The term "middle market" is too broad for risk assessment. KKR's analysis indicates that default risk and performance dispersion are not uniform. Instead, they will be most pronounced in the lower, smaller end of the middle market, while the larger companies in the upper-middle market remain more resilient.

Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.

As private credit funds absorb riskier, smaller deals, the public high-yield market is left with larger, more stable companies. This migration has improved the overall quality and lowered default rates for public high-yield bonds, creating a performance divergence.

Despite headlines blaming private credit for failures like First Brands, the vast majority (over 95%) of the exposure lies with banks and in the liquid credit markets. This narrative overlooks the structural advantages and deeper diligence inherent in private deals.

Unlike syndicated loans where non-payment is a clear default, private credit has a "third state" where lenders accept PIK interest on underperforming loans. When this "bad PIK" is correctly categorized as a default, the sector's true default rate is significantly higher, around 5% versus 3% for syndicated loans.

Official non-accrual rates understate private credit distress. A truer default rate emerges when including covenant defaults and 'bad' Payment-in-Kind interest (PIK) from forced renegotiations. These hidden metrics suggest distress levels are comparable to, if not higher than, public markets.

Investors are drawn to PE's smooth, bond-like volatility reporting. However, the underlying assets are small, highly indebted companies, which are inherently much riskier than public equities. This mismatch between perceived risk (low) and actual risk (high) creates a major portfolio allocation error.

The current rise in private credit stress isn't a sign of a broken market, but a predictable outcome. The massive volume of loans issued 3-5 years ago is now reaching the average time-to-default period, leading to an increase in troubled assets as a simple function of time and volume.

The massive growth of private credit to $1.75 trillion has created an alternative financing source that helps companies avoid default. This liquidity allows them to restructure and later refinance in public markets at lower rates, effectively pushing out the traditional default cycle.