The recent selloff of Blue Owl and firms like it after a redemption at one of its retail private credit funds has become the poster child for growing anxiety about the health of private credit markets.

Private credit has grown rapidly in recent years—approaching $2 trillion—and has never been tested through a full recession or financial market stress without the backstop of the Federal Reserve as during the pandemic.

The fault line exposed now is that exposure to private credit is being offered to retail investors and wealthy individuals who have different liquidity preferences than sophisticated, more patient institutional investors. They line up to get their money back, effectively forcing sales of illiquid assets as in the case of Blue Owl, at a time when entire segments of financial markets are getting repriced based on investor estimates of how artificial intelligence will disrupt the economy.

Shares of Blue Owl Capital Inc. (OWL) hit a 52-week low this month, as did shares of Blackstone Inc. (BX), while shares of Carlyle Group Inc., KKR & Co., Apollo Global Management Inc., and Ares Management Corp. were caught in the selloff.

It is worth noting that vulnerabilities in private credit are increasing at a time when growth is still strong and financial conditions are very accommodative, while the credit cycle is still benign. The answer to whether the stress in this nearly $2 trillion market can turn into something more systemic like the 2008 global financial crisis lies in its structure and interconnectedness. Let’s take a look.

Liquidity

Liquidity risk has historically been limited in private credit. Pension funds and insurance companies have long investing time horizons and understand that illiquid assets are the source of the higher yield or “illiquidity premium” they earn.

But the industry is expanding aggressively into retail, private wealth, and 401(k)s through offerings like interval funds, business development companies (BDCs), and integrated technology platforms. Retail investors generally have shorter horizons and stronger liquidity preferences.

The Blue Owl episode highlights the friction that can emerge when periodic, albeit limited, liquidity is promised against fundamentally illiquid underlying assets.

To provide cash to investors in its OBDC II fund, Blue Owl said it sold $1.4 billion of senior secured credit from 27 industries across three of its funds. Four pension funds and insurance companies were among the buyers at an average price close to par, and it was later reported that one of the buyers was an insurance asset manager it owns.

Saba Capital and Cox Capital Partners announced their intention to launch tender offers to purchase shares in three Blue Owl BDCs, with offer price reportedly at a 20 to 35 percent discount to estimated NAVs—a significant discount for investors in those vehicles to access immediate liquidity.

Leverage: Layered and Opaque

Leverage in the private credit ecosystem, while limited relative to institutions like banks, exists in complex and opaque layers.

The companies that are borrowing are leveraged. Then there is leverage at the fund level—through subscription lines or capital call facilities, net asset value lending, and BDC structures. There is potentially leverage at the investor level through the use of derivatives and other mechanisms.

This layering makes it difficult for investors and regulators to assess overall financial leverage in the system. More importantly, it complicates understanding how these layers may interact in stress—especially when combined with illiquid assets.

Interconnectedness: Strength or Vulnerability?

In principle, distributing risk across diverse investors with different horizons and risk appetite enhances financial stability. But under stress, this interconnectedness could rapidly transmit shocks.

For example, insurance companies play a central role in channeling funding into private credit markets, and some are owned by private credit managers.

Imagine a situation where, amid rising strains in credit markets, an insurance company needing liquidity but unable to retrieve capital from illiquid investments is forced to sell other more liquid assets like equities or investment-grade bonds. Correlations across asset classes could rise abruptly, propagating the initial stress like a wave across segments of the financial system seemingly uncorrelated.

Credit Quality: Calm on the Surface

Private credit funds appear to have diversified exposures across industries. Yet the broader economy is increasingly exposed to what amounts to a massive macro bet on AI. Investors have aggressively repriced sectors perceived as losers from AI disruption—software, data analytics, tax strategies, cybersecurity, and, most recently, delivery and payments. Blue Owl said about 13% of credits sold represented the internet software and services industries.

Other developments should give investors pause: increased use of payment-in-kind (PIK) interest, and the growing use of continuation funds to generate secondary liquidity. These tools can smooth short-term pressures, but they may mask underlying fragilities.

Opacity and Lack of Price Transparency

Private credit markets remain opaque. Prices of loans can vary widely across funds holding similar assets. Secondary liquidity and price discovery are limited.

This opacity matters most for retail investors, who have more immediate liquidity needs and rely more on timely and trustworthy pricing to assess risk. But it also matters for insurance companies, which depend heavily on ratings in determining capital treatment.

If trust in marks, ratings, or valuations were to evaporate, the lack of transparent price discovery could lead to a sudden rush for liquidity by retail investors that would amplify stress. Once credit assets are sold at a discount in secondary markets, that price becomes an actual mark for the entire industry.

A spiral of illiquidity, forced selling, markdowns and deleveraging could emerge—amplified by opacity and rapidly fading trust. Sounds familiar? It happened about 20 years ago during the 2007-8 financial crisis with securitization markets.

Achilles’ Heel

This scenario is a tail risk for now, and possible knock-on effects from the Blue Owl episode seem limited at the moment. Shares of listed asset managers rebounded on Tuesday and headed higher on Weds (2/25).

 But while private credit may not necessarily be the source of systemic stress, it may become an important transmission channel of stress, given its high degree of interconnectedness, particularly in the event of a sharp slowdown of the economy. Investors and policymakers should ask themselves whether the push into the retail space may turn out to be private credit Achilles’ heel.

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A version of this article first appeared on MarketWatch.