like a gold rush, many asset managers with little or no background in credit have scrambled to launch private credit funds over the last few years, chasing a hot industry trend. With so much capital flooding into the space, we're witnessing a classic "winner's curse": sponsors win deals by chasing prices higher in order to deploy capital, potentially sacrificing forward returns in the process.

In our view, poor underwriting and unexpected losses are more indicative of ballooning AUM in private credit than widespread credit concerns. Since the underwriting standards of many new entrants have yet to be tested, the dispersion of returns in this space will continue to widen, with strong, experienced managers competitively advantaged over less experienced peers.

This underscores the importance of rigorous due diligence on both the companies to which private credit sponsors lend and on the sponsors themselves. At Diversify, we conduct deep due diligence on our underlying sponsor partners. While potential fraud can be challenging to detect, there were red flags with both First Brands and Tricolor that did not meet the strict underwriting standards of many private credit vehicles. Our team curates a shelf of institutional-quality investment offerings with strong underwriting standards, talented management teams, a defined and consistent investment approach, and a demonstrated track record.

In our recent communications with our private credit sponsor partners, we have renewed confidence in their ability to navigate the market and maintain strong underwriting standards. That doesn't mean they'll go unscathed should we eventually enter a full-fledged credit cycle, nor does it mean they will "bat 1.000" in their decision making. But their track records and long-term excellence in that segment of the market provide reassurance relative to the broad opportunity set.

Private Credit Fundamentals:

Just like it’s helpful to remind equity investors that the composition of the S&P 500 is very different today compared to decades prior (more asset light, more services oriented, with higher margins and ROIC), it’s also helpful to compare the composition of today’s private credit market to prior decades. Shown below by Cliffwater, senior credit positions now dominate the direct lending market, compared to just ~30% two decades ago.² Having a senior position in the capital stack means those investors are the first to be paid should trouble arise.

While recent bankruptcy proceedings have drawn attention, they represent isolated cases rather than harbingers of systemic distress. Today’s credit market is supported by sound underlying fundamentals: strong corporate earnings growth, healthy balance sheets, and a resilient U.S. economy that may settle into trend growth of ~2% real GDP through 2026. Historically, meaningful credit deterioration requires recessionary conditions, which we do not see on the horizon.

Using data from Fitch, Morgan Stanley shows below that through the end of Q2, private credit default rates have stabilized and show a modest downward trend in recent quarters.³ The chart shows the two largest segments of the private credit market: direct lending and broadly syndicated loans (BSL).

Additionally, shown below by iCapital, other fundamental data like leverage ratios (debt-to-EBITDA) and interest coverage ratios (EBITDA-to-interest expense) have remained stable in recent quarters.⁴

The financial health of borrowing companies is critical in private credit markets. As the Federal Reserve (Fed) continues its easing cycle, lower short-term rates should provide meaningful relief. This matters because the majority of private credit loans are floating rate, meaning borrowers will see their interest costs decline in nearlockstep with Fed cuts.

The offset, of course, is that a declining short-term rates environment means the yields earned by investors may moderate from the low double-digit range into, perhaps, the high single-digit range in the coming quarters. We expect short-term rates to remain elevated relative to the ultra-low levels of recent years given economic resilience and inflation that continues to run above target.

The Case for Private Credit:

Given elevated yields and their seniority in the capital stack, diversified private credit portfolios have proven to be remarkably resilient and have generated attractive risk-adjusted returns through time. Using history as a partial guide, below is the trailing four-quarter total returns of the Cliffwater Direct Lending Index over the last two decades.⁵ The GFC was the only period in which the index sustained a negative total return on a fourquarter rolling basis. COVID produced one negative quarter (-4.8%), but on a rolling four-quarter basis, the total return stayed above water.

Private credit often includes stronger investor protections, high seniority, and creative remedies beyond bankruptcy, which has historically contributed to lower loss rates compared with publicly traded leveraged loans and high yield bonds. As shown by Morgan Stanley below, with an eight-year lookback, loss rates in direct lending have been extremely low compared to the public peers.⁶

Given today’s starting yield of ~10%, a typical private credit portfolio would need to experience a default rate of ~8% with recovery rates less than 40% in order to realize a negative total return. As shown in the Morgan Stanley chart above, default rates briefly touched the 8% level during COVID, and today they stand around 4%.

High yield bond spreads have compressed to near-cycle tights, offering limited compensation for risk, while private credit continues to provide attractive risk-adjusted returns with its structural advantages: higher yields, floating rate protection, and stronger covenant packages. For investors with appropriate risk and liquidity profiles, private credit may be a consideration for one’s portfolio.

Summary:

A recent Goldman Sachs research report captured the current private credit environment perfectly: "The Temptation to Connect the Unconnected." It’s natural for investors to search for patterns and warning signs when one-off issues enter the picture, but the dots today don’t connect with prior credit crises, in our view.

The great writer/investor, Howard Marks, described the environment with a similar conclusion to that of ours: “…Imprudent loans and business frauds often occur in clusters for the simple reason that people who make investments and loans are highly prone to error in good times. Investors and lenders are supposed to be riskaverse and thus exercise discipline and vigilance, but sometimes they fail in this regard. This isn’t part of the plumbing of the financial system but rather a regularly recurring behavioral phenomenon.”

Private credit may present a strong opportunity today when accessed through the right vehicles and at an appropriate allocation for each investor's individual risk tolerance and financial goals. As with all investments, especially ones that are inherently illiquid, we cannot overstate the importance of stringent underwriting standards and rigorous manager selection.

The asset class carries real risks: illiquidity, interest rate sensitivity, and potential defaults. But for investors who can tolerate these tradeoffs, private credit may continue to deliver compelling yields, diversification benefits, and potentially similar forward-looking returns as the equity market with lower volatility and shallower drawdowns.

We are here to help you navigate the market and answer any questions you may have.

David Wrigley

Chief Investment Officer

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1. Diversify Advisor Network, as of September 30, 2025.

2. Cliffwater, 2025 Q2 Report on US Direct Lending, as of June 30, 2025.  

3. Morgan Stanley, Addressing Credit Concerns, as of September 30, 2025.  

4. iCapital, Behind the Recent Private Credit Noise, as of September 30, 2025.

5. Cliffwater, 2025 Q2 Report on US Direct Lending, as of June 30, 2025.

6. Morgan Stanley, Understanding Private Credit’s Rapid Growth, as of September 30, 2025.

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The information contained herein is the opinion of the author as of the date the market update was written and is subject to change without notice as markets change, and new information is available. While Diversify utilizes sources deemed to be reliable, we have not independently verified the content. Investors should carefully consider any changes based on this market commentary and discuss their individual circumstances with their trusted advisors. Past performance is not indicative of future results. This communication is for informational purposes only and should not be construed as investment advice or a recommendation.