Goldman Sachs expects U.S. private credit default rates to reach 8%, industry giant admits: All valuations are wrong!

How AI Accelerates the Debt Default Crisis in the Software Industry

Concerns in the private credit market continue to spread on Wall Street.

A report released Monday by Morgan Stanley analysts indicates that software industry loans have the highest leverage and lowest coverage in the private credit market, with default rates potentially approaching the highest levels since the pandemic.

The report notes that as artificial intelligence continues to disrupt the software industry, the debt repayment capacity of software companies is weakening, with direct loan default rates expected to rise to 8%. Direct lending is a form of private debt where non-bank institutions (such as asset managers, private equity funds, insurance companies, etc.) bypass traditional financial intermediaries like commercial banks and lend directly to companies.

Meanwhile, according to The Wall Street Journal, John Zito, Co-President of Apollo Global Management, recently made unusually blunt remarks in a private setting, directly criticizing the private market’s “arrogance,” widespread valuation distortions in private equity, and risks far exceeding market perceptions.

Zito pointed out that many software companies acquired between 2018 and 2022 were valued incorrectly, and related private credit faces significant downward and default pressures.

Morgan Stanley: Default Rate Could Rise to 8%, Recession Probability Upgraded

Morgan Stanley analyst Joyce Jiang warned in a team report that, although the impact of AI on credit fundamentals has not yet materialized, the ongoing AI disruption suggests a persistent weakening of coverage ratios.

“Coverage ratio” refers to the interest coverage multiple (EBITDA divided by interest expense) of borrowing companies in the private credit space. Morgan Stanley believes that operating profits of software companies are already showing signs of difficulty covering their debt interest.

Morgan Stanley data shows that software companies are the largest industry focus within the Business Development Company (BDC) investment portfolios, with risk exposure around 26%. Private credit collateralized loan obligations (CLOs) also have a 19% exposure to the software sector.

CLOs are asset-backed securities that bundle hundreds of corporate loans (usually leveraged loans) into a resource pool, then issue securities of varying risk levels backed by this pool to investors.

Referring to PitchBook data, Morgan Stanley notes that 11% of software loans in direct lending will mature in 2027, with another 20% due in 2028, creating a concentrated maturity window that overlaps with the deepening AI impact.

Morgan Stanley analysts state:

The credit fundamentals of software loans are under pressure, with the highest leverage and lowest coverage among major industries.

They also note that cooling demand from retail investors for private credit may lead to a more institutional investor base and suppress future growth of this market.

As of Q3 last year, BDCs held a total of $530 billion in assets, with many retail investors participating. Their inherent liquidity issues have raised widespread concerns about the risk tolerance of less experienced investors.

However, the bank emphasizes that while overall credit risk is significant, it does not currently pose a systemic threat.

Software Exposure as the Biggest Hidden Risk

John Zito, Co-President of Apollo Global Management, believes that software companies acquired between 2018 and 2022 generally face three issues: lower revenues compared to similar publicly traded companies, smaller size, yet higher valuations.

He cites the example of Thoma Bravo’s 2021 $6.4 billion privatization of Medallia, stating that the credit situation of that deal “will be worse than the market expects.” Several creditors, including Apollo, have already written down related debt.

Zito criticizes the logic of relying on strong performance of listed tech companies to maintain overall optimism:

Most acquired companies are of lower quality than those listed, smaller in scale, and sold at valuations far exceeding those of comparable public firms — anyone claiming ‘no problem’ clearly doesn’t understand this.

He also points out that the AI wave is forcing companies to rush deployments before the technology is fully mature, which signals a broader economic slowdown. He believes the probability of a recession is “over 50%,” more akin to a “consumer confidence-led recession.”

Private Equity Valuations Overstated, Transparency Questioned

Zito also questions internal perceptions within the private market.

He observes that investors are eager to buy secondary shares in private equity but remain cautious about financing 80% of these assets through private credit, which holds a more senior position in capital structures. He says:

That doesn’t make sense logically, but maybe I’m mistaken. When I bring this up, I usually get blank stares.

Regarding valuation transparency, Zito clearly states Apollo’s stance and sees it as a competitive advantage:

If you don’t mark to market, you lose the trust of clients. We aim to be the market leader in true mark-to-market valuation.

He also warns that the next market cycle will be a “major moment” for private markets, and those private market participants who grew through wealth management channels with an “arrogant” attitude will face severe tests.

Apollo Claims a Conservative Position but Acknowledges Risks

While Zito remains cautious about the industry-wide risks, he defends Apollo’s own credit business. He states that 95% of Apollo’s assets are investment grade, with very low exposure to the software sector.

He expects that the private credit loans issued over the next 12 to 18 months will be of “higher quality” across company selection, leverage, documentation, and spreads.

However, Zito admits that if the economy enters a severe recession, Apollo will not be immune:

I am confident we will suffer some damage, like others, but I believe we will come out better and have enough flexibility to buy quality assets during that period, generating substantial returns.

On redemption management, he favors maintaining a quarterly redemption cap of 5% to protect existing investors, warning that short-term decisions to accommodate redemptions could be “a very bad decision after one quarter.”