Private Equity "Self-Lending to Self-Purchase": The Circular Game of Private Credit

Written by: Ariston

There’s a lot of discussion around Private Credit, but few people clearly explain it. Traditionally, private credit has always been a B2B model. In other words, large institutions lend money to companies to support their growth while managing risks. For lenders, this has been a highly profitable business model. Where there’s money to be made, capital flows there.

1. Like private equity firms, private credit institutions are non-bank lenders that provide debt financing to companies. The terms “private credit” and “direct lending” are often used interchangeably, but in reality, direct lending is just a sub-sector within the broader private credit market. Private credit has exploded to a $1.8 trillion scale. Ten years ago, this market was only $300 billion, and now it’s reached $1.8 trillion. Its growth rate is truly remarkable.

2. So, why are there alarms now? Mainly because some private credit firms are starting to raise funds from retail investors to support their lending activities. At the same time, private credit funds often offer some level of quarterly liquidity.

3. Specifically, what strategies does private credit include? The first is direct lending, which is an alternative to the broad syndicated loan market. It involves directly lending to companies. Borrowers can be sponsored—meaning backed by private equity—or non-sponsored.

In the US, 80% of direct lending flows to companies supported by private equity. In other words, direct lending largely finances private equity buyouts. Many private equity firms also operate private credit platforms.

The second category is asset-backed finance lending, which involves loans secured by contractual cash flows and related assets. The underlying assets are diverse, including mortgages, auto loans, leasing assets, or accounts receivable.

The last category is opportunistic distressed credit, which involves lending to troubled companies, financing corporate actions like spin-offs, or serving companies that don’t fit well into direct lending or private equity markets.

4. Who are the lenders? They are private credit funds, most of which are owned and operated by Business Development Companies (BDCs). BDCs are essentially specialized lending institutions. Some are publicly listed, others are private.

Many private credit funds are actually managed by BDCs controlled by private equity firms. For example, the largest private credit lender is Blackstone Private Credit Fund, or BCRED. It’s a non-listed BDC wholly owned by the publicly traded private equity giant Blackstone.

Thus, in part of their business, private equity firms buy companies; in another part, they use their private credit platforms to lend money to themselves to acquire these companies. If this sounds like a cycle, that’s correct—it’s inherently structured that way.

5. Currently, private credit faces two core issues. First, should private credit funds be sold to retail investors? Second, is a credit cycle forming? These questions are related but not identical.

A credit cycle means loan losses are increasing. There are very bad versions, like during the global financial crisis; and less severe ones, like the recession in 2001.

Since the global financial crisis, the US has not experienced a true credit cycle, which is why many analysts believe we are on the brink of one.

6. Of course, so far, the issues with private credit are still in early stages. It’s an unfolding story, and it’s too soon to tell how bad it might get.

7. Because these private credit loans are not publicly traded, by definition, they are illiquid. That’s not inherently wrong. Historically, investors in private credit funds have been large, mature institutions. That’s also fine—they understand what they’re buying: a higher-yield, illiquid product.

But once private credit funds have raised almost all the institutional capital, they’ve started to turn to retail investors, including broker-dealer clients, 401(k) plans, and others. That’s where the problems begin.

These loans are inherently illiquid. To create an illusion of “liquidity” for retail investors, funds allow redemptions, but usually with limits—around 5% to 7% of assets per quarter, depending on the fund. I believe these disclosures have been made to retail investors, but I also believe many don’t fully understand what they entail.

Now, as redemption requests continue to exceed the 5%–7% threshold, private credit funds are forced to find ways to limit redemptions or restrict withdrawals altogether.

8. Another important detail: private credit has excessive exposure to software companies. Due to AI’s impact on traditional software business models, valuations of software firms have fallen sharply.

Returning to the credit cycle issue, it’s worth emphasizing: 80% of direct lending loans are to private equity-backed companies. This is why the industry’s exposure to software companies is so high. About 25% of direct lending loans are to software firms, many of which were acquired by private equity between 2018 and 2022. Market concerns (and there’s debate about this) are that AI will enter the software industry at lower price points, disrupting the existing giants’ business models.

9. Another concern is that an estimated 11% of these software loans will need refinancing in 2027, and another 20% in 2028. When these loans were initially issued, interest rates were very low, reflecting the low-rate environment. When they refinance, if they can, interest rates will be much higher. If the turbulence in the software sector continues, who will be willing to refinance these loans? That’s a critical question.

10. Everyone is watching private credit now because most loan growth has occurred here. Historically, during a credit cycle, the first problem loans tend to come from the fastest-growing asset classes. During the 2008 financial crisis, for example, subprime mortgages grew rapidly and then collapsed.

11. That’s why investors are worried about private credit today. Because growth has been concentrated here. Since the financial crisis, bank lending has hardly increased, while almost all loan growth has been in private credit, which was only $300 billion ten years ago and has now reached $1.8 trillion.

12. Executives from several of the largest private credit funds are trying to downplay redemption issues and the risks of an unfolding credit cycle. But John Zito, co-president of Apollo’s asset management division, bluntly pointed out the problem during a UBS-hosted discussion.

Zito was initially off the record, but somehow his comments were reported by The Wall Street Journal. Regarding excessive exposure to the software industry, Zito said: “Most of the software companies acquired between 2018 and 2022 are not as good as larger firms, and their valuations are much higher, so I’m concerned about many of these privatized companies.”

From his remarks, it’s clear he expects some loan losses in the software sector. In fact, Apollo’s exposure to software is only 2%, compared to about 25% industry-wide. So, he can easily criticize competitors. It’s a comfortable position.

He also expects high redemption levels to persist for several quarters. He pointed out a contradiction: there’s still strong demand to buy secondary private equity interests—LP stakes in private equity funds. Yet, at the same time, investors optimistic about private equity and willing to buy these secondary shares are nervous about private credit, even though private credit supports 80% of private equity financing.