Howard Marks: Direct Lending's Newness Hides Familiar Risks

Howard Marks's latest memo, "What's Going On in Private Credit?", serves as a vital diagnostic for anyone navigating the complex world of non-government debt. It meticulously unpacks the evolution of credit markets, from the nascent acceptance of non-investment grade debt in the 1970s to the current boom in direct lending. The core thesis reveals a recurring pattern: the dangerous allure of newness in finance, where untested innovations, fueled by investor envy and the pursuit of yield, inevitably lead to inflated prices and weakened standards. This conversation is crucial for institutional investors, financial advisors, and sophisticated individual investors who seek to understand the hidden risks and potential dislocations within private credit, particularly as AI disrupts traditional software valuations and as rising interest rates expose the fragility of highly leveraged structures. By understanding this historical context and the systemic forces at play, readers gain a significant advantage in anticipating market shifts and avoiding the pitfalls of late-stage investment fads.

The Siren Song of Newness: How Direct Lending's Rise Hides a Familiar Tune

The narrative of financial innovation often follows a predictable arc: a novel instrument or market emerges, early adopters reap substantial rewards, envy spreads like wildfire, capital floods in, standards erode, and eventually, a reckoning occurs. Howard Marks, in his characteristically insightful analysis of private credit, meticulously traces this pattern through the history of non-government debt, culminating in a stark warning about the current state of direct lending. This isn't just about interest rates or market cycles; it's a deep dive into the behavioral economics of investing, where "what the wise man does in the beginning, the fool does in the end."

The journey began with the acceptance of non-investment grade debt in the 1970s, a concept pioneered by Michael Milken, which unlocked capital for companies previously reliant on bank loans. This paved the way for leveraged buyouts, broadly syndicated loans, and the complex securitization structures that defined the 1990s and early 2000s. The Global Financial Crisis (GFC) of 2008-2009, a stark reminder of the dangers of unchecked innovation and flawed securitization, led to a retrenchment by banks. This vacuum was precisely what allowed direct lending, a subset of private credit, to surge in the 2010s. Fueled by institutional investors seeking yield in a low-interest-rate environment and later marketed to individual investors, direct lending ballooned from a niche market to a multi-trillion-dollar behemoth.

Marks highlights a critical, often overlooked, aspect of this growth: the "normal pattern" of investment fads. Newness, he explains, creates a fertile ground for optimism. Its proponents can easily tout its merits because its flaws have yet to be revealed. Early successes, driven by favorable market conditions and less-tested standards, create envy, compelling latecomers to join the party. This dynamic, captured by Charles P. Kindleberger's observation that "there is nothing so disturbing to one's well-being and judgment as to see a friend get rich," fuels a cycle of rising prices and deteriorating underwriting.

"The investment world I first encountered in the summer of 1968, consisting exclusively of stocks and high-grade bonds, seems quaint and provincial in retrospect."

-- Howard Marks

The appeal of direct lending, particularly in the post-GFC era, was amplified by its perceived lack of price volatility due to its illiquidity. Advocates might have framed this as delivering high risk-adjusted returns, but Marks argues it was more accurately "high volatility-adjusted returns." The underlying credit risk, he contends, remained as significant as in liquid markets, but it was simply less visible. This opaqueness, coupled with a flood of capital and a benign economic environment, allowed underwriting standards to weaken. Managers, eager to deploy capital and grow assets under management, accepted lower yields, narrower spreads, and reduced protections. This "race to the bottom," as Marks termed it in a previous memo, set the stage for eventual disillusionment.

The AI Disruption: When Software's Moat Crumbles

The narrative takes a sharp turn with the emergence of artificial intelligence and its impact on the software sector, a cornerstone of the direct lending market. For years, software companies, with their recurring subscription revenues and strong moats, were considered prime candidates for leveraged buyouts and direct lending. Private equity firms, and subsequently direct lenders, flocked to this sector, often acquiring companies at high multiples and extending significant leverage. Marks notes that direct lending now represents a substantial portion of software debt, far exceeding its representation in high-yield bonds or broadly syndicated loans.

However, the rapid advancements in AI, particularly in coding, have begun to erode the perceived durability of software moats. Marks points to the release of powerful AI coding models and plugins as a "cognitive tipping point." While the market for software stocks and debt didn't immediately react in 2024-2025, the underlying disruption is undeniable. This technological shift creates a new layer of risk for direct lenders heavily exposed to software companies. The equity cushion for lenders, which previously provided a buffer, is shrinking as AI potentially reduces the need for traditional software development and impacts valuations.

"The market for software company stocks and debt didn't react much in 2024 to 2025. Then, in November 2025, Anthropic released a powerful new model for coding, followed in January by the release of 11 plugins to automate tasks in a number of fields. It seems a cognitive tipping point was reached."

-- Howard Marks

The immediate consequence for investors in direct lending vehicles has been a re-evaluation of risk and liquidity. Concerns about AI's impact, combined with the inherent illiquidity of private debt and the potential for overstated net asset values (NAVs), have led to investor anxiety. Reports of redemption limits in non-traded Business Development Companies (BDCs) and wider discounts in publicly traded BDCs signal a growing awareness of these intertwined risks. This situation exemplifies how a seemingly isolated technological disruption can trigger systemic consequences in financial markets, particularly when layered upon existing structural vulnerabilities.

The Interest Rate Reckoning: Private Equity's Shifting Winds

The rise of direct lending is inextricably linked to the fortunes of private equity (PE). Marks details how PE's growth was supercharged by a prolonged period of ultra-low interest rates following the GFC. This environment allowed PE firms to borrow cheaply, acquire companies at favorable valuations, and benefit from the appreciating value of assets. The virtuous cycle of rising capital commitments, increased leverage, and easy exits created an illusion of invincibility for the asset class.

However, the central banks' pivot to combat inflation in early 2022 marked a significant "sea change." The dramatic increase in interest rates has fundamentally altered the landscape for PE. Higher borrowing costs have squeezed portfolio company profitability, making deals less attractive and refinancing more challenging. The valuation of future cash flows, a critical component of PE deal-making, has declined, leading to slower sales of portfolio companies and reduced distributions to limited partners (LPs). Marks cites estimates showing a significant divergence in returns between private equity and the S&P 500 since 2022, underscoring the impact of this shift.

This economic reality has direct implications for direct lenders. Many PE-backed companies now carry capital structures that cannot withstand a 400-basis-point increase in interest rates. The ability of lenders to extend maturities or provide additional "payment-in-kind" (PIK) debt, which capitalizes interest payments, may be tested. The difficulty in monetizing portfolio companies and refinancing existing debt, coupled with potentially lower valuations, creates a challenging environment for debt repayment. This highlights how macroeconomic policy shifts, like interest rate hikes, cascade through the financial system, impacting everything from PE fund performance to the stability of direct loans.

"In the last several years, a lot of private equity companies have been saddled with capital structures that didn't anticipate a 400 basis point increase in interest rates."

-- Bruce Karsh (quoted by Howard Marks)

The interplay between AI's disruption of software valuations and the higher interest rate environment creates a potent cocktail of risks for direct lenders. The "normal pattern" of investment fads, where newness masks hidden flaws, is playing out with unsettling familiarity. The current discomfort in direct lending, Marks suggests, is not merely a cyclical downturn but a consequence of years of weakened underwriting and an overreliance on favorable market conditions that are now rapidly changing.

Navigating the Storm: Discipline in a Frenzied Market

Marks concludes by offering a perspective on what a conscientious manager should do in such an environment, drawing on Oaktree's own approach. He emphasizes the challenge of managing abundant capital when investor enthusiasm is high and standards are slipping. The temptation to join the "race to the bottom" is immense, but true investing success, he argues, lies in making decisions that are better than those of others, which often means resisting fads and maintaining discipline.

Oaktree's strategy, as outlined by Marks, involves a deliberate and measured approach to private credit. They have avoided the aggressive expansion into direct lending seen by many peers, maintaining a balanced portfolio of both private and liquid credit. Their direct lending exposure remains a relatively small portion of their overall assets, reflecting a cautious stance on the asset class's risk-return profile, particularly after pricing and terms were competed away. This disciplined approach has meant less pressure to invest quickly or compromise standards, allowing them to remain highly selective, especially concerning software investments.

Furthermore, Oaktree's limited exposure to public direct lending vehicles, with the majority of their private credit investments being for institutional clients, positions them differently from managers with massive retail-focused direct lending businesses. As investor enthusiasm wanes and opportunities become more attractive, this disciplined stance allows them to capitalize on dislocations.

The memo implicitly draws parallels to historical crises, such as the late 1980s/early 1990s high-yield bond market turmoil, suggesting that direct lending, like its predecessors, may need to navigate a credit cycle to reach a more stable equilibrium. The enduring lesson, echoing Andrew Ross Sorkin's analysis of the 1929 crash, is the need for humility -- the recognition that no system is foolproof and that human nature, with its propensity to forget past lessons, will continue to drive cycles of exuberance and despair.

Actionable Insights for Navigating Private Credit

• Recognize the "Newness" Trap: Be acutely aware that novel investment opportunities, especially those experiencing rapid growth, often carry hidden risks that are not apparent in their early stages. This applies strongly to direct lending and other emerging private credit strategies.
  • Immediate Action: Review existing allocations to rapidly growing, less-tested asset classes.
• Scrutinize Software Exposure: Given the disruptive potential of AI, rigorously assess the concentration of direct lending portfolios in software companies. Understand the specific business models and competitive moats of these companies and how AI might impact their recurring revenue and valuations.
  • Immediate Action: Request detailed breakdowns of software loan exposures, including specific company valuations and AI risk assessments.
• Understand Leverage and Interest Rate Sensitivity: Evaluate how rising interest rates impact the debt servicing capabilities of underlying borrowers. For PE-backed companies, assess their capital structures and their ability to refinance debt in a higher-rate environment.
  • Immediate Action: Model the impact of further rate increases on portfolio company debt service coverage ratios.
• Prioritize Liquidity and Transparency: Be wary of investments where liquidity is limited and transparency is lacking. Understand redemption terms, NAV calculation methodologies, and the potential for "gating" or other restrictions during periods of stress.
  • Immediate Action: Clarify redemption policies and NAV reporting for all private credit investments.
• Embrace Skepticism, Not Just Belief: Cultivate a healthy balance between belief in an investment's potential and a skeptical inquiry into its risks. Challenge assumptions and seek out dissenting views.
  • Immediate Action: Schedule a "red team" review of your private credit thesis.
• Focus on Manager Discipline: Favor managers who demonstrate a history of disciplined underwriting, consistent standards, and a willingness to forgo capital deployment when market conditions deteriorate or standards weaken.
  • Longer-Term Investment: Seek out managers with a proven track record of navigating credit cycles and resisting fads. This pays off in 12-18 months by avoiding the worst of any downturn.
• Diversify Across Credit Types: Do not over-concentrate in any single segment of private credit. Maintain exposure to liquid credit markets, which offer transparency and immediate pricing signals, alongside private credit.
  • Immediate Action: Review the overall credit allocation, ensuring a balance between liquid and illiquid instruments.