May 19, 2025

Private Credit Markets – Q1 2025 Update

Q1 2025 MARKET COMMENTARY

The first quarter of 2025 saw significant volatility across risk assets, driven by tariff uncertainty and the prospect of inflationary pressures. The S&P 500 declined 4.3% and the Nasdaq fell over 10%,¹ reflecting investor concerns over trade wars and slowing growth.

Gold surged 20%,¹ fueled by geopolitical tensions and safe-haven demand. Other commodities were mixed: copper rose 26%¹ due to tariff-related supply concerns, while WTI crude oil dipped 2%¹ amid weaker global demand.

High-yield bonds posted flat returns (1%)¹ with wider spreads (>300 bp)¹, and issuance dropped to ~$69B in Q1 from $85B in Q4 2024². Fixed income rates were lower by more than 30 bps¹ across the curve, except at the very long end.

The dollar, unsurprisingly, was weaker due to all the policy noise.

MONETARY POLICY: BALANCING INFLATION AND STABILITY

The Fed seems stuck between a rock and a hard place. Tariff-driven price increases might be temporary, but the Fed cannot count on that. Absent the tariffs, prospects for inflation reaching Fed’s targets were strong, hence the conundrum the central bank is faced with.

At the same time, the U.S. labor market showed signs of slowing.³ The decelerating job growth has been accompanied by strong real wage growth³ – again, some conflicting inputs for the Fed.

Most market participants expect no Federal Reserve rate cuts in 2025. The Fed’s March FOMC signaled a potential 0.5% rate reduction by year-end, but trade tensions cloud this outlook.

GLOBAL GROWTH: NAVIGATING TRADE AND REGULATORY RISKS

Global growth is under pressure in 2025: tariffs, regulatory shifts, continuing supply chain problems, and inflation risks. 22% of the Pitchbook Leveraged Commentary & Data (LCD) survey respondents cite White House policy as a top portfolio concern.⁴ The same LCD survey indicates 59% of respondents expect tighter credit conditions, reflecting concerns over inflation and policy uncertainty.⁴

U.S. GDP growth expectations for 2025 have all been revised substantially lower, ranging from 0.6% (Morgan Stanley, as of April 2025) to 1.8% (International Monetary Fund, as of April 2025). With tariff-driven uncertainty, the forecasts are wide-ranging and revised often, but we believe that how much, if any, the U.S. GDP is expected to fall remains a moving target.

The Keynesian economic “animal spirits” seem to have been tamed. Even if headlines turned more stable and business-friendly, rebuilding the economic mojo would still take time.

The on-and-off nature of tariff policies has created significant uncertainty for businesses, hindering planning and dampening those “animal spirits” that drive economic optimism and investment. While tariffs themselves pose risks (potentially devastating for sectors like automotive), the inconsistent policy signals have sidelined M&A and capital expenditure, delaying deal flow to H2 2025 or 2026.⁴

PRIVATE CREDIT: A RESILIENT AND STABLE ALLOCATION FOR 2025

The push and pull of supply and demand in the private credit market intensified in Q1. Deal activity slowed overall, while investors stayed buoyant.

On the demand side, investor appetite for private credit continued to be robust, driven by high yields (10-12% unlevered) and some insulation from public market volatility, fueling allocations via BDCs, ETFs, and dedicated funds.^4,5

Supply decreased

Direct lending remained the biggest part of the private credit market. Over half (56%) of private debt funds in the market are targeting direct lending strategies, representing 60% of capital being sought. Special situations funds represent 15% of targeted capital and 13% of the number of funds in the market, and distressed funds are seeking 12% of targeted capital.^4,5

Companies refinancing their direct lending deals with syndicated loans was the second-highest quarterly volume in many years.^4,5 Spreads for Broadly Syndicated Loans (BSLs) were significantly lower than in the private market as demand for private loans outstripped supply and stealing away from the private credit market was Plan A for syndicated loan managers. Contrast that to the small business market, where regional and consumer banks remain in ‘repair their balance sheet’ mode.

M&A activity slowed. There’s a potential for recovery in H2 2025/H1 2026, but we believe this hinges on rates stabilizing and less chaos in the news. This would boost demand for private credit solutions later in the year.

Market segments matter

Again, the dynamic between large-size and smaller-size deals was apparent. Similar to 2024, large deals faced spread compression due to bank and mega-fund competition.⁴

A Morgan Stanley U.S. Credit Playbook report dated April 20, 2025, forecasted higher default rates in high yield bonds and the leverage loan market and by implication, higher default rates in private credit. Much has been made of the last two-year phenomenon, where private credit has been winning more of the lower-rated deals, which strengthened the quality of the remaining public debt indices.

However, this trend applied mainly to large deals with money center banks, public leverage loans and large private credit funds, all chasing the same deals. The law of supply and demand, once again, is undefeated. The capital concentration in mega-funds (40% of 2024’s $209B fundraising)^4,5 leaves our lower middle market niche less competitive, enabling us to access proprietary deal sourcing with spreads 500 basis points above the risk-free SOFR rate.

According to Preqin, Q1 saw a decrease in the number of debt funds for the first time. As of the end of March 2025, 1,293 funds (seeking to raise $447B) were in market, down from 1,314 funds seeking $530B at the end of 2024. This further exacerbated the imbalance between the market segments.

Our specialized lower middle market approach excels in proprietary deals, supported by a few key partnerships and our strong private ecosystem. Our focus on non-sponsored deals also means less competition. This strategy, targeting stable borrowers with strong covenants, mitigates rate sensitivity, leveraging domestic operations and flexible structures like OID, PIK, and floating rates with floors to manage risks.

CONCLUSION

Q1 2025 was marked by slow US GDP growth (0.6%),⁶ tariff-driven uncertainty dampening economic “animal spirits” and a cautious Fed navigating inflation without expected rate cuts. Risk assets, including leveraged loans and high yield bonds, face volatility. However, private credit, particularly in the lower middle market where we operate, remains a stable allocation, in our opinion.

Our focus on non-sponsored deals ($5M-$50M) delivers pricing power, robust covenants, and reduced competition from mega-funds and banks. With a potential M&A rebound and strong investor demand, we believe we are poised to generate strong risk-adjusted returns in 2025, leveraging flexible structures and defensive positioning to navigate macro risks.

1 – Q1 2025 performance; Source: Bloomberg
2 – Barclays High Yield Corporate Update April 2025
3 – US Bureau of Labor Statistics
4 – PitchBook Credit Markets Wrap and/or PitchBook Leveraged Commentary Data
5 – Preqin
6 – Bureau of Economic Analysis

Chicago Atlantic makes no guarantee of future outcomes. All investment involves risk, including the risk of loss.