Default rates have become the dominant metric in private credit coverage. Every uptick generates headlines. Every high-profile bankruptcy spawns think pieces about systemic risk. The trade press and financial media have developed an almost singular focus on defaults as the measure of private credit health.
This focus is understandable. Defaults are observable, countable, and dramatic. They make for compelling stories. But the obsession with default rates reflects an incomplete understanding of how credit returns actually work. Defaults are only half the story. Recoveries are the other half. And right now, almost all of the attention is on the wrong half.
The Arithmetic of Credit Returns
Ratings agencies have understood this for decades. Expected loss is calculated as a simple formula:
Probability of Default (PD) × Loss Given Default (LGD) = Expected Loss (EL)
A 5% default rate with 20% loss severity produces a 1% expected loss. A 3% default rate with 60% loss severity produces a 1.8% expected loss. The manager with the higher default rate but lower severity delivers better outcomes.
This isn't theoretical. It's how credit investing actually works. The goal isn't to avoid all defaults—if it were, the optimal strategy would be to invest exclusively in AAA securities. The goal is to minimize expected loss while generating returns that compensate for risk.
Direct lenders who obsess over avoiding defaults may be optimizing the wrong variable. A lender who never experiences a default might be turning down reasonable credits or structuring loans so conservatively that returns suffer. The better question is: when defaults do occur, what are the recoveries?
Why Recoveries May Be Where Alpha Lives
Most direct lenders price loans similarly. Benchmarking data across more than 15,000 middle market loans shows very narrow pricing dispersion. Spreads cluster in a relatively tight range for comparable credits. If alpha were primarily a function of pricing—getting paid more for the same risk—we'd expect to see wider dispersion.
The similarity in pricing suggests that alpha in direct lending likely comes from somewhere else. Two candidates emerge: credit selection (picking borrowers less likely to default) and workout execution (recovering more when defaults occur).
Credit selection matters, but it's hard to consistently differentiate. Most institutional direct lenders employ similar underwriting frameworks, analyze similar financial metrics, and conduct similar due diligence processes. True information advantages are rare.
Recoveries, by contrast, offer more scope for differentiation. Workout capabilities vary substantially across managers:
- Some have dedicated restructuring teams with decades of experience. Others rely on junior investment professionals learning on the job.
- Some have relationships with restructuring advisors and distressed debt buyers. Others are operating in workouts for the first time.
- Document quality also matters for recoveries. The covenants, collateral packages, and remedies embedded in loan agreements determine what options a lender has when problems emerge.
Tip
Managers who structure documents carefully—and monitor compliance rigorously—have more leverage in workout negotiations. This capability is difficult to assess from marketing materials alone.
The Information Gap
The challenge for investors is that recovery data remains sparse. Default rates are relatively easy to track, even if definitional issues create noise. Recoveries take time to emerge and are harder to aggregate. A loan may enter workout and take years to resolve. The ultimate recovery depends on complex negotiations, collateral liquidations, and sometimes litigation.
This information asymmetry creates opportunity. Managers with genuine workout capabilities may not be appropriately rewarded by investors focused exclusively on default rates. The market may be underpricing recovery risk and overpricing default risk.
As default cycles mature and recovery data accumulates, we'll develop better visibility into which managers actually deliver strong risk-adjusted returns. The managers with low expected loss—whether through low defaults, high recoveries, or both—will be distinguished from those who simply operated in benign environments.
The Bottom Line
Rising default rates are cause for attention, but the impact on returns will depend as heavily on loss severity. The full picture requires both probability of default and loss given default. Until recovery data emerges, we're working with incomplete information. The managers who genuinely understand this—and who built their platforms around workout capabilities as much as origination—will be rewarded when the data finally arrives. Investors focused exclusively on default rates are looking at only half the picture.
Source: Pricing dispersion analysis based on proprietary dataset of 15,000+ middle market direct lending loans.