Weighing in on Direct Lending

Today, the case for investing in direct lending is not only strong on a structural basis but especially timely, reinforced by interest rate dynamics, recovering deal activity, M&A demand, and the potential risk of a pick-up in public market volatility. Taken together, we believe these forces present a potentially compelling moment for capital allocation to direct lending.

Direct lending, the direct, illiquid loans made to middle market companies, is the largest strategy within private credit. It has experienced impressive growth in recent years and now represents about $1 trillion in gross value.¹ For investors seeking yield, diversification and downside protection, direct lending offers a potentially compelling opportunity in an uncertain backdrop. For these reasons, direct lending has become a core strategy within a fully diversified portfolio that combines private and public investments.

An improving supply-demand environment

A more deal-friendly environment is emerging as private equity managers, who previously slowed their deployment of “dry powder” due to higher interest rates and an inability to make returns work for their investors, are now poised to capitalize on a robust M&A recovery driven by renewed Fed rate cuts and improved tariff clarity. This environment is reinforced by a significant refinancing wave, with $475 billion² in middle-market loans coming due in the next seven years, creating substantial demand for private equity and direct lending. As these factors gradually unfold over the next 24 months, direct lenders may experience improved pricing power and the potential for excess returns.

Resilience across a "higher-for-longer" rate environment

Across various economic cycles, direct lending has consistently demonstrated an ability to generate attractive returns. Direct lending’s resilience in different economic environments is due, in large part, to its floating-rate structure which offers protection against interest rate movements and inflation. Even in moderately declining rate environments, private credit strategies have delivered attractive returns, and over the last decade, they have delivered the highest returns per unit of volatility of all private asset classes, outpacing real estate, infrastructure, venture capital and private equity.³

An improving credit outlook

Lower interest rates could benefit a direct lending borrower’s credit profile by reducing floating-rate interest expenses, all else equal. While macro uncertainty remains on the horizon, recent evidence suggests that direct lending default rates, including restructurings,  have declined modestly falling below 4% for the first time in two years.⁴ In addition, the credit quality of middle-market companies has been stable, as evidenced by rising EBITDA to interest coverage ratios.

For a deeper exploration of these findings, please read the full-length insight:

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1 Source: PitchBook. As of March 31, 2024.
2 Source: LSEG, PitchBook LCD, Morgan Stanley Investment Management. As of June 30, 2025. U.S. only.
3 Source: PitchBook, Morgan Stanley Investment Management. For the ten years ending March 31, 2025.
4 Source: PitchBook LCD, S&P Global. As of June 30, 2025. U.S. only. Direct lending default rate is based on S&P’s universe of middle-market companies receiving “credit estimates” and includes distressed exchanges as a default event.

Definitions:

(EBITDA) Earnings Before Interest, Taxes, Depreciation and Amortization is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.

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