Private Credit Market Shows Overheating in Core Segments

In Brief:

Private credit markets are experiencing dangerous overheating in certain segments, with some lenders abandoning basic due diligence and offering borrower-friendly terms that strip away creditor protections, creating conditions ripe for significant losses when economic cycles turn. Michael Gatto, partner and head of private side businesses at Silver Point Capital, delivered this sobering assessment during an interview on Bloomberg's The Credit Edge podcast. With $38 billion in investable capital and two decades of experience since Silver Point's 2002 founding, Gatto brings unique perspective to private credit's evolution from a niche market to today's crowded landscape. His firm, which originated from Goldman Sachs' Special Situations Group, has navigated multiple economic cycles and positioned itself to capitalize when market fear replaces the current "fear of missing out" mentality driving questionable lending decisions.

Big Picture Drivers:

• Market Saturation: Core LBO lending has become an "overbanked" market with too much capital chasing vanilla deals

• Documentation Deterioration: Loan documents increasingly favor borrowers with carve-outs that can move substantial value away from lenders

• Due Diligence Decline: Some lenders are cutting corners on fundamental credit analysis to deploy capital quickly

• Cycle Preparation: Smart capital is positioning for market dislocations when easy money conditions end

Key Insights:

• Silver Point allocates over half of its $38 billion toward performing credits, with $20 billion dedicated to CLOs and private credit while maintaining significant dry powder for special opportunities when markets dislocate.

• The firm targets 30-40% of loans to non-sponsor companies because this segment remains "very underbanked" and requires full due diligence capabilities that many lenders avoid due to complexity.

• Current core LBO lending represents a "beta trade" with no excess returns, as overheated competition forces lenders to accept borrower-friendly terms and weakened documentation.

• When market cycles turn from "fear of missing out" to genuine fear, only lenders with adequate capital, confidence, and expertise will survive and thrive while others face portfolio triage or exit the business.

• Small companies with $10-15 million EBITDA present the highest risk because they lack significant market share and may not provide adequate downside protection for senior secured lenders during distress.

• Document quality has deteriorated significantly, with some loans allowing companies to move $250 million of a $1 billion enterprise value to unrestricted subsidiaries, making stated loan-to-value ratios misleading.

Key Trends To Watch:

• Payment-in-Kind (PIK) Interest: Rising PIK rates signal portfolio stress as companies defer cash payments when they cannot refinance in normal markets

• AI Disruption Risk: Every new loan must assess vulnerability to artificial intelligence displacement across software, tech, and service sectors that comprise large portions of private credit portfolios

• Retail Market Expansion: Private credit ETFs with daily liquidity backing fundamentally illiquid assets create potential mismatch risks that could trigger broader market volatility

• Bank Re-engagement: Traditional banks are preparing to return to direct lending markets, potentially as partners rather than competitors for established private credit funds

• Non-Accrual Rates: Despite 525 basis points of rate hikes, non-performing loan rates remain surprisingly low, potentially masking underlying credit deterioration

Memorable Quotes:

• "When the tide goes out, we're going to see who's naked" - Michael Gatto, explaining how market downturns will reveal which private credit funds have been taking excessive risks

• "We can't lose money. We have to be paranoid about everything that could go wrong" - Michael Gatto, contrasting the constraints of debt investing versus equity investing where home runs can offset losses

• "There's plenty of LBO deals where they tell the lenders zero access to management. Can't even have a conversation" - Michael Gatto, describing how overheated markets give borrowers excessive negotiating power

• "It's misleading to say I'm 50% loan to value" - Michael Gatto, explaining how document carve-outs can allow borrowers to move substantial assets away from lender collateral

• "We dig deeper. We enjoy due diligence, we think it's really important" - Michael Gatto, describing Silver Point's core philosophy of thorough credit analysis

The Wrap:

As private credit markets continue expanding into retail products and mainstream portfolios, Gatto's warnings about overheating serve as a crucial reality check for an industry that has benefited from years of easy monetary policy. His firm's positioning for market dislocations reflects hard-earned wisdom from navigating multiple credit cycles, suggesting that current market exuberance may be setting up significant opportunities for disciplined lenders while creating substantial risks for those prioritizing deployment speed over credit quality.