Osterweis's Sheehan and Manchuck: Private Credit's Fund Structure Is the Real Risk

In Brief:

John Sheehan and Craig Manchuck, Portfolio Managers at the Osterweis Strategic Income Fund, argue that private credit's most dangerous vulnerability is not its loan book but the liability structure of its retail-facing funds in a conversation on Bloomberg's Odd Lots podcast. Managing a $5.8 billion unconstrained bond fund that has operated for over two decades, the pair currently hold zero private credit exposure, a position they arrived at through underwriting discipline rather than macro timing. Their central claim is that the mismatch between how retail private credit funds raise capital (upfront, subscription-based) and how they deploy it (slowly, into an overcrowded market) has systematically degraded credit quality across the asset class, setting up a grinding deterioration that will separate disciplined managers from reckless ones as defaults rise and redemptions mount.

Big Picture Drivers:

• Capital-First Structure: Most private credit funds take money upfront and then hunt for investments, unlike private equity where managers find deals first and call capital from LPs second

• Deployment Pressure: Funds that grew 10x over five to ten years did not grow sourcing capabilities by the same factor, creating intense competition that weakens covenants and compresses rates

• Marking Opacity: Private credit NAVs appeared stable through the 2022 rate shock because funds were not taking their marks, attracting more capital and reinforcing the cycle

• Redemption Mechanics: When inflows slow, managers must sell their best assets or borrow to meet redemptions, creating a compounding deterioration with no obvious stopping point

Key Topics Covered:

• Credit Market History: The evolution from GE Capital's physical asset lending through mezzanine finance to today's four-tier credit market of investment grade, high yield, leveraged loans, and private credit

• Fund Structure Comparison: Why private credit's evergreen subscription model creates different pressures than private equity's drawdown structure, and how that difference drives underwriting degradation

• Gates and Redemptions: How interval fund gates protect against rapid runs but cannot solve the asset-side deterioration when defaults rise and quality positions are sold first

• Software Lending Risk: The migration of private credit into asset-light technology companies where recovery values in bankruptcy may be negligible compared to traditional collateral-backed lending

Key Insights:

• Underwriting Degradation: Subscription capital that arrives must be immediately invested in income-earning assets to avoid NAV drag, creating urgency that has led to weaker underwriting, more aggressive terms, and excessive leverage extended to companies that probably should not carry that much debt.

• Phantom Stability: In 2022, wealth advisors told Osterweis that private credit was "working great" while investment grade bond funds were suffering visible duration losses. Manchuck contends this was because private credit funds were not marking down, and the apparent stability attracted a fresh wave of capital that further degraded loan quality.

• Recovery Gap: The historical roots of private credit were in physical collateral: rail cars, aircraft engines, medical equipment. The shift to software companies with predictable subscription revenue but no hard assets means that when workouts begin, creditors may find virtually nothing protecting them in bankruptcy.

• High Yield Purification: What was once a two-tier credit market has become four tiers. The double-B portion of high yield now approaches 60%, up from about 35%, and triple-C's have shrunk from over 20% to about 9%. The riskiest borrowers have migrated entirely into leveraged loans and private credit.

• Default Threshold: Sheehan cites sell-side estimates of a potential 15% default rate in private credit, a figure he characterizes as within the realm of possibility given the combination of 6x-plus leverage on companies originated at historically low base rates that have since repriced on floating-rate resets.

• Manager Dispersion: The era of uniform private credit returns, where everything was marked at par with 8 to 10% coupons, is ending. The first visible signal will be widening performance gaps between managers with decades of experience and recent entrants who scaled rapidly during the low-rate environment.

Memorable Quotes:

• "If you look at some of these funds that have grown ten x over the last five, ten years, I don't think that they have grown their sourcing abilities by 5 to 10x." - Sheehan on the structural imbalance between capital formation and deployment infrastructure in private credit

• "In 2022, I'd say, what's working? Oh, gosh. Private credit. It's been working great. I would say, well, that's wonderful. But that's because they're not taking their marks." - Manchuck on the feedback loop where stable NAVs attracted more capital from advisors who mistook the absence of visible losses for the absence of actual risk

• "A company gets to six times levered, it's very, very difficult to get out from under that." - Sheehan, invoking a veteran colleague's principle to frame the mathematical trap facing private credit borrowers now that base rates have normalized

• "We're a bunch of old guys and we have our ways of doing things that have been developed over 30 or 40 years. We're not likely to change our credit approach just because the market now all of a sudden wants to get more aggressive." - Manchuck on why Osterweis chose to sit out private credit rather than compete on weakened terms

The Wrap:

Sheehan and Manchuck are not predicting a 2008-style systemic crisis. They are explicit that gates and term limitations make a rapid unwind unlikely. What they are predicting is a grinding deterioration: rising defaults, forced asset sales, increasing fund leverage, and widening dispersion among managers that will separate the disciplined from the reckless. The conditions that would validate their thesis are already forming, from floating-rate resets on 2020 and 2021 vintage software loans to slowing retail inflows and a public high yield market that has expelled its weakest credits into private vehicles. For allocators, the actionable insight is structural, not directional: the question is not whether defaults will rise but whether the fund you own can absorb them without triggering the sell-the-best, lever-the-rest spiral that Manchuck describes.