Private Credit Has Become More Selective: Why Liquidity and Covenant Risk Need Operating-Level Diligence
Private credit is no longer only a growth story. It remains an important source of financing for middle-market companies, sponsor-backed transactions, refinancings, and growth investments, but 2026 has introduced a more selective lending environment. Capital is still available, but lenders and investors are asking harder questions about borrower quality, liquidity, valuation, transparency, and downside resilience.
For investment banking leaders, lender advisers, sponsors, and borrowers, the practical implication is clear: financing confidence now depends on operating-level diligence. A borrower may show attractive adjusted EBITDA, but that is not enough if cash conversion is weak, working capital is volatile, covenant headroom is thin, customer concentration is high, or the operating plan depends on improvements management cannot execute.
Private credit selectivity is shifting diligence from headline EBITDA to the operating evidence behind liquidity, covenant compliance, and cash generation.
The Private Credit Market Has Cooled Sharply
Reuters reported in June 2026 in “Private credit boom cools as lending, flows slow sharply” that U.S. direct lending issuance fell to $44.76 billion for the three months ending May, down 40% from the first quarter, citing PitchBook data. Lending to private-equity-backed borrowers fell nearly 37%, while financing for leveraged buyouts declined about 34%. That is not a minor pause; it is a clear sign that the market is becoming more selective.
The same Reuters report pointed to several pressures behind the change: weaker fundraising, redemption requests, concerns about loan quality, competition from syndicated loan markets, and underperformance in some software-related private credit loans. Reuters also reported that some large private credit funds capped redemptions after requests exceeded limits, underscoring that liquidity management is becoming part of the market narrative.
The message for deal teams is not that private credit has disappeared. It is that lenders are less willing to rely on broad market momentum. They need clearer evidence that the borrower can generate cash, maintain operating performance, manage downside cases, and support the capital structure through a more demanding credit environment.
Regulators Are Watching the Vulnerabilities
The Financial Stability Board’s May 2026 “Report on Vulnerabilities in Private Credit” warned that the sector’s complexity, leverage, and interconnectedness could amplify stress in adverse scenarios. The FSB report highlighted interlinkages with banks, borrower credit quality concerns, valuation opacity, leverage, liquidity mismatches, and concentration as important areas for monitoring.
Reuters’ May 2026 reporting on the FSB report added that private credit had grown to an estimated $1.5 trillion to $2 trillion market, or as much as $3.5 trillion by some measures. The article noted that direct bank exposure remained low, but indirect ties through asset managers, insurers, private equity firms, and layered leverage could transmit stress in less visible ways.
That regulatory focus matters for investment banking because it changes the diligence standard. Lenders and advisers cannot rely only on the availability of private capital. They need to understand whether borrower economics, reporting quality, collateral, cash flow, and operating controls are strong enough to withstand a market where capital providers are scrutinizing risk more closely.
Liquidity Risk Begins in the Operation
Liquidity analysis is often framed as cash on hand, revolver availability, maturity schedule, interest burden, and covenant cushion. Those measures are necessary, but they are outcomes of how the company operates. Liquidity risk often begins earlier: in inventory that turns too slowly, receivables that are not collected on time, payables that are stretched beyond supplier tolerance, pricing leakage, margin drift, service failures, and uncontrolled capital spending.
The Federal Reserve Board’s May 2026 Financial Stability Report noted that some riskier firms, particularly those relying on private credit, faced more challenging conditions even while investment-grade corporate credit quality remained robust. For banks, direct lenders, and borrowers, that difference is critical. The stronger credits will be able to explain not only what the numbers are, but why the operation can support them.
Operating-level diligence should therefore test the mechanics of cash generation. Does the company know which customers consume working capital? Are billing and collections disciplined? Are inventory targets tied to demand and service levels? Are procurement savings real or theoretical? Does the management team have a track record of taking cost out before liquidity becomes urgent?
Covenant Headroom Must Be Tested Against Management Action
Covenants are not breached in spreadsheets first. They are breached when operating performance misses, cash conversion weakens, or management cannot respond quickly enough. A model may show covenant headroom under base-case assumptions, but that headroom can disappear if EBITDA softness, working capital drag, customer loss, integration delay, or cost inflation occurs at the same time.
The S&P Global Ratings May 2026 report, “U.S. Leveraged Finance Q1 2026 Update: Encouraging Discipline In Recent Deals, Lingering Default Risk In Legacy Vintages,” framed the market as improving in recent underwriting discipline while retaining default risk in older, more vulnerable cohorts. That is the environment in which covenant analysis must become more operational.
Deal teams should ask what specific actions protect covenant compliance. Which cost actions are available within 30, 60, or 90 days? Which pricing or mix changes can protect gross margin? Which working capital levers are credible? Which capex can be paused without damaging the business? Which customer or supplier risks could compress headroom faster than the model assumes?
Borrower Quality Is Becoming an Execution Question
In a more selective credit market, borrower quality is not only a function of industry, sponsor, EBITDA, or collateral. It is a function of execution credibility. A borrower with disciplined management routines, reliable reporting, clear cost controls, customer-level profitability, and visible cash conversion may finance more confidently than a superficially larger business with opaque operations.
This is where investment banking advisers can create more value. The financing process should identify the operating evidence that supports the credit story: forecast reliability, management cadence, working capital control, margin visibility, supplier and customer risk, maintenance capex needs, integration exposure, and ability to execute downside remedies.
The best financing materials do not simply present adjusted EBITDA. They explain how EBITDA becomes cash, how cash protects liquidity, how liquidity supports the capital structure, and how management will respond if conditions move against plan.
The Credit Story Must Be Built from Operating Evidence
A more selective credit market changes the quality of the borrower story. Lenders do not need a longer description of the market opportunity; they need better evidence that the borrower can operate within the proposed capital structure. That evidence should come from the company’s actual management system, not only from adjustments to historical EBITDA.
Useful evidence includes forecast accuracy by period and business unit, customer-level margin analysis, working capital aging, inventory turns, customer retention, supplier dependency, pricing governance, labor productivity, backlog quality, order-to-cash performance, and the causes of past budget misses. Those measures help lenders evaluate whether the company understands its own operating economics and can respond when performance changes.
This is also where advisers can strengthen the financing process. A borrower that enters the market with clear operating evidence can address risk directly and distinguish itself from companies that present only adjusted earnings, optimistic growth assumptions, and broad statements about management quality. In a selective market, credibility becomes a financing tool.
The same discipline helps borrowers avoid over-structuring the capital stack. When the operating evidence is weak, borrowers may accept terms that assume an improvement path the business cannot realistically deliver. When the operating evidence is strong, borrowers and advisers can negotiate from a clearer view of what the company can support.
The Brooks International Perspective
From Brooks International’s perspective, private credit selectivity makes operational diligence central to financing confidence. Lenders, sponsors, and borrowers need to know whether the operating model can support debt service, covenant compliance, working capital needs, and value creation under both base-case and downside conditions.
Brooks International helps transaction stakeholders connect financial structure to operating reality. That means testing the assumptions behind EBITDA, cash flow, synergies, working capital, cost takeout, revenue quality, capital requirements, and management capability. It also means identifying the actions required to protect liquidity and create measurable value after funding.
The objective is to reduce uncertainty before capital is committed. When lenders understand where the borrower creates cash, where cash is at risk, and which actions can protect performance, the financing discussion becomes stronger and more grounded.
What Investment Banking Leaders Should Be Asking Now
The leadership agenda should focus on whether financing confidence is supported by operating evidence, not only by market appetite.
• Which parts of the borrower’s EBITDA are most vulnerable to pricing, mix, customer loss, cost inflation, or operational underperformance?
• Can management explain how EBITDA converts to cash by customer, business unit, working capital component, and timing?
• Where is covenant headroom most exposed under realistic downside cases?
• Which liquidity levers are available quickly, and which require structural operating change?
• Are working capital assumptions supported by inventory, receivables, payables, billing, and collection routines?
• Does the borrower have the management cadence to intervene before a liquidity or covenant issue becomes visible to lenders?
The Leadership Imperative
Private credit remains important, but 2026 has made it more selective. That selectivity should be viewed as a warning and an opportunity. Weak borrowers may face tougher terms, slower processes, and more scrutiny. Stronger borrowers can differentiate themselves with operating evidence.
For investment banking leaders, the mandate is clear: make liquidity and covenant risk an operating diligence question. The strongest financing cases will be those that show not only what the borrower earns, but how the business generates cash, manages risk, and protects performance when conditions tighten.
