Covenant Lite #25: Leverage, Liquidity, & Lies: Lessons From Private Credit’s Fallen Stars (Part 1 of 3)

A three-part series on what can go wrong in private credit

Private credit today feels like a can't-miss proposition: steady yields, low defaults, and seemingly bulletproof structures. But as investors become increasingly optimistic on the potential of the asset class, history whispers cautionary tales—sometimes things that look indestructible can shatter spectacularly.

In this first installment of a three-part series, we dive deep into three infamous blow-ups from the annals of private credit history: Allied Capital, American Capital Strategies, and Carlyle Capital Corporation. All three had long simmering issues that were ultimately exposed by the Great Financial Crisis of 2008-09.

These stories aren't just historical curiosities—they’re instructive warnings about leverage, liquidity, and human psychology in the credit markets.

Meet the Fallen Stars

1. Allied Capital

• Founded: 1958

• Peak Assets: ~$5 billion (2007)

• Focus: Middle-market lending via a publicly traded Business Development Company (BDC).

• Fatal flaw: Inflated asset valuations, aggressive leverage, governance breakdowns, and accounting irregularities exposed in the 2008 financial crisis.

2. American Capital Strategies

• Founded: 1986

• Peak Assets: ~$20 billion (2007)

• Focus: Middle-market direct lending, mezzanine debt, and equity investments through a publicly traded BDC.

• Fatal flaw: Massive growth fueled by leverage and illiquid equity stakes, catastrophic liquidity crunch, forced asset sales at distressed prices during the 2008–09 crash.

3. Carlyle Capital Corporation (CCC)

• Founded: 2006

• Peak Assets: $22 billion in leveraged assets by late 2007, against only $670 million of equity

• Focus: High-leverage investments in AAA-rated mortgage-backed securities (agency MBS), relying on aggressive repo financing.

• Fatal flaw: Extreme leverage (30×), heavy reliance on short-term repo financing, and misjudged liquidity risks, culminating in margin-call-driven collapse in 2008.

Allied Capital: The Rise and Spectacular Fall of a BDC Pioneer

Allied Capital's dramatic collapse is one of the most instructive cautionary tales in private credit, showcasing how growth-driven ambition, opaque accounting, and complacent governance can create the illusion of stability until the moment of reckoning arrives.

Its demise wasn't an overnight event—it was the product of years of accumulating hidden risks, questionable valuation practices, and aggressive expansion that finally burst wide open during the financial crisis of 2008–09.

Humble Beginnings (1958–2000)

Founded in 1958, Allied Capital initially operated quietly as a Small Business Investment Company (“SBIC”), providing loans and growth capital to middle-market U.S. businesses. Over the subsequent decades, Allied grew into one of the earliest and most prominent Business Development Companies (“BDCs”), a publicly traded investment vehicle designed specifically to channel capital to mid-sized private businesses.

Throughout the 1980s and 1990s, Allied steadily built its reputation by offering stable dividend yields, primarily derived from interest income on private loans and modest equity stakes in borrowers. The company attracted a devoted following among retail and institutional investors looking for steady income with manageable risk.

By 2000, Allied was a mature public BDC with an established niche. However, as the 2000s began, ambitions for growth started reshaping its trajectory, setting the stage for trouble ahead.

Rapid Expansion and Hidden Risks (2000–2007)

From 2000 onward, Allied Capital transformed into a growth engine, significantly expanding its balance sheet. Assets under management surged dramatically—from roughly $1 billion in 2000 to almost $5 billion at the peak in 2007. At this height, Allied was a market darling, widely admired for its generous dividend payouts and stable-seeming returns.

To maintain its dividend amidst falling loan spreads, Allied diversified beyond traditional senior loans, moving aggressively into riskier junior lending, mezzanine financing, and equity stakes—which ultimately made up ~70% of the portfolio by 2007 (link). Protecting the dividend was crucial for retaining investors in a competitive environment.

But beneath the surface, hidden dangers lurked. Allied's loans and equity investments were in privately-held middle-market companies that were difficult to value precisely. And crucially, the valuations of these illiquid investments were largely left to Allied’s internal discretion. Management incentives skewed toward growth and maintaining valuations to support dividends, creating a potent conflict of interest.

Allied capitalized on these generous valuations to boost reported NAV (net asset value) and reassure investors. As long as capital flowed in and loan repayments remained steady, the questionable valuations seemed sustainable.

Einhorn Sounds the Alarm (2002–2007)

In 2002, investor David Einhorn publicly accused Allied Capital of manipulating asset valuations, using overly optimistic assumptions, and practicing deceptive accounting. Einhorn detailed these concerns in his now-famous book, "Fooling Some of the People All of the Time," meticulously documenting Allied’s questionable valuation methods and opaque disclosures.

Allied, however, aggressively fought back, denying wrongdoing, and launching a fierce PR battle against Einhorn. For several years, the market largely sided with Allied—its shares continued performing strongly, and Einhorn’s warnings went largely unheeded by investors, regulators, and rating agencies alike.

Behind the scenes, though, pressure was building. Allied’s investments had grown increasingly risky, its balance sheet more leveraged, and its valuation methods less transparent. Internal valuations continued marking troubled loans at par or minimal discounts, creating a growing gap between real economic value and reported NAV.

Crisis Strikes (2008–2009)

The 2008 financial crisis exposed Allied Capital’s hidden vulnerabilities in brutal fashion. As credit markets froze and the economy spiraled downward, many of Allied’s borrowers struggled or defaulted outright. Suddenly, the valuations that had long been questioned by Einhorn and others came under intense scrutiny.

As defaults and delinquencies mounted, Allied was forced to dramatically write down asset values—exposing just how significantly investments had been previously inflated. The combined impact of loan losses, credit rating downgrades, and evaporating investor confidence triggered a liquidity crisis. Banks pulled back credit lines, forcing Allied into desperate asset sales at fire-sale prices.

In the chaos of late 2008 and early 2009, Allied’s share price plummeted, losing more than 90% of its peak value. Dividends were slashed, and investor lawsuits piled up. Investigations by the SEC accelerated, eventually concluding that Allied had indeed engaged in misleading valuation practices.

The Aftermath and Resolution (2010 and Beyond)

With its stock price decimated, dividends slashed, and market reputation ruined, Allied Capital was essentially finished as an independent entity. In April 2010, fellow BDC Ares Capital stepped in, acquiring the battered Allied portfolio at a significant discount—effectively ending Allied’s half-century as a standalone company.

The SEC’s investigations concluded with significant criticism of Allied’s valuation and governance practices, though settlements avoided direct admission of fraud. Shareholders, however, experienced heavy losses with limited recourse.

For Ares, the acquisition marked an opportunistic expansion, buying distressed assets cheaply at a moment of maximum market panic. Ares methodically unwound the problematic Allied investments, eventually stabilizing and absorbing them profitably into its larger platform.

Today, Allied Capital no longer exists in name or form. Its legacy, however, endures as one of the clearest examples of how governance failures, conflicted valuations, and hidden leverage can conspire to devastate even longstanding market leaders.

American Capital Strategies: Even Goliath Can Fall

American Capital Strategies’ rise and dramatic fall stands is an equally sobering tale—a reminder of how unchecked leverage, hidden illiquidity, and complacency can devastate even a seasoned industry giant.

Origins and Growth (1986–2005)

Founded in 1986 by Malon Wilkus, American Capital Strategies began modestly as a private investment fund, later becoming one of America’s earliest publicly-traded Business Development Companies (BDCs). Its model was innovative and compelling for the time: providing flexible direct loans, mezzanine financing, and equity investments to middle-market companies largely ignored by traditional banks and capital markets.

Over the next two decades, American Capital emerged as a pioneer in private credit. Investors loved the business model—steady income from loans combined with substantial upside potential from equity stakes. By the early 2000s, American Capital was regularly posting double-digit returns, drawing accolades from Wall Street analysts and pension fund allocators alike.

Its success bred rapid growth: American Capital’s assets exploded from approximately $1 billion in the early 2000s to a peak of nearly $20 billion by 2007, making it one of the largest and most influential middle-market lenders in the United States.

Boom Years: Expansion, Complexity, and Hidden Risks (2005–2007)

By mid-decade, American Capital had shifted into overdrive. Hungry to grow, it expanded its lending activities aggressively, venturing far beyond the safer first-lien senior loans it traditionally favored. It increasingly allocated capital into riskier second-lien loans, mezzanine financing, and direct equity stakes in borrowers—securities that delivered higher yields and juiced returns, but also introduced significant illiquidity and risk. Before its collapse, investments in junior instruments made up ~70% of total investments (link), similar to Allied.

At the same time, American Capital also started expanding globally, launching European subsidiaries and other offshoots to pursue international private-credit opportunities. Complexity multiplied. Its asset base ballooned rapidly, driven by easy access to credit markets and demand for high-yield investments.

By 2007, the firm appeared invincible, boasting strong returns and a loyal shareholder base. But hidden dangers lay beneath this apparent success:

• Highly illiquid equity investments that could not easily be monetized.

• Aggressive use of short-term leverage to fuel further growth.

• A reliance on steady liquidity from banks and bond markets.

• Overly optimistic internal valuations that obscured real credit risks.

Few investors raised concerns—everyone was making money. The party seemed unstoppable.

The Financial Crisis: Cracks Emerge (2008–2009)

The 2008 financial crisis delivered a brutal and swift reckoning. As Lehman Brothers collapsed and markets froze, American Capital faced a simultaneous crisis across its balance sheet:

1. Liquidity evaporation:
   With credit markets shut, American Capital’s short-term liquidity sources vanished overnight. Banks began calling back credit lines, refusing renewals, and demanding margin payments.

2. Asset write-down spiral:
   Amid collapsing market conditions, its portfolio of illiquid loans and equity investments suffered enormous valuation hits. Internal valuations proved wildly optimistic, forcing massive markdowns and impairments as borrowers defaulted or struggled.

3. Covenant and leverage crisis:
   Steep portfolio write-downs quickly triggered breaches of NAV-based and leverage covenants in American Capital’s debt agreements, providing lenders with contractual rights to demand accelerated repayments or immediate asset sales. Upwards of 50% of American Capital’s liability stack was short term in nature, with daily or quarterly borrowing base tests, which forced management to rapidly deal with their deteriorating asset values (link).

4. Forced asset sales at distressed prices:
   Unable to refinance debt, American Capital was forced to dump portfolio holdings into collapsing markets. Illiquid stakes sold at enormous losses, crystallizing previously hidden valuation shortfalls and deepening the financial hole.

Between 2008–09, American Capital’s share price crashed from nearly $50 per share to under $1, reflecting catastrophic asset impairments and liquidity loss. Investors who once viewed it as a safe, income-producing investment were devastated.

Struggle for Survival (2010–2016)

In the aftermath, American Capital fought to stay afloat. CEO Malon Wilkus desperately negotiated with lenders, sold off core assets, and cut staff and overhead. Though it narrowly avoided bankruptcy, the company emerged severely weakened:

• Massive NAV erosion:
  From nearly $20 billion of peak assets, American Capital shrank dramatically, slashing dividends to shareholders and fighting continual liquidity fires.

• Investor trust destroyed:
  Lawsuits piled up from angry shareholders alleging mismanagement and misrepresentation of risk.

• Portfolio unwinding:
  Over several years, American Capital slowly and painfully unwound much of its portfolio at steep discounts to book value.

By the early 2010s, American Capital’s management publicly acknowledged their overly aggressive growth and flawed risk management. Wilkus himself stepped back, and the company underwent extensive restructuring, including winding down complex subsidiaries and exiting riskier asset classes.

But reputational damage proved irreversible. American Capital limped forward for several years, still trading at a deep discount to its shrunken NAV.

Resolution: Ares Capital Steps In (2016)

By 2015–16, after nearly eight painful years struggling to stabilize itself, American Capital became an acquisition target. Ares Capital, a better-capitalized, well-managed peer, stepped in, proposing to buy the remnants of American Capital at a steep discount.

In December 2016, Ares Capital successfully acquired American Capital in a deal valued at approximately $3.4 billion—just a fraction of American Capital’s former size and peak valuation. Under Ares’s management, the remaining portfolio was methodically absorbed, rationalized, and gradually stabilized.

For American Capital’s former shareholders, however, the damage was permanent, having endured deep losses and dilution in the painful years leading up to the acquisition.

Carlyle Capital Corporation: A High-Leverage Gamble

Carlyle Capital Corporation’s collapse in March 2008 was among the financial crisis’s earliest and most spectacular failures, vividly illustrating the risks of extreme leverage, even on assets widely assumed to be safe.

Though its lifespan was brief—barely two years—its rapid ascent and sudden demise encapsulated the deadly combination of aggressive financing, hidden liquidity risk, and complacent assumptions about asset safety.

Origins: An Ambitious Spin-off (2006)

In mid-2006, at the height of the global credit boom, the Carlyle Group—one of the world’s most prestigious private equity firms—launched Carlyle Capital Corporation (“CCC”).

Domiciled in Guernsey as a publicly traded, closed-end fund, CCC aimed to offer investors steady, modest returns from a portfolio of high-quality, AAA-rated securities backed by government-sponsored enterprises (GSEs), primarily mortgage-backed securities issued by Fannie Mae and Freddie Mac.

The fund promised investors:

• Attractive dividend yields (~10–12%)

• Exposure exclusively to highly rated, "safe" agency mortgage assets

• Carlyle’s reputation for prudent risk management

Yet beneath the reassuring promise lay an aggressive strategy—Carlyle Capital would employ extreme leverage (approximately 30 times equity), relying almost entirely on short-term repo financing to juice modest yields into double-digit returns.

At launch, Carlyle Capital raised roughly $670 million of equity. Levered 30x, this modest equity base was intended to support more than $20 billion in mortgage securities. Such leverage magnified tiny interest-rate spreads into handsome dividend payouts, making it initially attractive to investors chasing yield with presumed minimal risk.

Rapid Growth: From Launch to $22 Billion (2006–07)

Within months, Carlyle Capital ramped quickly. By mid-2007, it had amassed a portfolio totaling approximately $22 billion, primarily in AAA-rated agency mortgage-backed securities.

Key details of CCC’s asset and liability profile at its peak (mid-2007):

• Equity capital: ~$670 million

• Assets: ~$22 billion (AAA agency MBS)

• Leverage ratio: 30-to-1 debt-to-equity

• Funding source: Primarily short-term repurchase agreements (repos), refinanced continuously—typically overnight, weekly, or monthly maturities.

At the time, such extreme leverage seemed manageable given two widely-held assumptions:

1. AAA agency MBS were virtually risk-free:
   Agency mortgages carried implicit government backing, leading investors—and lenders—to assume negligible default risk.

2. Unlimited liquidity in short-term repo markets:
   Short-term repo financing had historically always been available, allowing Carlyle to continuously refinance positions cheaply.

These assumptions would soon prove dangerously flawed.

Early Warning Signs (August 2007)

In August 2007, markets felt their first tremors from subprime mortgage defaults. Even though Carlyle Capital’s holdings were not subprime, rising concerns around mortgage assets prompted some lenders to tighten repo terms, requesting increased collateral ("haircuts").

Carlyle briefly stabilized the situation by injecting additional equity and negotiating with banks. However, this was merely a temporary fix. The underlying risks—massive leverage and dependency on rolling short-term repos—remained unaddressed.

Rapid Collapse (March 2008)

In early March 2008, as Bear Stearns teetered toward collapse, liquidity conditions rapidly deteriorated. Lenders, anxious about exposure to mortgage-backed securities—even AAA-rated—started dramatically increasing margin requirements. Repo lenders demanded significantly higher haircuts (collateral margins) or outright refused rollovers.

Suddenly, Carlyle Capital’s short-term funding model unraveled spectacularly:

• Margin calls explode:
  In early March, repo lenders, including major investment banks like Merrill Lynch, Citigroup, and Deutsche Bank, issued margin calls, demanding billions of dollars of additional collateral within days.

• Liquidity evaporates:
  Carlyle desperately scrambled to secure financing, but credit markets had effectively closed overnight. With virtually no unlevered cash available, the fund was unable to meet margin calls.

• Forced liquidation:
  Lenders began seizing and selling CCC’s assets to recover funds. Agency MBS were dumped rapidly into the market, causing asset prices to spiral downward. This liquidation exacerbated losses, wiping out equity at extraordinary speed.

By March 12, 2008, CCC admitted publicly that it could not meet margin calls totaling more than $400 million. Just days later, on March 17, the fund filed for liquidation. Its entire $670 million equity capital was effectively wiped out in under two weeks, shocking investors who assumed these AAA-rated securities were bulletproof.

Aftermath and Legal Fallout

The collapse of Carlyle Capital marked one of the earliest and most vivid financial disasters of the global crisis—predating even Bear Stearns’s collapse by days. Its failure highlighted previously underappreciated systemic risks inherent in:

• Reliance on short-term repo financing

• Extreme leverage—even against supposedly "risk-free" assets

• Implicit guarantees (Fannie Mae, Freddie Mac) that did not provide liquidity support

Years of litigation followed, with investors alleging mismanagement, inadequate risk disclosures, and breaches of fiduciary duty by Carlyle management. Lawsuits stretched over a decade, ultimately resolved mostly in Carlyle’s favor, though reputational damage persisted.

Five Repeating Fault-Lines in the 3 Cases

Lessons for Today’s Private Credit Allocators

Post-GFC, BDCs improved their processes to avoid repeating the mistakes of Allied or American Capital. Today’s vehicles focus on originating 1L debt, with much smaller allocations to equity or equity-like instruments. They also make less use of short-term leverage, with management teams preferring to use term debt with maturities many years in the future. Many of the bigger BDCs also make use of CLOs as a financing source, enabling them to avoid mark-to-market triggers on at least a portion of their liability stack.

But while the structures have improved over time—and are less exposed to hair-trigger-sensitive cascading defaults—no amount of tweaking can eliminate the risk of leveraging up illiquid assets.

Indeed, today's market conditions echo certain aspects of the pre-GFC environment: easy financing, generous valuations, and an insatiable appetite for yield. As these cases show, good times often mask underlying vulnerabilities.

For allocators currently evaluating private credit:

• Scrutinize Leverage Terms: Favor vehicles that use stable, long-term financing rather than market-sensitive short-term debt.

• Demand Valuation Discipline: Insist on independent oversight to avoid optimistic marks that inflate returns and conceal risk.

• Monitor Liquidity Profiles: Assess how quickly assets can be liquidated under stress, not just how liquid they appear in bull markets.

• Challenge Concentrations: Look beyond surface diversification metrics. Correlated risks, even in seemingly unrelated sectors, can pile up quickly.

Private credit is robust today—but remembering the lessons from Allied, American Capital, and Carlyle can help allocators spot the cracks before they widen.

Stay tuned for Part 2, where we'll explore more recent blow-ups—and the fresh lessons they offer for private credit investors today.

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