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News
Surge in direct lenders’ debt-equity swaps makes trouble for LPs
by Lisa Fu & Sonia Basmaji
Investors that piled into direct lending counting on steady fixed-income returns are getting more than they bargained for — in the shape of equity stakes in troubled firms.
As stress grows in private credit, the private equity sponsors of highly leveraged firms are increasingly being forced to swap senior loans for equity. The trend, if unchecked, could become a headache for institutional investors, such as pension plans, that provide loan capital by becoming limited partners (LPs) in direct lending funds run by private credit managers.
“They signed up knowing there’s a risk of getting some equity,” said Scott Roberts, senior managing partner at investment consultant Belvedere Direct Lending Advisors. “A few hundred basis points or even 5% of the fund… that’s kind of the upper limit. I don’t think they want 10% of the fund being equity.”
In the US, the amount of debt converted into equity (known as pre-takeover principal) surged to nearly USD 21bn over the first six months of 2025, dwarfing the total of USD 15.9bn for the period 2019-24, according to data from Lincoln International (see chart).
Pre-takeover principal ($bn)
Source: Lincoln International
This jump in debt-for-equity swaps is a concern for LPs. It not only threatens to upset carefully calibrated asset allocation strategies — an investment that started in the fixed-income bucket is now equity — but also disrupts the predictable flows of interest income that pension managers, for example, need to pay retirement benefits.
The deterioration in creditworthiness has coincided with a normalisation of interest rates after years of ultra-low borrowing costs. Heavily indebted firms have seen their balance sheets come under strain, forcing some to conserve cash by renegotiating borrowing terms or restructuring debt.
Default rates are still in the low single digits, but the steady rise in the use of payment-in-kind to defer interest payments is a warning sign. A turn in the market could lead to larger and more frequent restructurings.
Any troubled investment is an embarrassment because, as a “special mention” item, it must be brought to the attention of the institutional investor’s investment committee and board of directors, Roberts said. But large troubled credits are more than an embarrassment: they could threaten the fund’s overall return.
Other problems loom. It is questionable whether direct lenders, having taken equity control, have the expertise to turn troubled companies around and recover their investments. Many lack experience managing businesses, one direct lender acknowledged.
And whereas lenders generally want a swift exit, private equity funds can afford to wait years to recoup value, the lender said. In other words, the interests of the two groups are misaligned.
An accumulation of equity positions from restructurings can play havoc with an LP’s asset allocation strategy. When an institutional investor puts money into a private credit fund, certain restrictions are typically attached to the investment, said Sasha Burstein, a partner at law firm K&L Gates.
Swapping debt for equity may fundamentally alter the fund’s portfolio composition, such that it no longer meets the criteria originally agreed by the investment committee. An LP may then have to seek additional approvals, or rebalance its portfolio to comply with its allocation policies, Burstein said.
To rebalance the portfolio, the LP could consider offloading its stake in the direct lending fund on the secondary market. However, it will likely need to sell at a discount.
“You can try and do a secondary sale, but you’re going to take it on the chin,” said Roberts. “Everyone is going to know that the manager is having trouble.”
