The Private Credit Paradox

Why the best time to lend may also be the riskiest. A deep dive into the structural vulnerabilities hidden behind the $1.5 trillion opportunity.

Executive Summary

For family offices and institutional investors, private credit has been the uncontested growth story of the last decade. The asset class has swelled to over $1.5 trillion, offering attractive yields, floating-rate protection, and the promise of stronger covenants than public markets [1].

As we enter 2026, the bullish consensus is stronger than ever. A massive wave of upcoming debt maturities is expected to create a lender’s market, allowing disciplined managers to dictate favorable terms and secure premium returns. However, at Gallery, we believe this is the precise moment for sophisticated allocators to look past the marketing materials and ask a harder question: what if the best time to lend is also the riskiest?

This article explores the central paradox of today’s private credit market. We argue that the very forces creating this seemingly golden opportunity—a looming refinancing wall and a flood of capital seeking deployment—are also amplifying structural vulnerabilities that many are choosing to ignore. A complex web of leverage, opaque valuation practices, and the rise of semi-liquid products has created a system where stress can travel farther and faster than ever before. For family offices, navigating this paradox is the most critical challenge—and opportunity—in alternative allocations today.

The Bullish Case: A Lender’s Paradise

It is easy to understand the enthusiasm for private credit. For years, the asset class has delivered on its core promises. In 2025, as part of a broader surge that saw hedge fund assets cross the $5 trillion mark for the first time, private credit continued to attract significant inflows, driven by strong performance and sustained investor demand [2].

Looking ahead, the outlook appears even brighter. A 2026 outlook from Morgan Stanley’s investment management arm highlights the central thesis: a massive refinancing wave, combined with new deal demand, is expected to gradually overtake the available supply of capital. This supply/demand imbalance, they argue, will allow lenders to “preserve discipline, strengthen terms, and capture the illiquidity premium to public markets” .

This is the quintessential pitch for 2026: as trillions in corporate debt come due, companies will have little choice but to turn to private lenders, who can in turn demand stronger protections and higher returns. It paints a picture of a lender’s paradise. But is it too good to be true?

The Hidden Vulnerability Stack

While the front-facing view of private credit is one of strength and discipline, the plumbing behind the scenes has become increasingly complex and, we believe, fragile. A recent, and aptly titled, article from HedgeCo.Net, “Wall Street Braces for a Private Credit Meltdown,” outlines several of these interconnected risks [4].

1. The Leverage Behind the Leverage

Perhaps the most significant and least discussed risk is the growing use of leverage by private credit funds themselves. This isn’t just about the leverage on a borrower’s balance sheet; it’s about the financing used by the funds to scale originations and manage liquidity. These include:

• Subscription Lines: Borrowing against LP commitments.

• Warehouse Lines: To accumulate loans before allocating them to a final vehicle.

• NAV Loans: Borrowing against the net asset value of the fund itself.

This layering of leverage creates a network of interconnections with the traditional banking system that has grown at an astonishing rate. A 2025 analysis by the Federal Reserve documented that committed bank lending to private credit vehicles exploded from roughly $8 billion in 2013 to nearly $95 billion by the end of 2024, while the total dollars deployed to private lending vehicles more than tripled to almost $1.4 trillion [5].

In a stress scenario, this system can create margin-like dynamics, where banks tighten terms, haircuts increase, and funds are forced to deleverage at precisely the wrong moment.

2. Valuation Opacity: The Smoothest Ride Until It Isn’t

Private credit’s low reported volatility has always been a key selling point. Unlike public high-yield bonds, which are marked-to-market daily, private loans are typically valued quarterly by the managers themselves, often with third-party assistance. This appraisal-based method smooths out returns and helps investors look through market noise.

However, this opacity cuts both ways. In a downturn, it can lead to lagged markdowns that hit a fund’s NAV long after the problems are widely known. This can create disagreements between GPs and LPs and, more dangerously, can trigger covenants on NAV-based loans if valuations are forced to catch up with reality too quickly. The smooth ride can become a trap.

Metric	Private Credit (Direct Lending)	Public High-Yield Bonds
Valuation Method	Manager Appraisal (Quarterly)	Market Price (Daily)
Reported Volatility	4-6% (Smoothed)	10-15% (Real)
Source of Volatility	Actual Defaults / Credit Events	Sentiment / Rates / Liquidity
Transparency	Opaque	Transparent
Investor Experience	Smoother, less frequent pricing	Volatile, daily mark-to-market

Table 1: The illusion of stability? Comparing reported volatility metrics

3. The Liquidity Mismatch: A Test for Semi-Liquid Products

The industry’s push into private wealth channels has led to a proliferation of semi-liquid products like interval funds and tender-offer funds. These structures promise periodic liquidity to investors in an inherently illiquid asset class. If redemptions rise during a period of market stress, managers may be forced to gate withdrawals or sell their most liquid, highest-quality assets first—turning a credit problem into a business model and reputational problem.

What Sophisticated Allocators Should Watch

For family offices, the answer is not to abandon private credit, but to approach it with a new level of diligence that goes far beyond the manager’s pitchbook. The focus must shift from simply evaluating a manager’s track record to stress-testing their entire operational and financial structure.

Key questions to ask include:

•   Leverage Philosophy: How much and what type of fund-level leverage is being used? Under what terms? What are the covenants?

•   Valuation Policy: Who marks the book? How are disputes handled? How have marks compared to secondary market trades for similar assets?

•   Liquidity Management: For semi-liquid funds, what are the gate provisions? What is the composition of the underlying portfolio? How much cash is held on hand?

•   Documentation Standards: Are covenants truly tight, or are they weakened by permissive add-backs and EBITDA adjustments?

The Gallery Perspective: Navigating the Paradox

We believe the private credit market is at a critical inflection point. The opportunity for skilled lenders is real, but so are the systemic risks. The coming cycle will create a stark divergence between managers who have built resilient platforms and those who have simply ridden the wave of cheap leverage and easy capital.

For our clients, this environment demands a move beyond passive allocation and toward active, critical partnership. It requires a willingness to challenge consensus, to dig into the plumbing of fund structures, and to prioritize managers who demonstrate a deep understanding of risk, not just an appetite for returns. The paradox of private credit is that the greatest rewards in the coming years will likely go not to those who lend most aggressively, but to those who lend most wisely.

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References:

[1] Preqin, "Global Private Debt Report 2026"[2] Hedgeweek, "Global hedge fund assets surpass $5tn for the first time, says HFR," January 23, 2026.

[3] Morgan Stanley, "Alts In Focus: 2026 Outlook," December 16, 2025.

[4] HedgeCo.Net, "Wall Street Braces for a Private Credit Meltdown," January 26, 2026.

[5] Federal Reserve, “Bank Lending to Private Credit: Size, Characteristics, and Financial Stability Implications,” May 23, 2025