Alternative Investments: Private Credit in a Rising Rate Environment

Executive Summary¶

The private credit market has grown from a $400 billion niche in 2015 to an estimated $1.7 trillion in assets under management as of mid-2025 (Preqin). This expansion has been fueled by banks' retreat from middle-market lending post-Dodd-Frank, institutional investors' search for yield in a low-rate era, and the structural advantages of floating-rate exposure in a rising-rate environment.

With SOFR anchored near 5.30 % and the Fed signaling a protracted "higher-for-longer" stance, private credit's income advantage over traditional fixed income has widened to historic levels. However, elevated base rates also raise concerns about borrower debt-service capacity, default rates, and recovery values. This report provides a comprehensive analysis of the opportunity and the risks.

Key Takeaways¶

• Private credit yields currently range from SOFR + 450--650 bps (senior secured) to SOFR + 800--1,200 bps (mezzanine/unitranche), translating to all-in yields of 9.8--17.5 %.
• The trailing 12-month default rate for middle-market direct lending stands at 2.1 % (S&P LCD), well below the 4.5 % long-run average for broadly syndicated leveraged loans.
• Interest coverage ratios (ICRs) have compressed to 1.6x on average (from 2.8x in 2021) for leveraged middle-market borrowers, representing the most significant stress metric to monitor.
• Apex's Private Credit Allocation Model targets a 10--14 % net return with a 0.6x Sharpe ratio, meaningfully above the Bloomberg U.S. Aggregate's expected return of 5.2 %.

Market Structure & Growth¶

The private credit ecosystem encompasses several sub-strategies, each with distinct risk/return profiles:

Source: Preqin Global Private Debt Report 2025; S&P LCD.

The growth trajectory has been remarkable: the market has more than quadrupled since 2015 and nearly doubled since 2020. Key structural drivers include:

1. Regulatory arbitrage: Basel III and IV capital requirements have made middle-market lending uneconomical for banks. Private credit funds, operating outside the banking regulatory perimeter, can offer faster execution, more flexible terms, and customized covenants.
2. Institutional demand: Pension funds, endowments, and insurance companies facing 7--8 % return targets cannot achieve them with traditional 60/40 portfolios yielding 5--6 %. Private credit's illiquidity premium fills the gap.
3. Sponsor relationships: Private equity sponsors increasingly prefer direct lenders who can underwrite $200M--$1B+ commitments with certainty of close, avoiding the syndication risk inherent in bank-led processes.

The Rising-Rate Advantage---and Its Limits¶

The Income Tailwind¶

Private credit's floating-rate structure means that portfolio income has increased approximately 525 bps since the Fed began hiking in March 2022. A representative senior direct lending portfolio earning SOFR + 500 bps has seen its all-in yield rise from 5.5 % (SOFR at 0.05 %) to 10.3 % (SOFR at 5.30 %)---an 87 % increase in income.

The Debt-Service Squeeze¶

The flip side of higher floating-rate income for lenders is higher debt-service cost for borrowers. The average middle-market leveraged borrower has seen its annual interest expense roughly double since 2022, compressing interest coverage ratios (ICR = EBITDA / Interest Expense) to uncomfortable levels.

The compression of ICRs from 2.8x to 1.6x is the single most important risk metric in private credit today. Historically, borrowers with ICRs below 1.5x experience default rates 3--4x the market average. Apex estimates that approximately 15 % of middle-market direct lending borrowers currently have ICRs below 1.5x.

Credit Selection in a Stressed Environment¶

The dispersion between top-performing and bottom-performing private credit managers has widened to approximately 800 bps (top vs. bottom quartile), underscoring the importance of manager selection and credit underwriting discipline.

Apex's Private Credit Allocation Model applies six screening criteria to evaluate direct lending opportunities:

1. EBITDA > $25 million: Larger borrowers have more diversified revenue streams and greater capacity to absorb rate shocks.
2. LTV < 55 % (senior) / < 65 % (unitranche): Maintains adequate equity cushion to absorb EBITDA declines of 20--30 % before loan value is impaired.
3. ICR > 1.8x (current): Ensures adequate debt-service capacity at current rates; stress-tested to maintain > 1.3x under a +100 bps rate shock.
4. Non-cyclical sectors preferred: Healthcare services, software/SaaS, business services, and food & beverage exhibit lower EBITDA volatility than retail, hospitality, and manufacturing.
5. Sponsor quality: PE sponsors with fund vintages > $1 billion, < 50 % net-debt-to-value at entry, and demonstrated willingness to inject equity in stress scenarios.
6. Covenant package: Minimum financial maintenance covenants (leverage, ICR, minimum liquidity) with quarterly testing---not "covenant-lite."

Portfolio Construction¶

Apex's recommended private credit allocation within a $20 million+ diversified portfolio:

Diversification guidelines: minimum 40 borrowers, maximum 3 % single-name exposure, maximum 25 % single-sector concentration, vintage diversification across 3+ fund years.

Risk Considerations¶

• Liquidity risk: Private credit funds typically feature 3--5 year lock-up periods with limited (quarterly) redemption windows. Investors must align liquidity needs with commitment schedules.
• Valuation opacity: Unlike public bonds, private credit positions are marked to model rather than market. NAVs may not reflect true economic value during stress periods, creating "smoothed" return profiles that understate actual volatility.
• Leverage on leverage: Some private credit funds employ fund-level leverage (subscription lines, NAV facilities) of 1.0--1.5x, amplifying both returns and losses. Apex excludes managers with fund-level leverage above 1.25x.
• Crowding risk: The rapid growth of private credit AUM raises concerns about credit-quality deterioration as capital chases deals. Spreads have compressed approximately 75 bps from 2023 peaks, and covenant protections have weakened in competitive processes.
• Regulatory risk: The SEC's proposed rules on private fund advisers (enhanced reporting, audit requirements, restrictions on preferential terms) could increase compliance costs and reduce operational flexibility for GPs.

Outlook & Recommendations¶

Private credit remains a core strategic allocation in the Apex Alternatives platform. The asset class offers:

• Attractive absolute yields (9.8--12.5 % net) that exceed most liquid fixed income alternatives.
• Floating-rate protection that benefits from the "higher-for-longer" rate regime.
• Low correlation (0.25--0.35) to traditional equity and bond indices, improving portfolio-level Sharpe ratios.

However, we are increasingly selective in deployment, emphasizing:

1. Managers with proven workout and restructuring capabilities (given rising defaults).
2. Senior-secured positions with LTV < 55 % and ICR > 1.8x.
3. Non-cyclical, recurring-revenue business models (software, healthcare, essential services).
4. Vintage diversification to mitigate entry-point risk.

The next 12--18 months will represent a critical test for the private credit market. Managers who underwrote deals at peak leverage and minimum spreads in 2021--2022 are likely to experience elevated losses. Conversely, disciplined lenders deploying capital in 2024--2025 at wider spreads and tighter covenants are well positioned to deliver strong risk-adjusted returns.

This material is provided for informational purposes only and does not constitute investment advice or an offer to buy or sell any security. Private credit investments are illiquid, involve substantial risk of loss, and are suitable only for qualified purchasers. Past performance is not indicative of future results. Apex Financial Partners is a registered investment adviser.