Morgan Stanley: defaults in private credit are increasingly hitting software companies

The private credit market, long viewed as a safe harbor for investors, has begun flashing warning signals precisely where stability was most expected. According to Morgan Stanley strategists, the rise in defaults is now particularly visible in the software sector — one of the largest segments of private lending.

Where Defaults Are Rising

Morgan Stanley points to a troubling concentration of problems: defaults are increasingly occurring among software companies, even though they have long been considered convenient borrowers for private credit funds. The logic was simple. SaaS businesses operate on subscription models, receive revenue regularly, scale relatively easily, and do not require the capital expenditures demanded by manufacturing or logistics. For alternative asset managers, this appeared an almost ideal combination of growth and predictability. But now this structure has begun to unravel.

According to Bloomberg's credit reporter Emily Graffeo, new research shows an acceleration in defaults within private credit and especially in software. This matters not just because of the bankruptcies or defaults themselves. Software occupies a significant share of private lenders' portfolios, meaning a localized problem quickly becomes systemic risk for an entire asset class. In private credit, this is felt more acutely than in public markets: such deals are less liquid, and deteriorating borrower quality is harder to quickly remove from the balance sheet.

Why the Model Failed

The main reason currently being discussed in the market is the AI shift within the software business itself. For a decade, funds financed companies based on the thesis of "reliable recurring revenue." If a customer paid each month, the product was embedded in workflows, and churn was low, debt burden seemed manageable.

This thesis still works for some companies, but no longer for the entire sector. Now investors see that even sticky subscriptions do not guarantee protection from technological obsolescence. The emergence of new AI tools is changing the rules faster than weak players can adapt.

Features that were a separate paid product yesterday become an embedded capability in a larger platform today. Pricing pressure intensifies, product update cycles accelerate, and barriers to entry for new competitors fall. For leveraged companies, this is particularly painful: they must simultaneously retain customers, rewrite product strategy, and service their debt.

This does not mean that all software has suddenly become a bad asset. Rather, the market is ceasing to view it as a homogeneous category. The difference between a platform without which a customer's critical process would stop and a narrow service whose function could be embedded in a competitor's package now becomes critical not just for equity valuation but for credit committees. This distinction was often lost in averaging-based credit models but now comes to the forefront.

What Investors Will See

For private credit, this is not just a story about one sector. If software, considered "defensive," begins to falter, creditors will look more harshly at the old assumptions behind risk assessment. Especially at deals where growth was valued too optimistically and revenue sustainability was treated almost as given.

The reassessment will affect not only new loans but also already-assembled portfolios, where software durability was once assumed almost automatically. Likely, the next phase will not be a complete withdrawal from software but rather tighter segmentation within it. Money will remain with companies that have high integration into customer processes and clear unit economics, but due diligence will become deeper and slower.

The market will look more carefully not at broad growth promises but at concrete signs of business durability.

Creditors will first begin examining several things:

• how easily a company's product can be quickly replaced by a competitor's AI function;
• what share of revenue comes from truly irreplaceable use cases;
• how quickly a business loses margin if forced to lower prices;
• whether cash flow is sufficient not just for development but also for debt service;
• whether management has a realistic plan to redesign the product for new competition.

This changes the behavior of both sides. Creditors will likely demand stricter covenants, lower leverage, and more conservative multiples. Borrowers will have to prove not just growth rates but that their product won't become an "AI feature" embedded in a competitor's ecosystem within six months. For later-stage SaaS companies, this could mean more expensive capital and more difficult refinancing negotiations. Especially for those counting on covering old debt with new funding on similar terms.

What This Means

The story of rising software defaults signals a simple shift: the market is no longer ready to automatically treat subscription revenue as a guarantee of durability. In the age of AI, investors are beginning to evaluate software not as an abstractly stable sector but as a field of sharp technological revaluation — and for private credit, this may become one of the major stress tests of 2026.