Direct lending has exploded in recent years, boosting competition and putting pressure on pricing. 

The growth of private credit has been largely driven by direct lending’s ability to replace bank debt, having grown substantially over the past 15 years. Direct lending made up just nine per cent of the private credit sector in 2010, according to Pitchbook data, but this has since swelled to 36 per cent – the largest subset of private credit, and more than asset-based and distressed debt combined. The overall private credit industry is anticipated to hit $2.3tn in size by 2028, from $1.8tn at the end of last year, and direct lending is widely expected to help lead this charge.

Direct lending is seen as the ‘bread and butter’ of the private credit industry, in the same way that leveraged buyouts are often synonymous with private equity.

“A considerable amount of capital continues to be raised in direct lending, particularly within the perpetual, private business development company structures.”

The wider macroeconomic climate has been supportive of this. Market uncertainty has created increased volatility in public markets, with more investors shifting away from public fixed income and towards private credit. Private credit’s lack of vulnerability to macroeconomic swings has helped the asset class to grow according to Mark Wilton, head of European investments at Corinthia Global Management.

“This inherent stability has allowed the asset class to perform well and grow during challenging times, such as the Covid-19 pandemic, the Russia/Ukraine conflict, and the aftermath of the financial crisis,” adds Wilton. “Uncertainty in broader markets can, in fact, present opportunities for private credit.”

Despite the continued optimism around direct lending, spreads have been steadily declining since 2023 according to KBRA data. There are mixed opinions as to whether spreads will continue to tighten this year.

“Generally we have seen spreads compress in public markets and, as that market tightens, so does the private credit market,” reflects Stuart Mathieson, head of European private credit and capital solutions at Barings.

“Typically around 200-250bps of spread premium has been maintained but absolute spreads themselves have come down. Another factor is that the number of new platform opportunities, driven by primary LBO activity, have been quite low. This has driven more competition on some transactions.”

Fitch Ratings’s Neenan sees spreads as “close to bottom,” and points out how 2024’s backdrop of intensifying competition and sparse M&A deal flow led to spreads tightening. Though the conditions remain the same she argues there “is only so far” that spreads can go.

In agreement is Will Sheridan, partner in the finance group at Travers Smith, who says that direct lending firms are having to respond to market conditions.

“The trend of sponsors re-pricing large cap deals in 2024 has since filtered down to the middle market, and we are seeing credit funds reduce margin significantly in order to stay in deals,” says Sheridan. “Given the liquidity available in private credit and the pressure to deploy, it is hard to see the recent downward pressure on pricing fading away anytime soon.”

Intensifying competition has placed a premium on tried-and-tested managers, and Kort Schnabel – partner and co-head of US direct lending at Ares – points to this favouring the bigger firms.

“Often the larger and longer tenured private credit managers have global origination platforms, better due diligence capabilities and in-house portfolio management teams,” says Schnabel. “Couple this with the significant market opportunity and the trend of LPs consolidating their GP relationships, it’s only natural that you see the larger funds with strong track records still growing.”

Scale is key, according to Barings’ Mathieson who points to the sheer challenges of trying to become organically established as a direct lending firm.

“To be successful in private credit, you need a big team of people, scale and incumbency, and scale isn’t just about inhouse resources but means having a large and diverse capital base,” says Mathieson. “I don’t tend to view newcomers in the space as our primary competition in the sense that at an entry-level point you need to be able to write sizeable business.”

Mathieson knows first-hand about the intensifying competition in the space as Barings lost 22 members of its private credit team in 2024 to new direct lending specialist Corinthia. The Barings team has since become “fully resourced” but the episode shined a spotlight on the fierce battle for talent in the direct lending space, and raised the question of how new entrants can gain a foothold in a crowded market.

“It is not sufficient for new entrants to simply participate; those without a compelling plan will struggle to gain traction,” says Corinthia’s Wilton. “Demonstrable access to hard-to-reach markets and a well-articulated reason for existence are essential for standing out and commanding market share.”

Meanwhile, Adelbert Garcia, managing director of the investment team at NorthWall Capital, says newcomers need to target underserved areas. Here, he points to the background of narrowing spreads as a natural backdrop for newcomers to use specialist and novel approaches to prove their worth.

“We see a compelling opportunity to service quality borrowers overlooked due to their size,” says Garcia. “In these underserviced lower middle market borrower segments, more disciplined underwriting and robust documentation can underpin attractive risk-adjusted returns.

“Experienced managers can achieve compelling risk-adjusted returns by capturing complexity premiums and focussing on broader private credit strategies beyond vanilla direct lending.”

Industry stakeholders are broadly positive about direct lending’s prospects but some are looking beyond the eye-catching figures to what needs to happen next. Bevis Metcalfe, partner of private credit and restructuring at law firm Cadwalader, says direct lending is “unquestionably” here to stay but that it is now time for managers to prove their worth as more flock to the space.

“That all boils down to the credit basics and staying disciplined – in terms of structuring, documentation and underwriting,” adds Metcalfe. “That discipline was probably less evident in a more benign economic environment that prevailed pre-2022, but in today’s markets it’s what will drive successful deployment.”

Private credit may be less susceptible to macroeconomic shocks than public markets, but there is a consensus that many direct lending providers have not been thoroughly tested yet. Several metrics, such as the Proskauer Private Credit Default Index, indicate a muted default landscape but should this return, Corinthia’s Wilton expects a skewed response among direct lenders.

“The lower mid-market and micro-business segments are particularly vulnerable to defaults,” says Wilton. “However, high-quality managers with strong market access and prudent selection processes, especially in the mid-market, where portfolios are often unique and less prone to overlap, are well-positioned to maintain solid performance and demonstrate the value of their differentiated approach.”

Additionally, James Charalambides, head of European private credit at Adams Street Partners, points to a wide delta in fixed income after the financial crisis, which puts fresh scrutiny on direct lenders’ models.

“This ultimately comes down to the manager’s ability to be selective – what you will see is the managers that are the most selective will continue to perform like they have, and others will see materially worse performance,” says Charalambides.

“To be selective as a manager, you need a few things to be true: firstly, your opportunity set needs to be much larger than the pools of capital you have to invest; secondly, you need to have a right to win the deals you chose; and thirdly, you need to have a credit intensive investment culture.”

Direct lending has rapidly grown to be a significant driver of private credit, with competition continually intensifying for market share. After a stellar few years, the question is how the industry will perform amid an impending rise in default rates and ever-squeezed margins. Rockier conditions could unveil just how selective managers have been – or have not been – in the race for business.