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Shadow defaults: Economic distress without a technical breach
A troubling trend in the current loan market is the visible increase in default rates. In November 2025, Fitch Ratings reported that the private credit default rate climbed to 5.7% on a trailing twelve months basis, the highest level recorded since February 2024. However, this figure captures only part of the picture: shadow defaults are also on the rise at an alarming rate, as sponsors pull various levers to lengthen the runway and determine the best exit next steps.
In short, shadow defaults occur when there is technically no breach of the credit agreement ongoing, but the business is showing clear signs of economic stress. The company can satisfy financial covenants, but not without effort, strain, and sponsor intervention (most often through an injection of EBITDA for financial covenant compliance). At the same time, liquidity is likely tightening, cash burn accelerates, and often, revolver availability is used to fund operations or payroll rather than serve as a contingency. In some cases, EBITDA remains positive while cash flow is persistently negative. Nevertheless, the company’s debt remains marked near par, income continues to accrue, and capital continues to circulate as though portfolios are stronger than they truly are.
The tools that defer a technical breach and mask performance
The defining feature of a shadow default is deferral. The sponsor-friendly technology in a credit agreement allows a borrower to remain current even as its economic position deteriorates, widening the gap between compliance and reality. To identify risk that headline metrics miss, it is worth examining the specific mechanisms that make this possible. Several common features of private credit documentation enable this deferral.
Maturity extensions, typically structured as amend-and-extend transactions, are among the most visible. These amendments provide additional runway for operational turnarounds, refinancings, or sales. In limited cases, time helps. More often, recovery is already impaired, absent a meaningful shift in the company fundamentals. Extending maturity without addressing the core performance issues in the business merely delays restructuring rather than preventing it. Each extension kicks the can further down the road, making eventual recognition more painful.
Second, payment-in-kind (PIK) interest provisions are a very well-utilized tool for good reason, but also warrant particular scrutiny. Instead of paying interest in cash as it becomes due each quarter, the borrower will pay in kind by adding that amount of interest as additional principal that will become due at maturity. Used alongside sponsor equity cures or covenant adjustments, PIK elections can allow borrowers to sidestep default tests that would otherwise surface distress. The credit appears current; economically, risk compounds as the principal grows.
Finally, covenant amendments frequently introduce further flexibility. Covenants may be loosened or suspended, leverage tests reset, or fees paid in exchange for waivers. In more stressed situations, amendments may introduce or expand PIK features that reduce near-term cash obligations while increasing leverage.
These tools are not problematic in isolation, but they become concerning when repeatedly used to preserve technical compliance without restoring financial health. When deployed in combination – maturity extensions, PIK toggles, and covenant relief – the gap between reported performance and economic reality widens fast.
Why shadow defaults distort the market
The most immediate consequence of shadow defaults is delayed loss recognition and the ripple effect this has on the market. Troubled credits often remain marked close to par, and accrued interest – frequently PIK – continues to inflate reported net asset values. Portfolios appear stable even as embedded stress grows. The result is a false sense of stability that shapes capital allocation across the market.
That distortion affects real decisions. Limited partners may deploy or recycle capital into strategies that already contain impaired assets. Lenders pricing new loans may rely on default and recovery assumptions that understate true loss experience. Spreads clear at levels that fail to reflect accumulated risk. Risk gets systematically mispriced, and the problem compounds as more capital flows into strategies based on misleading performance metrics.
When those stresses surface through restructurings or discounted exits, confidence erodes. Stakeholders are beginning to question the transparency of performance reporting and the reliability of stated risk metrics. For established private lenders who pride their underwriting platforms on discipline and resilience, those optics matter and invite greater scrutiny from regulators and renewed competition from traditional lenders. The longer shadow defaults go unreported, the sharper the eventual correction – and the more damage to market confidence.
Sponsor capital: Buying time versus solving problem
Sponsor support plays a central role in determining how long shadow defaults persist. Capital injections may take the form of equity contributions, preferred equity, holdco-level PIK financing, or incremental term loans that are lender-led but sponsor-backstopped. The timing and structure of these injections can signal whether a situation is actually recoverable or just being propped up.
Outcomes are highly situation-dependent. Capital deployed early, when stress is transitory, and proceeds used to meaningfully deliver or reposition the business, can reset a company’s trajectory. Capital deployed later, when control or franchise value is already at risk, rarely produces a durable recovery.
In many cases, sponsor capital buys time rather than resolves underlying issues. Sponsors often wait until economics or governance are threatened before injecting new money. By then, operational challenges may be entrenched, and exit options are limited. While such investments can preserve optionality, they seldom restore a business to robust financial health once distress is visible. For lenders, the distinction between genuine turnaround capital and defensive delaying tactics matters when assessing true exposure.
How sophisticated limited partners read through the noise
Institutional limited partners (LPs) with established private credit programs do not take stated default rates at face value. For many, those figures function as compliance statistics rather than meaningful indicators of risk. The focus instead is on economic stress and downside exposure. There’s good reason for that skepticism: official default metrics capture only formal payment defaults, not the economic deterioration that precedes them.
LPs apply internally adjusted frameworks and ask more revealing questions: How many credits would struggle to refinance at current rates? How many companies have required sponsor support over the past year? How much income is being capitalized rather than paid in cash? How many businesses report positive EBITDA but generate negative cash flow?
PIK usage is often viewed as a red flag or recognition of deferred loss. Repeated amendments, covenant resets, or fee-for-waiver transactions raise similar concerns. Together, these signals allow LPs to form an independent view of shadow default exposure and assess whether reported performance reflects durable value or postponed impairment. The most sophisticated investors treat any combination of these indicators as evidence of economic stress, regardless of what official metrics show.
Approximating what cannot be measured precisely
There is no precise way to quantify the shadow default rate. By definition, these situations sit outside formal default metrics. Still, experienced market participants know how to approximate the scale of stress, as an increasing frequency of amend-and-extend transactions, expanded PIK usage, covenant holidays, and liquidity pressures all point in the same direction.
Liquidity profiles are particularly telling when companies rely on revolver availability to fund operations or face less than a year of runway without external support. Where available, secondary market pricing can also provide insight into how risk is perceived beyond reported values. When loans trade at significant discounts to par despite appearing current in official reporting, the market is pricing in what formal metrics miss. Tracking these indicators across portfolios gives a more realistic picture of embedded stress than headline default rates alone.
Looking ahead: Discipline in a scaling market
Private credit is expected to continue expanding in 2026, driven by acquisition financing, refinancings, and borrowers seeking certainty of execution outside traditional banking channels. At the same time, margin compression and elevated leverage are testing assumptions that were held during the last cycle. The combination of rapid growth and rising stress creates a particular hazard: new capital flowing in based on backward-looking metrics that do not capture forward-looking deterioration.
As defaults rise, the distinction between technical performance and economic reality will matter more. Managers who emphasize disciplined underwriting, conservative leverage, and transparency around stress will be better positioned than those who rely on documentation flexibility alone. The market will force recognition of shadow defaults eventually – the only question is whether that happens gradually through proactive disclosure or abruptly through distressed exits.
Shadow defaults are not inherently failures. In some cases, they reflect recoverable situations navigating temporary disruption. The risk lies in treating them as invisible. In a market built on private information and bespoke structures, the ability to recognize economic stress early may be one of the most durable competitive advantages. For investors, lenders, and regulators, looking beyond headline metrics to identify shadow defaults is no longer optional – it is how any disciplined market player meaningfully assesses risk.
Client Alert 2026-028
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