AI is disrupting one of the largest investments in the shadow banking sector

Market Turmoil Fueled by AI Fears

Concerns about artificial intelligence disrupting established business models have turned the stock market into a battleground, with frequent sell-offs as investors worry about the impact of new technology.

One of the hardest-hit sectors has been software-as-a-service companies, as anxiety grows that chatbots and AI tools may soon replicate their offerings. Major players like Salesforce and Palantir have seen their share prices tumble amid this uncertainty.

The fallout extends beyond software firms. Financial institutions, particularly those involved in private credit, are also feeling the strain.

Recently, Blue Owl, a leader in private credit, halted withdrawals from a tech-focused fund, causing ripples throughout the industry. This decision led to a 10% drop in its stock and negatively affected other private credit providers.

The move has heightened worries about a broader crisis in private credit, often referred to as the shadow banking sector.

In response, the Bank of England is working quickly to assess the risks facing the UK. It intends to launch the world’s first stress test of the shadow banking sector to evaluate its resilience against global shocks.

Even as preparations for this test are underway, real-world challenges are already emerging. Since the beginning of the month, private credit firms have experienced a sharp decline, with an index tracking 44 business development companies losing approximately $5 billion in February.

Blue Owl’s funds have been among the most affected, but other providers like Sixth Street, Crescent Capital, and Stellus Capital have also suffered significant losses. According to Barclays, about 20% of loans held by these companies are tied to the software industry.

Industry Trends and Risks

Corry Short, a Barclays analyst, notes that private credit lenders and BDCs often favor industries with steady growth, minimal capital requirements, and less cyclical risk—criteria that software companies have historically met.

UBS warns that default rates in private credit could climb to 13% in a worst-case scenario, with up to 35% of the $1.7 trillion market exposed to AI-driven disruption.

The bank also suggests that the current downturn in the credit market may only be beginning, with further declines likely.

Potential Ripple Effects

These forecasts have implications far beyond Manhattan, where many shadow banks are headquartered. Because shadow banks are interconnected with traditional banks and pension funds, any crisis could quickly spread to the broader economy.

The exact impact of private credit troubles on banks and pension funds remains unclear, prompting the Bank of England to investigate further. Due to limited data, it is still uncertain whether the sector poses a systemic risk to the UK’s financial stability.

UBS reports that the riskiest segment of private credit loans has seen issuance drop by 30% year-over-year, often a sign of deeper problems ahead.

‘We Don’t Have Red Flags’

With the UK’s private market second only to the US, there are concerns that turmoil in America could affect Britain. Julien Conzano of UBS attributes the sector’s heavy investment in software to abundant capital and numerous start-ups aiming to emulate tech giants.

Craig Packer, co-president of Blue Owl, described his firm as the largest lender to private equity-backed software companies in 2023. However, Blue Owl has since taken a more cautious tone, with co-CEO Marc Lipschultz assuring investors that their software lending portfolio remains in excellent condition.

Despite these reassurances, investor confidence has waned. Withdrawal requests led Blue Owl to restrict access to its funds and begin winding them down. The company announced plans to make periodic payments to shareholders and sell $1.4 billion in assets across three funds to return cash to investors.

JP Morgan Chase CEO Jamie Dimon recently cautioned that surprises are common in credit cycles, noting that software could be the next industry hit hardest by AI, just as utilities and telecoms were in previous downturns.

‘Is Software Dead?’

Alastair Unwin of Polar Capital Technology warns that software may no longer be the main product; instead, the intelligence it provides could become the true value. Companies offering tools for people may lose out to those providing automated agents that perform tasks.

He suggests that leading software firms might successfully reinvent themselves by investing heavily in AI, but the transition period is likely to be challenging.

Shadow banks have been aware of these risks for some time. While many competitors increased their exposure to software last year, Apollo Global Management began reducing its investments. At a Toronto event, co-CEO John Zito highlighted AI as a significant threat to the software industry and private credit, potentially greater than tariffs, inflation, or rising interest rates.

“The real risk is: is software dead?” Zito asked.