Setting the US private credit record straight: Opportunities in direct lending

US private credit: Myth versus reality

After basking in the investment limelight for the last few years, US private credit has come under scrutiny in recent months in the wake of the collapses of First Brands and Tricolor. Yet, in our view, doubts over lending standards and transparency are misplaced, plus neglect to consider both the differentiating features and significance of this maturing asset class.

In short, the two transactions making headlines are part of the broadly syndicated loan space – not true private credit.

More specifically, the First Brands transaction involved off-balance sheet factoring and trade finance, which allegedly may have allowed the company to pledge the same collateral more than once. Tricolor, which was an asset-based lending structure and not middle market direct lending, may have also double-pledged auto loans that were funded with a form of factoring or securitisation.

The contrast with lower and core middle market direct lending is stark. For lenders to these segments of the middle market, for example, documentation is much tighter. The borrowers also tend to be more domestically focused and don’t require trade financing or other forms of factoring. Further, lenders have access to the management teams of the business being underwritten and significantly more data from the borrower and third parties.

As a result, middle market direct lending has evolved into a core component of the US private credit landscape. Healthy fundamentals, diversification across industries and the potential for attractive risk-adjusted returns underpin its institutional appeal. For investors able to accept its relative illiquidity and complexity, direct lending offers a compelling way to generate income and capture private-market growth in an increasingly yield-constrained world.

Even more notable about the distinction, many private credit players say they didn’t finance First Brands and Tricolor due to the weaker underwriting standards in that part of the market.

A growth engine for portfolios

Middle-market companies, typically defined as companies generating EBITDA of around US$5 million to US$100 million, account for roughly 44% of US GDP. With so much influence in the domestic economy, middle market companies increasingly prefer working with direct lenders rather than  seek broadly syndicated loan or public high-yield bond financing. And, the mature and expanding direct lending market remains primarily first lien senior secured, but also spans to non-senior lending such as second lien and mezzanine loans.

For investors, the asset offers income potential via consistent cash flow, diversification benefits given relatively low correlation to public credit markets, and liability-matching capabilities.

Inevitably, there are some structural risks, such as periods of illiquidity. Yet credit discipline enables direct lending to enhance portfolio yield, provide downside protection and serve as a stable, income-oriented allocation through changing market environments. Historically, middle market direct lending has weathered uncertain market and economic conditions much better than the broadly syndicated loan market and public corporate high yield, delivering a higher return while experiencing significantly less draw down and a lower default rate.

In addition, as the market deepens, disciplined underwriting and thoughtful portfolio construction have become key to realising its potential benefits. The strong risk-adjusted returns of the past were realised when middle market direct lending consistently required good credit structures with meaningful covenants.

As the market grows and larger upper middle market deals or large cap private credit (beyond middle market size) deals become more like broadly syndicated loans or public high yield bonds with covenant lite features and greater leverage, investors should consider risks associated with the market evolution.

Five features helping direct lending pay off

Increasingly, robust middle market direct lending strategies are the result of transactions that achieve several features:

• Targeting companies in the lower to core middle market with EBITDA typically between US$5 million and US$50 million, which are often sponsor-backed (private equity-owned) borrowers along with many non-sponsored opportunities.
• Emphasising conservative leverage and robust covenant protection along with active lender portfolio monitoring, which are common in the lower and core middle market.
• Primarily investing in first-lien senior secured and unitranche loans, with selective exposure to second-lien or mezzanine positions.
• Focusing on defensive, cash-generative sectors, such as healthcare, business services and technology-enabled industries.
• Diverse and unique loan origination leveraging deep partnerships with leading middle market private equity sponsors as well as many sources for non-sponsored loan opportunities including direct engagement with borrowers.

Finding the next opportunity in direct lending

Despite misperceptions of US private credit, the outlook for middle market direct lending looks promising for 2026.

We see borrower demand continuing to rise as middle-market firms favour private, relationship-based financing over traditional bank channels.

Within this universe, the opportunity set is diversifying. Non-bank lenders are gaining market share due to their ability to offer speed, flexibility, and low-amortising structures that free up company cash flows for reinvestment. As a result, deal flow is expanding, now also originating from both private-equity sponsor and non-sponsor channels.

More specifically, companies attracting new capital are those which are growing, generating stable cash flows and operating in industries that are not overly sensitive to swings in sentiment or economic conditions. These are typically durable, essential businesses in industries, such as healthcare, accounting and legal services, as well as maintenance-based businesses across HVAC (Heating, Ventilation, and Air Conditioning) plumbing, electric, auto repair, landscaping, and many others.

At the same time, lending opportunities continue to expand across the software and technology sector as middle market companies deliver products and services essential to their customers.  New opportunities are also emerging across technology-linked sectors as consumers and businesses are increasingly investing in automation, IoT (Internet of Things), and AI (artificial intelligence) tools.

At the same time, capital flows are also finding their way to businesses which enhance the efficiency of ageing utilities, power grids and the data-centre ecosystem.

A different type of market

In reality, various market indicators suggest middle market direct lending remains healthy, with underlying borrowers performing well on average.

With new transactions generally being funded at reasonable levels of leverage, and typical loan-to-values below 50%, investors need to see the landscape through an untarnished lens.

In fact, misperceptions such as recent headlines have also enabled middle marker direct lending deals to reinforce their differentiation – in terms of their greater scrutiny over structure, more covenants, and a sharper focus on borrower transparency and ownership.

Principal is a global private markets manager with over US$601.5 billion in assets¹ and 50+ years of private credit experience. Click here to read more about Principal Alternative Credit.
 

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