Trends in corporate direct lending 2H24

Executive summary

Returns: Direct lending continues to provide attractive returns, supported by elevated base rates contributing to high, albeit decreasing, gross asset yields. Despite expectations for further moderation in base rates, yields should remain above long-term averages. Middle-market firms’ fundamentals proved resilient with relatively few defaults. This means that realized losses remained low and did not affect returns materially.

Pricing: The spread tightening observed in 2024 may have reached its limit, as GPs are increasingly reluctant to reduce spreads further. Moreover, with base rates already moderating and projected to decline further, spreads may start widening. Historically, spreads have typically compressed during periods of rising or elevated interest rates and widened when interest rates decrease or remain lower.

Fundamentals: Middle-market borrowers continue to demonstrate financial resilience, supported by robust—though declining—revenue and EBITDA growth, which helps cushion the effect of higher interest rates. Key underwriting credit metrics, such as interest coverage ratios and leverage levels, appear to have stabilized.

Defaults: Default rates in the direct lending market remain low at 1.9%, below the long-term average of 2.9%. While modest increases in defaults are expected, recovery rates are expected to remain relatively high, mitigating potential losses.

Volume: Middle-market transaction volumes have normalized after subdued activity in 2023, with further growth expected as interest rates decline and M&A activity accelerates. With direct lenders benefiting from improved deal flow, better pricing terms could be expected going forward.

Relative value: Expected risk-adjusted direct lending returns look very attractive on a relative value basis when compared with other credit markets. The spread over the 10-year Treasury yield remains high, providing a significant buffer against potential market shocks. In contrast, compressed risk premiums in public markets, driven by historically low spreads and high P/E ratios, heighten downside risks.

Macroeconomic environment: Economic growth is expected to normalize in 2025, with US GDP projected at 2% and European growth near 1.5%. Inflation is easing, but structural factors suggest that interest rates will settle at higher levels than in the previous decade. Geopolitical uncertainties, including the potential policies of the incoming US administration, could introduce further volatility and affect economic growth and inflationary pressures globally.

Direct lending market

Direct lenders continue to provide investors with relatively high returns

The strong returns direct lending delivered in 2024 (Figure 1) are largely attributable to:

1. Elevated base rates; and
2. Strong performance by middle-market companies that have successfully managed higher debt burdens and navigated macroeconomic uncertainties over multiple quarters.

Figure 1 | US direct lending quarterly returns

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Source: Cliffwater, as of September 2024.
 

Borrowers in the direct lending market have demonstrated relatively strong revenue and EBITDA growth, providing a cushion against the effects of higher interest rates. This financial resilience has been key in mitigating potential losses, which have remained modest so far.