Banks should prepare for rising private credit litigation risks

Private credit is a form of lending capital outside of the traditional banking system, in which non-bank lenders work with borrowers to originate and negotiate privately held loans not traded in public markets. It has evolved from a niche source of financing which has enjoyed significant growth in recent years, with Moody’s estimating that assets under management (AUM) will exceed $2 trillion in 2026 and approach $4 trillion by 2030.

Recent developments suggest that market participants are entering a more challenging phase of the credit cycle with the collapse of Market Financial Solutions Limited and Godwin Capital drawing attention to issues around collateral management, creditor rights and governance, while increasing borrower distress is placing pressure on private credit portfolios. Private credit default rates are rising across various sectors, particularly in industrials/manufacturing and healthcare.

At the same time, regulators are paying closer attention to standards within private markets. In the UK, the Financial Conduct Authority (FCA) has identified governance, conflicts of interest and valuation practices and investor protection as areas of focus.

Where does litigation risk lie?

Lender v lender disputes

Private credit transactions frequently involve multiple non-bank lenders and creditors with differing economic interests. Where a borrower enters financial distress, disputes may emerge regarding the priority of security interests, entitlements to recovery and the treatment of creditors during a restructuring.

In some cases, disagreements may arise where a borrower has granted additional or preferential security to one lender, leaving other creditors arguing that their position has been unfairly diluted.

Disputes may also arise in the context of court-approved restructurings under Part 26A of the Companies Act 2006. As restructuring plans become more common in distressed situations, creditors may challenge valuation assumptions, voting arrangements or the treatment of different creditor classes.

Where asset values are deteriorating and recoveries are uncertain, lenders are more likely to pursue litigation to protect their position.

Claims against fund managers by co-investors

Banks or traditional lenders increasingly participate in private credit transactions as investors alongside private credit funds.

Where a fund performs poorly, disputes may arise between investors and fund managers regarding decisions that contributed to losses.

Potential areas of challenge include valuation methodologies used by the fund, decisions to continue supporting distressed borrowers, restructuring strategies pursued by the fund manager, the management of conflicts of interest, and governance and oversight arrangements.

Where losses are suffered, a bank acting as a co-investor may seek to argue that a fund manager acted outside its mandate, failed to exercise reasonable care, or made decisions that were detrimental to the interests of the fund. Where there is asymmetry of information being provided to investors, such as GP-led transactions involving continuation vehicles, there may be disputes relating to the pricing process.

The FCA's recent focus on valuation practices and standards in private market investing may increase scrutiny of these issues in future disputes.

Claims by investors

A further risk arises where banks become involved in aspects of fund management or investment decision-making.

Traditionally, banks have occupied a relatively straightforward role as lenders. However, as private credit markets evolve, banks are increasingly providing the customer base, deal flow and operational infrastructure that support many private credit transactions.

Where a bank becomes closely involved in fund management, advisory activities or strategic decision-making, investors may seek to bring claims for negligence, breach of fiduciary duty or misrepresentation if a transaction results in significant losses. This is particularly the case where allegations of fraud have been made.

Whilst such claims remain relatively uncommon, the risk increases where the distinction between lending and fund management roles becomes blurred.

Banks should therefore carefully assess the capacity in which they are acting throughout the lifecycle of a transaction and ensure legal duties and obligations are clearly documented and defined.

Claims following borrower insolvency

When a borrower enters administration or liquidation, banks and lenders will often seek to maximise recovery through enforcement action and participation in insolvency processes. However, formal insolvency proceedings also frequently generate additional disputes which adds another layer of risk, especially for banks whose role, obligations, and legal duties in the private credit funding lifecycle may come under increased scrutiny.

Possible areas of legal challenges include:

• failure to protect customers’ interests arising out of authorised push payment (APP) fraud;
• breach of the so-called ‘Quincecare duty’ of care;
• applications to trace assets; and
• claims under the Insolvency Act 1986, including claims under sections 235-236 and 423 of the Insolvency Act 1986 relating to transactions entered into to put assets beyond the reach of creditors.

Practical considerations

Private credit should not solely be considered through the lens of borrower default risk.

Banks should assess their exposure across the entire private credit ecosystem. This means understanding exposure not only ‘upstream’ as a lender to a fund, but also ‘midstream’ through co-investment arrangements and ‘downstream’ through lending to underlying borrowers.

The nature of any potential liability may differ significantly depending on the role being performed at a particular stage of the transaction.

All lenders should regularly review borrowers' financial positions and monitor for signs of distress. Particular attention should be paid to covenant compliance, liquidity pressures, refinancing risks, declining asset values and sector-specific challenges.

Early intervention often provides more options for preserving value and managing risk. Reliance on information provided by borrowers or external counterparties should be avoided and security packages, collateral valuations, perfection requirements and priority arrangements should be reviewed on a regular basis.

Independent collateral reviews can help identify potential issues before they become the subject of disputes.

Finally, banks should periodically review transaction documentation to ensure that risk allocation provisions remain appropriate. Equally important is maintaining comprehensive records of important decisions, particularly those relating to restructurings, valuations and distressed borrowers.

Clear contemporaneous documentation may prove critical if decisions are challenged at a later date.

Co-written by Natasha Fons of Pinsent Masons.