Historical analysis of distressed cycles in sectors like energy and retail shows that roughly one-third of the industry's debt defaulted over a two-year period. Applying this precedent to the software sector, which has approximately $300 billion in debt, suggests a potential default wave of around $100 billion if current pressures continue.

During the 2021-22 peak, private credit firms abandoned profit-based underwriting for "Annual Recurring Revenue" (ARR) loans to software companies. They gambled these companies would become profitable. Many have not, creating a vintage of bad loans that now poses a significant risk to the lenders who changed traditional lending economics.

An expert warns of a "mini bubble" where private credit funds lent heavily to PE firms buying unprofitable software companies based on high ARR multiples. With falling valuations, AI disruption, and a wall of debt maturing, a wave of defaults and restructurings is imminent.

As over-leveraged software companies fail, a new investment class will emerge. "Software special situations" funds will acquire these distressed assets from creditors, abandon growth-at-all-costs, and focus on restructuring for profitability and dividends, akin to a Constellation Software model.

Once considered safe due to low CapEx and recurring revenue models, the technology sector now shows significant credit stress. Investors allowed higher leverage on these companies, but the sharp rise in interest rates in 2022 exposed this vulnerability, placing tech alongside historically troubled sectors like media and retail.

A significant portion of private credit is concentrated in software companies. Many of these loans were made when rates were low, often with high leverage and weak terms. The emergent threat of AI-driven disruption to their business models now adds a new layer of fundamental risk to this already vulnerable cohort.

Recent financial distress in large, private equity-owned software companies is being misattributed to the threat of AI. The actual cause is over-leveraging when interest rates were low, followed by an inability to service that debt as rates rose and growth slowed. It's a credit problem, not a technology disruption problem.

Beyond the long-term threat of AI disruption, highly leveraged, lower-quality software companies funded by private credit face a more immediate problem: a $65 billion wall of debt maturing by 2028. They must refinance this debt amid high uncertainty, creating significant near-term risk separate from AI's eventual impact.

While software exposure is a serious concern for credit markets, it is unlikely to cause a systemic crisis. Mitigating factors include low leverage in BDCs (around 2x), minimal direct linkage to the core banking system, and a recent corporate credit cycle characterized by de-leveraging rather than aggressive debt accumulation.