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Scaling advantage in a tight market
Key Points
- Investor demand remains stable across individual and institutional channels.
- Private credit can do well in a shallow rate cut environment that spurs a credit quality recovery.
- A “higher for longer” M&A cycle may shift supply and demand in favor of private credit lenders more quickly than industry observers appreciate.
We expect new deal demand and a large refinancing wave to gradually overtake private credit supply... allowing lenders to preserve discipline, strengthen terms, and capture the illiquidity premium to public markets.”
What We Are Seeing
Private credit continues to attract capital at a healthy clip, especially among individual investors who have gained access to the strategy for the first time. Semi-liquid vehicles for the wealth channel now command almost a third of the $1 trillion US direct lending market.1 Institutional demand is also robust. Flows to private credit CLOs have captured 20% of that market as new issuance easily eclipsed last year’s record volume.2
Private credit has retained its broad appeal in no small part due to lingering inflation fears, even as yields and coupons decline. As we enter 2026, inflation remains sticky, having exceeded the Fed’s 2% target for five consecutive years3. We believe that goal will elude policymakers for at least another year. Private credit’s performance while inflation raged and then slowly receded in recent years has kept investors engaged.
The year ahead promises more in the way of shallow US rate cuts. That is an environment in which private credit may deliver attractive returns, as demonstrated during the first leg of mild cuts in 2024.4 We believe asset yields on directly originated first lien loans will trough in the 8.0% to 8.5% vicinity in 2026 even after factoring in a slight compression in spreads. That is still elevated by historic standards, leaving yields in the upper half of their 12-year range.5
What We Are Doing
Our approach to private credit in 2026 is defined by a combination of scale, breadth, selectivity, and structural innovation, leveraging the full breadth of the Morgan Stanley ecosystem and a disciplined investment process across our various strategies.
In direct lending, new investment commitments have focused on senior secured loans to high-quality, sponsor-backed middle market companies with a defensive bias toward non-cyclical sectors like software and business services. We maintain a significant underweight to healthcare, which has led all sectors in loans placed on non-accrual status over the last year.6
In our more solutions-oriented credit strategies, we are working closely with management teams and sponsors to support growth, capital structure optimization, and strategic M&A, where an uptrend is now firmly in place. In 2026, we expect M&A to broaden and create more exit opportunities for mid-sized private companies, and the cycle to last longer than what is generally appreciated. Given that as a backdrop, combined with a growing backlog of long-tenured unsold companies, we believe that hybrid capital solutions will likely continue to attract investor focus and sponsor demand.
Over time, we expect new deal demand together with a large refinancing wave to gradually overtake private credit supply, creating an imbalance that allows lenders to preserve discipline, strengthen terms, and capture the illiquidity premium to public markets. Industry consolidation further tilts the balance toward scaled platforms with the sponsor relationships, origination capacity, and underwriting rigor to lead in this environment.
What We Are Watching
Barring any unforeseen macro shock or recession event, the combination of declining interest expense and rising EBITDA levels should support improving fundamentals among private credit issuers. We see this in our portfolio and in recent industry data that track borrower stress. Fully loaded default rates, inclusive of restructurings, have trended lower in recent quarters, as have non-accrual rates in seasoned BDC portfolios (Display 1).
Meanwhile, EBITDA-to-interest coverage ratios have moved modestly higher, with the mean consensus forecast calling for an EBITDA rebound among leveraged loan borrowers over the next four quarters.7 We expect mid-sized private companies to participate fully in an EBITDA recovery, especially those with ample PE backing and resources who are pushing portfolio companies out on the AI adoption curve.
Trailing 12-Month Default and Non-Accrual Rates
Trailing 12-Month Default and Non-Accrual Rates
Display 1
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