Credit investing is not only about low default rates but also about achieving adequate returns. These returns must reflect the risks taken and should not decline while risks increase. This is a fundamental rule we follow when making credit investment decisions. However, most credit investors overlook this basic principle.1
In recent years, Direct Lending has become an increasingly popular asset class for investors seeking higher yields outside traditional fixed income markets. The asset class is in high demand as it promises attractive risk adjusted returns, significantly higher than similar risk of other credit sub-asset classes and strong structural protections of the invested capital.2
However, we believe Direct Lending no longer offers the same compelling risk-reward profile that once made it a standout in private credit portfolios. In our view, the tides have started to turn! Direct lending, once the crown jewel of credit investing, is beginning to lose its shine due to two key challenges:
Pricing Pressure from Excess Capital Inflows
The success of Direct Lending has ironically sown the seeds of its current struggles. The significant inflow of capital into the space has led to intense competition among lenders, driving down yields.
Market Expansion: Direct lending (light blue) has seen substantial growth. Assets under management (AUM) by U.S.-based private credit managers reached approximately US$1.7 trillion in 2023, up from US$725 billion in 2018. During the same period, the broadly syndicated loan market BSL (blue line in chart below) reached a peak of US$1.4 trillion in September 2022 before experiencing a slight decline in 2023.3
Private Credit’s Ascent Has Generally Not Come at the Expense of Broadly Syndicated Loans
Growth in private credit and broadly syndicated loan markets (US$ billion)
Spread Compression: In a recent conversation4 with a very reputable U.S.-based Direct Lending manager, the dilemma became clear as they mentioned pricing trends in their evolving deal flow. A typical Uni-Tranche Direct Lending deal 24 months ago would pay SOFR+700 basis points (bps) while today the same deal only pays SOFR+425bps or 450bps. That is substantial price erosion.
English 
German