Khan Capital | January 2026
Key Takeaways
- Private credit faces its first genuine stress cycle: After a decade of growth in benign conditions, Jamie Dimon’s “cockroach” warning and the Tricolor/First Brands collapses signal that underwriting weaknesses are surfacing across the $1.7 trillion asset class.
- Interest coverage has deteriorated sharply: Average coverage ratios have fallen from 3.2x to ~1.5x, with 47% of borrowers below 1.5x, as floating-rate loan costs have roughly doubled from 2021 levels.
- PIK conversions are masking real losses: “Bad PIK” now represents 57% of all PIK arrangements, generating phantom income that overstates fund returns while compounding eventual loss severity.
- Default rates depend on what you measure: Proskauer’s index shows 2.46% while Fitch’s broader measure reaches 5.8%, with the gap explained by whether restructurings and liability management exercises are counted.
- The BDC sector is the visible stress indicator: BlackRock TCP Capital’s 19% NAV decline, widespread dividend cuts, and a 17% price-to-NAV discount across the public BDC index suggest the market expects further deterioration.
For most of its existence, private credit has been tested by nothing more serious than a brief pandemic-era wobble that was immediately backstopped by the largest monetary intervention in history. The asset class grew from approximately $500 billion in 2015 to an estimated $1.7 trillion by mid-2025, powered by a decade of declining rates, abundant liquidity, and the structural retreat of banks from mid-market lending after the Dodd-Frank reforms.
That era of benign conditions is over. In the final months of 2025, a series of events, none individually catastrophic but collectively unmistakable, has signalled that private credit is entering its first genuine stress cycle. Jamie Dimon’s “cockroach” warning, the collapses of Tricolor and First Brands, rising default rates, deteriorating interest coverage, and a surge in payment-in-kind structures have all converged in what amounts to the asset class’s first real examination under pressure.
The question is no longer whether private credit will face losses. It is whether the structures, incentives, and transparency standards that define the market are adequate to manage them without broader contagion.
The Cockroach Theory
On JPMorgan’s Q3 2025 earnings call, Jamie Dimon offered one of the most consequential warnings in recent financial history: “When you see one cockroach, there are probably more.” The remark, directed squarely at private credit, came after JPMorgan wrote off $170 million in exposure tied to the collapse of Tricolor Holdings, a Dallas-based subprime auto lender whose executives were subsequently charged with systematic fraud.
Dimon’s concern was not about Tricolor specifically. It was about what Tricolor revealed: that underwriting standards across the private credit ecosystem had loosened materially during the growth years, and that the opacity inherent in the asset class made it impossible to assess the full extent of the deterioration from the outside. “We don’t know all the underwriting standards that all of these people did,” he said, “and I would suspect that some of those standards may not be as good as you think.”
Within weeks, the First Brands Group bankruptcy confirmed the thesis. The global auto parts manufacturer filed for Chapter 11 in September 2025, after it emerged that off-balance-sheet financing arrangements and alleged double-pledging of assets had inflated its apparent creditworthiness. Lenders who believed they were underwriting debt at roughly 5x leverage were, in reality, exposed to leverage closer to 20x.
Two cases do not constitute a systemic crisis. But two cases of alleged fraud, concealed leverage, and inadequate due diligence in a single quarter, drawn from a universe where valuations are self-reported and audits are infrequent, are precisely the kind of signal that warrants attention.
The Interest Coverage Squeeze
The most dangerous number in private credit right now is 1.5x. That is the average interest coverage ratio across middle-market private credit borrowers, down from a peak of 3.2x in 2021. More alarmingly, 47% of borrowers now have interest coverage below 1.5x, up from just 7% in Q4 2020.
The arithmetic is straightforward. Private credit loans are overwhelmingly floating-rate, typically priced at SOFR plus a spread of 500 to 650 basis points. When SOFR was near zero in 2021, a borrower paying SOFR + 600bp faced an all-in rate of roughly 6%. With SOFR now above 4%, that same loan carries an all-in cost of 10 to 12%. For a mid-market company with $50 million in EBITDA and $250 million in debt, the annual interest bill has roughly doubled, from $15 million to $28 million, without any change in the underlying business.
This is not a theoretical exercise. It is happening across thousands of portfolio companies simultaneously, and the consequences are becoming visible in the data.
| Metric | Q4 2020 | Q4 2023 | Q4 2025 | Trend |
|---|---|---|---|---|
| Average interest coverage ratio | 3.2x | 2.1x | ~1.5x | Deteriorating |
| Borrowers with IC ratio below 1.5x | 7% | 28% | 47% | Sharply rising |
| Proskauer Private Credit Default Index | N/A | ~1.3% | 2.46% | Rising |
| Fitch US Private Credit Default Rate (TTM) | N/A | N/A | 5.8% | Record high |
| \”Bad PIK\” as share of total PIK | ~37% | ~45% | 57% | Majority now distressed |
The PIK Problem: Phantom Income and Hidden Losses
When a borrower cannot pay its interest in cash, the lender has a choice: declare a default, or convert the cash interest obligation into payment-in-kind (PIK), where the unpaid interest is capitalised onto the loan balance. In theory, PIK is a legitimate structuring tool used in subordinated or mezzanine debt. In practice, in the current environment, it has become private credit’s primary mechanism for deferring the recognition of losses.
The scale is striking. According to Bloomberg, “bad PIK,” defined as PIK conversions triggered by borrower distress rather than original loan structuring, reached 57% of all PIK arrangements in Q3 2025, up from 37% in Q4 2021. By early 2026, “bad PIK” represented approximately 6.4% of total private credit deal volume and accounted for nearly 10% of total investment income at major Business Development Companies.
The incentive structure is perverse but understandable. A PIK conversion avoids triggering a default event, preserves the loan’s par valuation in the fund’s NAV, maintains the manager’s performance fees, and allows the fund to report investment income that was never actually received in cash. For investors evaluating these funds on the basis of reported returns and NAV stability, the distinction between cash income and PIK income is invisible unless they read the footnotes carefully.
The risk is that PIK conversions are creating a growing stock of “phantom income”: reported earnings backed not by cash flows but by an ever-expanding loan balance owed by a borrower that could not afford the original terms. When that borrower eventually defaults, the loss is not just the original principal but the accumulated capitalised interest, a compounding mechanism that amplifies losses in precisely the way that the asset class’s marketing materials promised would not happen.
The BDC Canary: BlackRock TCP Capital
If investors are looking for a case study in how private credit stress materialises in practice, BlackRock TCP Capital (TCPC) provides it. The mid-sized BDC reported a 19% decline in net asset value in Q4 2025, driven by $73.9 million in realised losses and $66.5 million in unrealised markdowns on specific portfolio investments. Non-accrual loans reached 4% of the portfolio at fair value and 9.7% at cost, a gap that itself illustrates the valuation opacity problem.
Management noted that 91% of the NAV decline stemmed from investments underwritten in 2021 or earlier, during the peak of the zero-rate environment when underwriting standards were at their loosest and competition for deals was most intense. KBRA downgraded the fund’s credit rating, and TCPC was forced to trim its dividend, joining a growing list of BDCs adjusting distributions downward.
TCPC is not an outlier. Across the broader BDC universe, KBRA’s Q3 2025 BDC Compendium documented a pattern of tightening spreads, declining net investment income, and increasing supplemental dividend cuts. MidCap Financial Investment Corp., affiliated with Apollo, reduced its quarterly dividend by 18%. Golub Capital cut dividends by 15% with analysts forecasting a further 10 to 20% reduction. The public BDC index now trades at a 17% discount to NAV, matching the June 2022 low and signalling that the market is pricing in further deterioration that reported NAVs have not yet reflected.
The Default Rate Puzzle
One of the most contentious debates in private credit is the actual default rate. The answer depends almost entirely on what you count.
The Proskauer Private Credit Default Index, which tracks a broad sample of middle-market loans, recorded a default rate of 2.46% for Q4 2025, up from 1.84% in Q3 and 1.76% in Q2. This is the number the industry’s proponents cite as evidence that losses remain manageable.
Fitch Ratings tells a different story. Its private credit default rate reached 5.8% on a trailing twelve-month basis through January 2026, the highest since the index’s inception. In its Privately Monitored Ratings portfolio, which tracks the credits it rates directly, the default rate hit 9.2% for full-year 2025, up from 8.1% in 2024.
The gap between these figures is explained by what each measure includes. The lower estimates typically exclude selective defaults, where a borrower restructures its obligations without a formal bankruptcy filing, and liability management exercises (LMEs), where borrowers and lenders renegotiate terms to avoid triggering a technical default. When these events are included, the picture darkens materially. Fitch’s broader measure captures them; Proskauer’s narrower index does not.
For investors, the practical question is not which number is “correct” but which number better reflects the actual risk of loss in their portfolio. A borrower that has restructured its debt, extended its maturities, and converted its interest payments to PIK has not technically defaulted. But the economic reality is that the loan is impaired, the recovery value is uncertain, and the originally underwritten return profile no longer applies.
What the Industry’s Defenders Get Right
It is important to note what the stress data does not show. The Cambridge Associates analysis of the Tricolor and First Brands collapses concluded that both were idiosyncratic cases of alleged fraud, not indicators of systemic weakness. The median private credit borrower continues to generate positive EBITDA growth, and the asset class’s senior-secured positioning means recovery rates, when defaults do occur, are meaningfully higher than in unsecured high-yield bonds.
The industry’s structural advantages remain intact: private credit lenders have direct relationships with borrowers, can negotiate bespoke amendments, and hold concentrated positions that give them control of the capital structure in a way that broadly syndicated loan holders cannot replicate. The “amend and extend” flexibility that critics describe as loss-masking is, from the lender’s perspective, a genuine tool for maximising recovery by giving viable businesses time to work through temporary cash flow challenges.
These arguments have merit. The question is whether the scale of the current stress, with nearly half of all borrowers below 1.5x interest coverage and PIK surging to record levels, can be managed through bilateral amendments alone, or whether the system is deferring an inevitable reckoning.
What Comes Next
The trajectory of private credit stress in 2026 depends on two variables that are largely outside the industry’s control.
Interest rates: If the Federal Reserve resumes cutting rates meaningfully, the interest coverage squeeze will ease, PIK conversions will slow, and many stressed borrowers will survive without formal restructuring. The three consecutive cuts in late 2025, bringing the fed funds rate to 3.50 to 3.75%, have provided some relief but not enough to reverse the deterioration at the margins.
Economic growth: If the US economy avoids a recession, revenue growth will support debt service even at elevated rates. But if growth slows meaningfully, the combination of high leverage, floating-rate debt, and deteriorating coverage ratios will produce a default cycle that the industry’s amend-and-extend toolkit cannot fully absorb.
The base case, which this analysis reflects, is neither a systemic collapse nor a painless resolution. It is a grinding, multi-quarter stress cycle in which defaults rise from current levels, NAV writedowns accelerate across the BDC universe, dividend cuts become more common, and the gap between private credit’s reported returns and its economic reality narrows uncomfortably.
Investor Implications
BDC Investors: The 17% discount to NAV in the public BDC index reflects justified scepticism. Investors holding publicly traded BDCs should scrutinise the proportion of PIK income in reported earnings, the vintage composition of the portfolio (2021 and earlier vintage loans carry the highest risk), and the manager’s track record during prior credit cycles. Not all BDCs will face the same degree of stress: those with conservative leverage, diversified portfolios, and high proportions of first-lien senior-secured loans are better positioned.
Private Credit Allocators: Institutional investors evaluating new commitments to private credit should demand greater transparency on portfolio-level interest coverage distributions, PIK exposure, and amendment activity. The era of allocating to private credit as a homogeneous asset class is over; granular due diligence at the portfolio company level is now essential.
Broader Market Implications: If private credit defaults accelerate, secondary market activity in distressed private credit will create opportunities for specialised distressed investors. The elevated rate environment that is pressuring borrowers is simultaneously creating attractive entry points for patient capital willing to deploy into dislocated credits at wider spreads.
Conclusion
Private credit’s first real test has arrived not as a single dramatic event but as a slow accumulation of stress across the ecosystem. The cockroaches Jamie Dimon warned about are emerging: not just in the fraud-tainted collapses of Tricolor and First Brands, but in the quiet deterioration of interest coverage ratios, the creeping expansion of PIK, and the growing gap between reported NAVs and market-implied valuations.
The asset class will survive this test. Private credit’s structural advantages, senior-secured positioning, direct lender relationships, and amendment flexibility, are genuine, and the majority of loans will ultimately be repaid. But the “zero-loss fantasy,” as it has been aptly described, is ending. Default rates are rising, reported returns are overstating economic reality, and the investors who allocated to private credit on the basis of its historical track record are discovering that a track record built entirely in fair weather is not a reliable guide to how the asset class performs when conditions deteriorate.
The test has only just begun. How private credit’s managers, investors, and regulators respond over the coming quarters will determine whether this is a manageable stress cycle or the prelude to something more systemic.
Sources: Fortune: Jamie Dimon Cockroach Warning · CNBC: Tricolor Fraud Charges · Cambridge Associates: First Brands & Tricolor Analysis · Proskauer: Q4 2025 Default Index · Funds Society: Fitch Default Rate Data · Bloomberg: Bad PIK Analysis · Yahoo Finance: BlackRock TCP Capital NAV Decline · KBRA: BDC Ratings Compendium · Valuation Research: Interest Coverage Data · Morgan Stanley: Private Credit Outlook
Related Reading: For the culmination of the stress signals described here, including how Blue Owl, Apollo, and Blackstone responded when redemption requests surged in Q1 2026, see The Private Credit Crackup: Blue Owl, Redemption Gates, and the Liquidity Illusion. The interest rate environment that created both private credit’s golden era and its current stress is explored in Fed Cuts Again: Three Consecutive Cuts to Close 2025 and 10-Year Treasury Hits 5%: Bond Vigilantes Return. For earlier episodes of hidden leverage and concentrated risk producing outsized systemic consequences, see Silicon Valley Bank Collapse and Archegos Capital Collapse. The semi-liquid fund structures that channelled retail capital into private credit, and the systemic risks they carry, are examined in The Rise of Semi-Liquid Funds: Private Markets’ $4 Trillion Gamble. The decade-long growth story that built the $1.7 trillion market now under stress is chronicled in The Rise of Private Credit: From Niche to $1.7 Trillion. The specific mechanics of how AI is repricing software collateral are examined in Private Credit and AI Disruption: When Collateral Loses Value Overnight.
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