A financial journalist warns that rapid growth in a new bank can be a red flag. It often signifies aggressive lending to win market share, but the quality of those loans and associated risks may not become apparent for several years. This makes fast-growing banks, like the new tech-focused Erbador Bank, a source of cautious skepticism.

Years of low interest rates encouraged risk-taking, resulting in a large pool of low-rated loans (B3/B-). Now, sustained higher rates are stressing these weak capital structures, creating a boom in distressed debt opportunities even as the broader economy performs well.

Unlike private equity, where a long-held asset can have a late-stage turnaround, private credit loans operate differently. A loan that has not been refinanced after four years likely has underlying issues, as healthy companies typically refinance early. Therefore, a secondary portfolio of aged loans carries a high risk of adverse selection.

In large loan portfolios, defaults are not evenly distributed. As seen in a student loan example, the vast majority (90%) of defaults can originate from a specific sub-segment, like for-profit schools, and occur within a predictable timeframe, such as the first 18 months.

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.

Problem loans from the 2021-22 era will take years to resolve due to private credit's tendency to "kick the can." This will lead to a prolonged period of underwhelming mid-single-digit returns, even in a strong economy, rather than a dramatic bust.

A critical insight for secondary buyers is that most credit risk is front-loaded. Data shows that two-thirds of all defaults occur within the first three years of a loan's life. This means that by purchasing seasoned assets in the secondary market, investors can bypass the period of highest risk and gain greater visibility into a portfolio's long-term health.

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.

Lenders allow struggling borrowers to skip cash interest payments by adding the amount to the loan's principal balance. This practice, called 'Payment in Kind' (PIK), hides defaults, artificially inflates asset values, and creates a deceptively low official default rate, masking escalating risk within the system.