Private Credit Is Showing Cracks. Can Islamic Finance Build It Better?

For much of the past decade, private credit has been one of the clearest success stories in modern capital markets.

As banks retreated from leveraged and middle-market lending following the Global Financial Crisis, private funds stepped in. The model had obvious advantages. Investors committed capital for long periods, managers negotiated directly with borrowers, financing could be tailored around individual businesses, and lenders were compensated with yields well above most public fixed-income markets.

The growth that followed was extraordinary.

By the second half of 2025, the Federal Reserve estimated that U.S. private credit had reached approximately $1.4 trillion, equivalent to roughly 10% of all U.S. nonfinancial corporate debt and about one-third of below-investment-grade corporate debt excluding bank loans. Private credit has evolved from a relatively specialized alternative asset class into a major component of corporate financing.

That growth has provided real economic benefits. Private lenders can finance companies underserved by banks, move quickly when borrowers need certainty of execution, and negotiate structures that public bond markets cannot easily replicate.

Yet scale changes incentives.

As more capital competes for the same opportunities, some of the features that made private credit attractive in the first place have begun to weaken.

McKinsey estimates that covenant-lite transactions increased from just 4% of direct-lending deals in 2023 to 21% in 2025. Median leverage on new transactions remained around 4.9 times EBITDA, barely below 5.0 times in 2024, while all-in new-issue yields compressed from approximately 10.5% to 9.3%. Lenders are receiving less compensation while borrower leverage has barely changed and contractual protections have weakened.

The underlying borrower data is also beginning to show strain.

KBRA's Q2 2026 analysis covers 2,785 middle-market borrowers representing more than $1.2 trillion of direct-lending debt. Its Middle Market Default Monitor reached a record 92 borrowers representing more than $30 billion of debt, while median interest coverage remained only 1.6 times.

None of this means private credit is approaching an imminent systemic collapse.

The more useful question is what happens as an asset class built around patient capital, bespoke underwriting and close lender relationships becomes larger, more competitive, more leveraged and increasingly accessible through investment structures promising periodic liquidity.

And as cracks begin to appear in the conventional model, Islamic finance offers an interesting question of its own.

Could private credit be built on a stronger foundation?

Stress Can Be Restructured Without Disappearing

Headline default rates in private credit remain relatively low.

The Financial Stability Board's May 2026 review of the sector found outright loan defaults running at approximately 1%.

Once certain restructuring transactions classified as selective defaults are included, however, that figure rises to roughly 5%.

That distinction matters.

Private lenders have more flexibility than public creditors to work directly with distressed borrowers. That can be a major advantage. If a fundamentally viable company experiences temporary cash-flow pressure, forcing an immediate bankruptcy may destroy more value than restructuring the obligation.

But restructuring does not necessarily eliminate economic stress.

One increasingly important mechanism is payment-in-kind, or PIK, financing. Rather than paying interest in cash, a borrower can add that interest to the outstanding principal and pay it later.

The FSB estimates that PIK arrangements are now used in approximately 12% of private-credit loans, with PIK toggles accounting for about half of those cases. It also notes that PIK usage has increased materially since 2022.

Again, PIK is not inherently problematic.

For a growing company temporarily short of liquidity, deferring interest can preserve cash that would otherwise be removed from the business at exactly the wrong moment.

The tradeoff is straightforward: today's liquidity relief becomes tomorrow's larger debt burden.

A company therefore does not need to miss an interest payment or enter bankruptcy for its capital structure to be under pressure. Interest can be capitalized, maturities extended, terms renegotiated and additional sponsor capital injected.

The loan survives.

The economic burden may still be growing beneath it.

This becomes especially important in a market where borrower leverage remains high and transparency remains limited. The FSB itself warns that private-credit borrowers often carry greater leverage than comparable broadly syndicated borrowers, while limited public reporting makes system-wide credit conditions harder to assess.

The issue is less whether restructuring is good or bad.

It is whether investors are measuring the health of the underlying enterprise or simply the absence of a conventional default.

The Liquidity Question

Private credit historically possessed another important structural advantage.

Much of its institutional capital was locked into funds for seven to ten years.

Long-duration capital financed long-duration, illiquid loans. Investors accepted limited liquidity in exchange for higher returns, while managers were less vulnerable to being forced sellers during periods of market stress.

That alignment is beginning to change as private credit expands into private wealth.

According to the Federal Reserve, perpetual-life business development companies now hold approximately $306 billion in gross assets and $161 billion in net assets. Credit-focused interval funds hold another $119 billion gross and $80 billion net.

Together, these semi-liquid vehicles represent approximately $425 billion in gross assets and $241 billion in net assets, equal to roughly 20% of net assets across private-credit vehicles.

Unlike traditional closed-end funds, these products generally provide investors with periodic opportunities to request their money back.

The tension became more visible in early 2026.

The Federal Reserve found that several perpetual BDCs received first-quarter redemption requests far above the typical 5% quarterly redemption cap. Most managers responded by limiting the amount investors could withdraw, while accepted redemptions exceeded new subscriptions for the first time since these structures became established.

For now, the Fed considers those pressures manageable.

Managers retain liquidity through cash, credit facilities, loan repayments and their ability to restrict redemptions.

But the structural contradiction remains.

An asset class whose underlying loans are intentionally illiquid is increasingly being distributed through products designed to provide investors with periodic liquidity.

Private credit is therefore beginning to confront an old financial problem: the difference between the liquidity promised by a financial claim and the liquidity of the asset underneath it.

The Lesson From 2008 Was Larger Than Bad Mortgages

This is where Islamic finance becomes particularly interesting.

The Global Financial Crisis is often remembered primarily as a failure of mortgage underwriting and a housing bubble.

Those were central causes.

They do not fully explain how losses originating in one segment of the U.S. housing market became capable of destabilizing financial institutions across the world.

The financial system amplified the underlying economic risk.

At the end of 2007, the Bank for International Settlements estimated that the global over-the-counter derivatives market had reached approximately $596 trillion in notional value.

Credit-default swaps alone had reached $58 trillion, increasing 36% in only six months.

Notional value should not be confused with actual capital at risk, and derivatives themselves perform legitimate functions ranging from hedging to price discovery.

The structural issue was that financial exposure no longer needed to correspond directly with the creation of another productive economic asset.

A mortgage begins with something identifiable: a borrower finances a home.

Once credit exposure is repeatedly securitized, tranched, insured, referenced through derivatives and reconstructed synthetically, multiple layers of financial claims can depend on the performance of the same underlying pool of assets.

Financial risk can multiply without a corresponding increase in houses, factories, infrastructure or productive capacity.

Islamic finance approaches that relationship differently.

Shariah places restrictions on riba, excessive gharar, maysir, excessive leverage and transactions where parties sell risks or assets without the required ownership relationship. Financing is expected to maintain a meaningful connection to identifiable economic activity, while ownership and assumption of risk carry economic significance.

That does not make Islamic finance immune to crises.

It does constrain several of the mechanisms through which financial risk can become detached from the real economy and multiplied through layers of leverage and synthetic exposure.

The experience of Islamic banks during the Global Financial Crisis gives us an imperfect but useful natural experiment.

An IMF study comparing Islamic and conventional banks found that characteristics of the Islamic banking model helped contain the decline in profitability in 2008. The researchers specifically pointed to Islamic banks' lower leverage, smaller investment portfolios and Shariah restrictions that prevented exposure to instruments such as collateralized debt obligations and credit-default swaps that contributed to losses at conventional institutions.

Islamic banks also maintained substantially stronger lending through the crisis.

The IMF found that their credit growth was, on average, around twice that of conventional banks, while their asset growth between 2007 and 2009 was more than twice as high. Islamic institutions were therefore less affected by the deleveraging that forced many conventional banks to shrink their balance sheets.

That is arguably the more important result.

A financial institution's economic value during a crisis extends beyond its ability to avoid losses. It also depends on whether it can continue providing financing when otherwise viable businesses are starved of capital.

Islamic banks appeared comparatively well positioned to continue doing so.

The evidence also gives us an important warning.

In 2009, once the financial crisis had spread into the real economy, several Islamic banks experienced larger profitability declines. The IMF linked much of this weakness to poor risk management and excessive concentration in individual borrowers and sectors, particularly real estate. Across 2008 and 2009 together, the difference in profitability between the Islamic and conventional groups was no longer statistically significant.

That distinction is critical.

Islamic finance cannot prevent businesses from failing.

It cannot prevent property prices from falling.

It cannot eliminate poor underwriting, concentration risk, fraud or economic recessions.

What its architecture can potentially do is limit the mechanisms through which those underlying economic losses are amplified by leverage, synthetic risk creation and financial claims detached from productive activity.

That lesson deserves renewed attention as private credit enters its next stage of development.

What Would Islamic Private Credit Actually Look Like?

Islamic private credit already exists, and an institutional market is beginning to take shape.

Janus Henderson's emerging-markets private-capital team, formerly NBK Capital Partners, reports approximately $1.1 billion of historical capital commitments and describes itself as having pioneered MENA's first dedicated private-credit vehicle and the region's first institutional Shariah-compliant private-credit fund.

Its current MENA Private Credit Fund IV reached $125.5 million at first close toward a $300 million target, illustrating growing institutional appetite for direct lending across the region.

The financing opportunity is substantial.

Deloitte estimates that SMEs account for only around 3% of total lending in the GCC, leaving an estimated regional financing gap of approximately $250 billion.

These businesses often occupy an awkward middle ground.

They may be too small to issue public sukuk.

They may be too mature for venture capital.

Their owners may not want the dilution or governance changes associated with private equity.

And commercial banks may have neither the appetite nor the underwriting flexibility to meet their needs.

Private credit is almost perfectly designed for this segment.

The question is what kind of private credit gets built.

Islamic financing can use structures such as murabaha, ijara, istisna, musharakah and mudarabah, each creating a different relationship between the financier, enterprise and underlying economic activity.

A logistics business can finance vehicles through ijara.

A manufacturer can finance equipment or expansion through asset-based structures.

Infrastructure financing can be tied to construction and eventual ownership or leasing of identifiable productive assets.

Growth capital can incorporate genuine profit participation through musharakah or mudarabah.

The financing process therefore begins with a basic question:

What economic activity is this capital enabling?

That sounds almost trivial.

In practice, it represents a very different starting point from asking how much additional leverage a borrower's EBITDA can support.

Risk Sharing Changes the Capital Structure

The deepest potential contribution of Islamic private credit lies in risk sharing.

Conventional direct lending generally gives the lender a contractual claim on fixed or floating payments regardless of how the borrower's operating performance evolves.

If EBITDA increases substantially, the lender receives its agreed return.

If EBITDA stagnates, the obligation remains.

If EBITDA falls sharply, the same contractual payment continues until the borrower restructures or defaults.

That predictability has obvious advantages. Businesses often prefer knowing exactly what their financing will cost, while institutional investors need reliable cash flows.

The structure can also become procyclical.

A struggling company faces its greatest financing burden precisely when its ability to service that burden is deteriorating.

Profit-and-loss-sharing structures can behave differently.

Under musharakah or mudarabah-style financing, part of the capital provider's return depends on the actual performance of the enterprise. Strong operating results can generate higher distributions to investors, while periods of weakness naturally reduce the amount extracted from the business.

Part of the economic shock is therefore absorbed through the financing structure itself.

This begins to blur the rigid boundary between debt and equity and moves private financing toward patient risk capital.

There are tradeoffs.

Investors sacrifice some certainty.

Valuation becomes more complicated.

Governance rights matter more.

Monitoring must become deeper.

And underwriting requires considerably more than calculating a leverage multiple and estimating recovery value.

Those disadvantages can also create better incentives.

When the financier's return depends more directly on the productive success of the business, the lender must begin thinking more like an owner.

Underwriting becomes closer to investment.

What Does “Ethical Finance” Actually Produce?

Islamic finance is frequently described as ethical finance.

That description becomes much more useful when economic outcomes can be measured.

Does financing create employment?

Does it expand productive capacity?

Does it support trade, infrastructure, healthcare, housing or business formation?

Can the financial return ultimately be connected to something tangible being produced within the economy?

The Islamic Corporation for the Development of the Private Sector provides one useful illustration.

In its 2025 Annual Development Survey, based on responses covering 80% of its clients, ICD reports financing 2,381 SMEs with approximately $661.9 million, alongside 100,044 new clients gaining access to Islamic finance.

Across the institutions and businesses represented in the survey, ICD reports 347,216 jobs supported and 23,531 new jobs created, approximately $1 billion in domestic purchases, $557.3 million in export sales, and 1,062 megawatts of energy capacity financed.

It also reports approximately $283.8 million in government revenues generated and healthcare services reaching around 3.55 million patients.

These figures should be interpreted carefully.

They do not prove that Islamic finance inherently generates greater social value than conventional finance, nor do they establish that every reported outcome would have disappeared without ICD's involvement.

They demonstrate something more useful.

The economic footprint associated with capital allocation can be measured.

Private credit used to finance a new factory, logistics network, healthcare provider or energy project creates a different form of economic additionality than financing primarily used to refinance an already leveraged acquisition or distribute capital to existing equity owners.

Both transactions can be commercially rational.

Both can generate legitimate investment returns.

Their effect on productive capacity is different.

Islamic private credit has an opportunity to make that distinction part of underwriting itself.

The Opportunity Is Becoming Large Enough to Matter

Islamic finance now has the scale to make this relevant well beyond a specialized investor base.

According to the 2025 ICD-LSEG Islamic Finance Development Report, global Islamic financial assets reached approximately $5.98 trillion in 2024, growing 21% year over year. The report tracks the industry across 140 countries.

Yet much of that system remains concentrated in Islamic banking and public sukuk markets.

That leaves a large financing space between traditional bank lending and public capital markets.

A sovereign government or multinational corporation can issue a billion-dollar sukuk.

A privately owned industrial company seeking $20 million to expand production usually cannot.

That gap is precisely where private credit operates.

The combination of growing Islamic financial assets, increasingly sophisticated Gulf institutional capital, persistent SME financing gaps and investor demand for alternative yield creates an environment where Islamic private credit can become a genuine institutional asset class.

Its long-term contribution, however, will depend on how closely the industry follows the economic principles that originally distinguished Islamic finance.

Shariah Compliance Alone Will Not Solve the Problem

This is where Islamic finance faces its own contradiction.

An Islamic contract can comply with formal Shariah requirements while still reproducing much of the economic behavior of conventional debt.

The Islamic Financial Services Board has begun warning about exactly this issue.

Its 2025 Financial Stability Report highlights the rapid growth of hybrid debt-like instruments, particularly commodity murabaha. The IFSB reports approximately $512 billion of commodity-murabaha deposits and $380 billion of financing as of Q2 2024. It warns that their fixed-payment characteristics can increase leverage, liquidity mismatches, concentration and interconnectedness in ways that begin to resemble conventional banking vulnerabilities.

That warning should be taken seriously.

If Islamic private credit simply takes a highly leveraged conventional loan and reconstructs the same economics through a technically permissible series of transactions, very little has changed at the level that matters for financial stability.

The documents changed.

The incentives did not.

This creates a useful distinction between Shariah-compliant private credit and what could be described as Shariah-native private credit.

The first asks:

How can we reproduce a desired financing outcome using permissible contracts?

The second asks:

What financing structure best embodies ownership, sustainable leverage, real economic activity, risk participation and fairness between the provider and user of capital while still producing an institutional-quality return?

That distinction could determine whether Islamic private credit simply becomes another wrapper around conventional finance or develops into something genuinely different.

A Shariah-native private-credit strategy could therefore be evaluated through four basic tests.

Economic substance: Is capital clearly connected to an identifiable enterprise, asset or productive activity?

Risk alignment: Does the capital provider bear meaningful economic risk, or has essentially all downside been transferred to the borrower?

Leverage discipline: Is debt being used to finance productive capacity at sustainable levels, or simply to maximize the amount of financial claims that can sit above the same cash flow?

Additionality: What has the capital actually enabled the economy to produce?

Those questions extend well beyond religious compliance.

They are questions every credit investor should probably be asking.

Building Better Credit

Private credit remains a valuable financial innovation.

Long-term institutional capital can finance businesses poorly served by traditional banks. Direct lender-borrower relationships can produce better information and more flexible restructurings. Closed-end fund structures can align investor capital with illiquid assets more effectively than many traditional financial intermediaries.

Those strengths should be preserved.

The emerging weaknesses deserve equal attention.

Competition has compressed yields.

Borrower-friendly documentation is becoming more common.

Leverage remains elevated.

PIK usage has risen.

Broader measures of default reveal more stress than conventional payment defaults alone.

Semi-liquid vehicles are introducing a new liquidity question into an inherently illiquid market.

And the Financial Stability Board now warns that private credit, at its current scale and level of interconnectedness, has yet to be tested through a prolonged economic downturn.

Islamic finance offers an opportunity to approach those vulnerabilities from first principles.

The evidence from 2008 suggests that lower leverage, restrictions on synthetic financial exposure and a closer relationship between financing and underlying economic activity can improve resilience. The problems Islamic banks encountered in 2009 provide the equally important reminder that principles cannot replace diversification, disciplined underwriting or competent risk management.

Both lessons matter.

The strongest future for Islamic private credit would combine the best elements of modern direct lending with the economic discipline embedded within Shariah: patient capital, direct relationships with borrowers, identifiable economic assets, sustainable leverage, genuine risk participation and measurable productive impact.

Its ambition should extend beyond creating another compliant investment product for Muslim institutions and investors.

There is a larger opportunity.

Private credit was originally attractive because it brought capital closer to the businesses using it.

Islamic finance can take that principle further, bringing the return on capital closer to the productive activity that creates it.

At a time when parts of global credit markets are once again discovering how easily financial claims can grow faster than the economic foundations beneath them, that may be one of Islamic finance's most valuable contributions.

The opportunity is not merely to build Islamic private credit.

It is to build better credit.