Hidden leverage, new sources of complexity, contagion arise as funds evolve.

Innovation in private credit is bringing greater complexity and ramping up risks, warns Moody’s Ratings.

In a report Monday, the rating agency said private credit innovation is not only driving growth in that sector, but it’s transforming the risk landscape too, by introducing new risks and creating new ways for risks to be transmitted and amplified.

Among other things, private credit funds are increasingly teaming up with traditional financial institutions, including banks and insurers; private credit funds are being structured to be increasingly flexible; funds are developing novel debt structures to better serve borrowers’ needs; and covenant-lite structures, which were typically rare in private credit, are becoming more common.

“These innovations introduce new risks — particularly around transparency, recoveries, and structural subordination,” Moody’s said.

For instance, increased partnerships between banks, insurers and private credit funds “blur the lines between traditional and alternative lenders, increasing interlinkages and potential contagion channels,” the report said.

Additionally, the contagion risk can be amplified when private credit funds also rely on bank-funded credit lines, it said: “These developments are enhancing deal execution but also raising questions about risk transfer, regulatory oversight, and systemic exposure.”

Similarly, innovation in debt structures can introduce new risks, such as hidden buildups of leverage, the report said.

“While these structures enhance capital efficiency and investor reach, their complexity can obscure priority of claim and reduce recoveries in distress,” Moody’s noted.

As well, innovation in fund structures — such as funds that combine illiquid private credit investments with liquid assets to provide investors with greater liquidity — can generate valuation and redemption risks.

“In stressed scenarios, forced sales of portfolio assets in the secondary market could depress valuations across the broader portfolio,” the report said. “This decline in asset valuation can adversely affect the valuation of similar or related positions within the portfolio, amplifying mark-to-market volatility.”

Financial covenants in private credit transactions are weakening too, the report noted.

“This shift reflects both borrower bargaining power and the pressure on lenders to deploy capital in a crowded market,” it said, which is pushing the private sector to behave more like the public markets to compete, yet, “private credit remains comparatively opaque.”

“The lack of transparency around price and valuation complicates benchmarking and may mask underlying credit deterioration,” Moody’s noted.