If 2021 was all about the fear of missing out then 2026 seems to be increasingly about the fear of being the last one left in. Every week that passes brings with it a story about a new lending scandal or major investor looking to reduce its exposure to private credit.

The vast increase in the size of the private credit industry was a natural consequence of a drive for yield during a decade of historically low interest rates and the regulations imposed on “traditional” lenders following the global financial crisis.

Pressures on the private credit market now are largely a consequence of those conditions going into reverse: of higher interest rates and a late-stage credit cycle, pressures that are often multiplied by overly optimistic future earnings assumptions, covenant-light terms and, often, very light touch due-diligence – all results of what was an extremely competitive lending environment.

Looser lending terms and lighter-touch due diligence have undoubtedly facilitated fraudulent behaviour. It seems likely that tighter terms, especially in relation to reporting, and better due diligence would have resulted in the exposure of some fraudulent schemes at a much earlier date.

Opacity is a further issue. It is notable that some recent collapses have left lenders further down the creditor chain struggling to gain an immediate understanding of their exposure. Opacity impacts pricing and liquidity, with book values not being tested by the cold reality of public markets and the potential for a significant time-lag between emergent issues and losses becoming known to investors.

The increased reliance on smaller ratings agencies, rating agency shopping and the potential for conflicts of interest are familiar to all those who were involved in and litigated the aftermath of the global financial crisis. As ever, an indemnity or insurance policy is only ever as good as a counterparty’s ability and willingness to pay.

In the US alternative assets have been opened up to retail investors for some time. The gating of retail focussed private credit funds illustrates the difficulties in selling an inherently illiquid asset class to individuals and it remains to be seen what losses retail investors will eventually bear. The position is very different in the UK where regulations are much stricter and retail participation has not been as wide.

The stress in private credit markets is giving rise to litigation risk across a number of areas impacting investors and shareholders. No structure is the same but there are some common themes.

Many structures were developed with low interest rates in mind and stop working economically if leverage becomes more expensive, particularly if they are reliant on overly optimistic forecasts. It is rare that these issues manifest overnight unless there is a fraudulent element. Usually, it is a slower burn as parties consider enforcement, assess their legal rights and look to use whatever commercial and legal leverage they have to reposition themselves as best they can for when the music finally stops.

The possibility of future insolvency requires careful navigation and there is significant potential for satellite disputes by parties left holding the proverbial parcel of valueless assets. Private credit lenders often hold large parts of a borrower’s capital structure and it seems likely that we will see restructuring exercises forced through via the courts using Part 26A of the Companies Act (which allows for cross-class cramdown, binding dissenting creditors if certain tests are met) and an increase in unfair prejudice cases where minority shareholders consider they have been treated unfairly.

Valuation is eternally cited as an art not a science but becomes particularly subjective in the absence of an external market and presents an obvious temptation for managers to go beyond what is a reasonable range when it is in their interests to do so, giving rise to misrepresentation claims. Redemption and contractual mechanics can also often give rise to disputes, particularly if individuals are involved who may not have had the benefit of formal legal advice at the outset.

It remains to be seen whether or not private credit presents the kind of systemic risk that gave rise to the global financial crisis but it is clear that previous cosy relationships are being replaced with cold legal realities as the music slows down.

This article was first published by FT Adviser