Default Risk

Definition

Default risk measures the likelihood that a borrower cannot meet interest or principal payments. It is influenced by leverage, cash flow stability, industry cyclicality, sponsor support, and macro conditions. Default risk does not only concern probability—it also includes loss severity and recovery timing, which determine actual investor outcomes. Allocator Context Allocators evaluate default risk through underwriting standards, portfolio diversification, covenant strength, and workout capability. In private credit, defaults can be managed through restructuring, collateral enforcement, and negotiated outcomes. Institutions often care as much about the manager’s ability to handle distress as they do about avoiding defaults. Decision Authority Default risk influences credit sleeve sizing, concentration limits, and committee comfort, particularly when the portfolio is exposed to cyclical sectors or higher leverage structures. Evidence of disciplined loss management can materially improve re-up probability. Why It Matters for Fundraising Managers should communicate default risk honestly: how underwriting reduces it, what early warning indicators are monitored, and how workouts are managed. Allocators are wary of credit managers who focus only on yield and ignore loss mechanics. Key Takeaways Outcomes depend on probability, severity, and recovery timing Covenants and collateral shape recoveries Distress management capability is a differentiator Transparency improves allocator confidence and sizing