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The 5% At-Risk Scenario: Stress-Testing Middle Market Portfolios for 2026

Lisa Rafter

Lisa Rafter

Lisa Rafter is Publisher of ABF Journal.

While headline default rates remain low, a closer look at the 5% of middle-market borrowers under real strain reveals where hidden stress, refinancing risk, and “bad PIK” structures could turn today’s friction into tomorrow’s defaults.

The headline default rate in private credit remains enviably low — 1.1% payment defaults in 2024, according to KBRA’s surveillance of nearly 2,000 middle market borrowers.¹ But beneath that surface figure lies a more complex story about emerging stress, masked distress, and the 5% of borrowers that KBRA has identified as most at risk of default in the coming 12-18 months.

For an industry that has marketed itself as structurally superior to broadly syndicated markets, the emergence of identifiable stress pockets demands careful examination—not because crisis is imminent, but because sophisticated ecosystem participants need frameworks for distinguishing between manageable friction and genuine deterioration.

Understanding the 5% At-Risk Cohort

KBRA’s Q4 2024 surveillance identified approximately 5% of the 1,903 unique middle market sponsored borrowers in its database as “struggling” — companies with fundamentally weak performance, limited financial flexibility, and vulnerability to prolonged elevated base rates.²

These companies collectively represent borrowers most likely to experience payment defaults, debt restructurings, or bankruptcy filings unless lower-than-expected interest rates, sponsor exits, equity injections, or other interventions provide relief. The 5% figure represents KBRA’s assessment of borrowers where fundamental performance has deteriorated sufficiently that the normal course of business is unlikely to resolve their challenges.

This cohort is not randomly distributed across the economy. Sectors with disproportionate representation include:

  • Chemicals, Containers, Metals & Materials: Over 10% of companies at risk — reflecting commodity price volatility, inventory management challenges and margin pressure from input cost inflation
  • Consumer Retail: Over 10% at risk — continuing the sector’s multi-year struggle with shifting consumer behavior, e-commerce competition, and discretionary spending sensitivity
  • Electrical Equipment & Construction Materials: Over 10% at risk — exposed to housing market softness and commercial real estate challenges
  • Media: Over 10% at risk — facing structural disruption in advertising markets and content distribution models³

By contrast, the sectors where private credit concentrates its heaviest exposure — Commercial & Professional Services, Software, and Health Care Services & Technology — account for nearly 60% of KBRA’s assessment portfolio and “consistently ranked among the top performers across all credit metrics.”⁴

This concentration in resilient sectors helps explain why aggregate private credit performance remains strong even as pockets of distress emerge. But it also suggests that lenders with overweight exposure to challenged sectors may face materially different outcomes than industry averages suggest.

The Shadow Default Rate: Why Reported Metrics Understate Stress

The distinction between reported defaults and actual credit stress has become a defining analytical challenge in private credit. Because direct lenders typically hold entire positions (rather than participating in syndicated structures), they possess the flexibility to amend terms, extend maturities, and restructure documentation without triggering technical defaults.

This flexibility is a feature, not a bug — it enables value preservation through constructive workout processes rather than destructive forced liquidations. But it also means that reported default rates may systematically understate the actual level of credit stress in portfolios.

Lincoln International has introduced the concept of a “shadow default rate” — the percentage of borrowers that have added PIK interest after their original deal closed, indicating unexpected stress that required documentation modifications. This shadow rate stood at 6% in Q1 2025, up from 2% in Q4 2021.⁵

The trajectory matters: that 6% figure represents a tripling of the shadow default rate in approximately three years, suggesting stress is building even as formal payment defaults remain muted.

“While not all ‘bad PIK’ borrowers are distressed, as a sign of the poor performance of these borrowers, LTV for these deals increased from 49% at close of the investment to 86% in Q1,” Lincoln observed — a deterioration that would raise serious concerns about ultimate recovery in any credit evaluation.⁶

By Q3 2025, Lincoln’s data showed the overall PIK rate had risen to 10.6% of investments (up from 7% in Q4 2021), with 57.2% of those PIK arrangements classified as “bad PIK” — meaning PIK interest was added after the original deal closed rather than being part of the initial structure.⁷

“There’s cracks in the private markets,” observed Brian Garfield, Lincoln’s managing director and head of U.S. portfolio valuations. However, he noted that the cracks don’t yet threaten the foundation: 68% of companies in Lincoln’s database grew revenue over the trailing twelve months, and 62% grew adjusted EBITDA.⁸

Distinguishing Good Stress from Bad Stress

Not all portfolio company stress translates to lender losses. The private credit model — with its covenant protections, relationship-based lending, and ability to act early — provides structural advantages in navigating borrower challenges.

KBRA’s Q3 2025 surveillance noted that the median interest coverage ratio increased for the first time in over a year, to 1.5x, with nearly 60% of obligors improving their coverage ratios as rate cuts and continued EBITDA growth provided relief.⁹ This improvement — modest but consequential — suggests that the median middle market borrower is weathering the rate environment better than peak-stress projections suggested.

The strongest sectors continue demonstrating resilient fundamentals. Revenue CAGR stood at 14% across KBRA’s portfolio in Q2 2025, while EBITDA CAGR accelerated to 31% — actually improving from prior quarters as sector rotation and operational execution drove margin expansion.¹⁰

The question is whether the 5% at-risk cohort represents isolated situations manageable through workout processes — or the leading edge of broader deterioration that tariffs, persistent rates, and slowing growth could accelerate.

The 2026 Maturity Cliff

One concrete risk factor commands attention: refinancing exposure. KBRA’s Q3 2025 data shows that 10% of notional debt in its surveillance portfolio matures before year-end 2026, down from 13% in Q2 as borrowers proactively managed near-term maturities.¹¹

The decline reflects constructive behavior: borrowers and lenders working together to extend maturities, amend terms, and create runway for business improvement. But the composition of the remaining 10% matters enormously.

Nearly 30% of companies with maturities before year-end 2026 also had leverage above 10x or negative EBITDA and received assessment scores of CCC+ or below — “factors that will likely intensify refinancing risk, and lead to a potential source of defaults in the portfolio during 2026.”¹²

For these borrowers, the refinancing math may not work at current rate levels. A company with 10x leverage, 1.0x interest coverage, and negative free cash flow faces limited options:

  • New money is expensive: Lenders pricing refinancing risk will demand significant spread increases, potentially pushing all-in costs above sustainable service levels
  • Equity cures are dilutive: Sponsors may be unwilling to inject additional capital into situations where prior investments are already impaired
  • Asset sales take time: Monetizing non-core assets to de-lever requires execution in challenging M&A markets
  • Strategic alternatives may be limited: Companies that needed restructuring 18 months ago but received extensions instead now face more constrained option sets

Without sponsor equity injections, lender concessions, or M&A exits, some portion of this cohort will transition from “stressed” to “defaulted” over the next 12-18 months.

What Would Accelerate Defaults?

Several scenarios could push actual defaults toward or beyond the 5% at-risk threshold:

Tariff Implementation: KBRA’s Q1 2025 report explicitly warned that “new macroeconomic headwinds — including the effects from proposed tariffs — may reverse recent positive credit trends.”¹³ Companies in tariff-exposed sectors (manufacturing, retail, consumer products) face margin compression that could rapidly deteriorate interest coverage.

The tariff impact operates through multiple channels: direct cost increases on imported inputs, competitive pressure from domestic producers who raise prices toward tariff-inflated levels, demand destruction as consumers face higher prices, and working capital pressure as inventory costs rise. For leveraged borrowers already operating with thin coverage cushions, even modest tariff-driven margin compression could trigger covenant breaches.

Rate Persistence: The original private credit stress thesis assumed rate cuts would provide relief. The Fed’s measured approach to easing has extended borrower pressure. Deutsche Bank suggests defaults may fall to approximately 4.4% by end of 2025 before climbing to 4.8% to 5.5% in 2026 — a trajectory that assumes rates remain elevated.¹⁴

Private credit loans are predominantly floating-rate, meaning borrowers bear the full burden of elevated SOFR plus spread. While the median borrower has adapted, marginal borrowers who structured transactions assuming rate normalization face extended pressure that erodes their ability to execute improvement plans.

Sponsor Fatigue: Private equity sponsors have demonstrated willingness to inject additional equity to support portfolio company liquidity. But for vintage 2021-2022 deals acquired at peak multiples, the calculus on additional capital becomes more difficult.

Consider a sponsor who paid 12x EBITDA in 2021 for a company now trading at 9x in secondary markets. The equity is already substantially impaired. Injecting additional capital simply increases exposure to a situation where recovery requires business performance that hasn’t materialized. At some point, sponsors may choose to cede control to lenders rather than continue supporting underperformers—particularly when new fund deployment opportunities offer better risk-adjusted returns than rescue capital for troubled portfolio companies.

Contagion Effects: Private credit markets lack the transparency of public markets, but information flows through professional networks. A high-profile default or restructuring in a bellwether credit could trigger broader reassessment of underwriting assumptions, pricing, and risk appetite — potentially creating refinancing challenges for borrowers who might otherwise have navigated to stability.

Implications for Credit Documentation

The emerging stress environment highlights provisions that may receive increased attention in workout scenarios:

PIK Optionality: Credit agreements increasingly include PIK toggle provisions that allow borrowers to defer cash interest under defined circumstances. The prevalence of “bad PIK” — PIK added after close — suggests these provisions are being activated more frequently than original deal models anticipated.

Maturity Extensions: Many agreements contain extension options subject to lender consent or compliance thresholds. Borrowers approaching maturity walls will seek extensions; lenders must evaluate whether extension serves recovery interests or simply delays inevitable restructuring.

Covenant Definitions: The EBITDA add-back baskets negotiated during 2020-2022’s competitive environment may prove more generous than current performance justifies. Lenders re-underwriting credits should scrutinize how add-backs affect reported leverage versus economic leverage.

Intercreditor Provisions: For credits with multiple tranches or hybrid structures, intercreditor arrangements govern relative priority in workout scenarios. The LME playbook — drop-downs, uptiers, and other liability management exercises — has sensitized lenders to the importance of protective provisions that may have received less attention during origination.

Ecosystem Implications

For PE Sponsors: Portfolio company triage has never been more important. Identify which companies can weather extended pressure, which require intervention, and which may be better served by accelerated exits or sales — even at modest losses — rather than prolonged restructuring. The reputational cost of defaults may be lower than the opportunity cost of management attention consumed by troubled situations.

Develop explicit criteria for “support” versus “abandon” decisions: What level of additional capital would you invest? Under what business improvement scenarios? With what timeline expectations? Making these decisions analytically — before crisis forces reactive choices — enables better outcomes for sponsors, lenders, and portfolio companies.

For Lenders: The 5% at-risk figure is a portfolio-wide average. Individual platforms may have higher or lower exposure depending on sector concentration, vintage, and underwriting discipline. Honest internal assessment of portfolio-specific stress levels enables proactive workout positioning before situations deteriorate.

Consider implementing early warning systems that track not just covenant compliance but leading indicators: revenue trajectory relative to plan, margin trends, working capital efficiency, management turnover, and customer concentration changes. Companies that will default in 2026 are showing stress signals today — the question is whether monitoring systems capture those signals in time for constructive intervention.

For Investment Bankers: Distressed M&A mandates will increase. Some portion of the at-risk cohort represents viable businesses with salvageable value — attractive acquisition targets for strategic buyers or better-capitalized sponsors willing to invest in turnaround execution.

Build sector expertise in challenged industries where restructuring activity will concentrate. The ability to advise both sellers (sponsors seeking exits from troubled situations) and buyers (strategics or sponsors seeking distressed opportunities) positions advisory practices for increased workflow as stress converts to transaction activity.

For Legal Advisors: Credit documentation created during 2020-2022’s competitive environment may contain looser protections than current market standards. Review intercreditor provisions, restricted payment baskets, and covenant definitions for clients with exposure to stressed borrowers.

Prepare for increased amendment and workout activity. Lenders will need documentation support for PIK conversions, maturity extensions, covenant waivers, and potentially DIP financings. Sponsors will need advice on fiduciary duties as equity positions become impaired. Portfolio companies will need restructuring counsel. The legal workflow from the 5% at-risk cohort will generate substantial activity over the next 18-24 months.

For Turnaround Advisors: The pipeline is building. The 5% at-risk figure, combined with the 6% shadow default rate and 30% of near-term maturities facing refinancing challenges, suggests substantial workflow emerging over the next 18 months.

Early engagement—before payment defaults force crisis-mode decision-making—creates better outcomes for all stakeholders. Position your practice for early warning mandates where sponsors and lenders jointly engage turnaround support to stabilize situations before they become restructurings. These engagements are often more constructive, less adversarial, and generate better recoveries than bankruptcy-driven processes.

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