Key Takeaways
- • UBS maintains a Neutral stance on direct lending, citing balanced but moderate risk-return prospects in the near term amid rising concerns over AI disruption to legacy software companies and elevated defaults among lower-middle-market borrowers.
- • Private credit default rates have diverged sharply by borrower size: Fitch data shows Q4 2025 default rates of 11.7% for companies with EBITDA below $25 million versus 2.4% for those exceeding $100 million, with 2021-22 vintage loans accounting for approximately half of new non-accruals in 2025.
- • UBS recommends investors with overallocations to direct lending consider rebalancing toward senior, sponsor-backed, upper-middle-market loans in non-cyclical sectors, which have demonstrated greater durability under late-cycle conditions.
- • Alternative asset diversification is advisable for those seeking to reduce direct lending concentration, with recommended alternatives including private infrastructure, quality bonds, low-correlation hedge funds, or selective reduction in high-yield credit and equity exposure.
- • Several evergreen direct lending funds have implemented redemption restrictions to preserve asset values, signaling structural stress within segments of the private credit market.
Summary
UBS's Chief Investment Officer has adopted a Neutral outlook on direct lending, cautioning that while the asset class continues to offer long-term yield and diversification benefits, the near-term risk-return profile has become increasingly balanced and returns are likely to be more moderate. This reassessment reflects several emerging headwinds pressuring private credit markets as of May 2026.
The primary concerns center on loan quality deterioration and sector-specific disruption risks. AI developments pose a competitive threat to legacy enterprise software companies that have received direct lending financing. More acutely, default and non-accrual rates have risen substantially among lower-middle-market borrowers, particularly those with loans originated during 2021-22, a vintage cohort that accumulated exposure during favorable lending conditions and is now struggling under the interest rate environment. According to Fitch data referenced by UBS, the default rate in Q4 2025 reached 11.7% for companies with EBITDA below $25 million, compared to only 2.4% for those above $100 million. Approximately half of new non-accruals recorded in 2025 came from the 2021-22 vintage loans, underscoring their vulnerability to rate increases implemented in 2022-23. Structural stress is evident in the market: several evergreen funds have restricted redemptions to protect asset valuations.
In response to these late-cycle dynamics and an increasingly bifurcated market, UBS has recommended since September that investors adopt a more selective approach. Those biasing exposure toward direct lending should prioritize funds focusing on senior, sponsor-backed, upper-middle-market loans in non-cyclical sectors, which have proven more resilient. For investors with overall overallocations to direct lending, UBS suggests broader diversification across alternative asset classes, including private infrastructure, alongside hedging strategies or portfolio rebalancing away from high-yield credit and equities toward quality bonds or low-correlation hedge funds. This tactical reallocation is intended to balance portfolio risks amid persistent macroeconomic uncertainty.
The primary concerns center on loan quality deterioration and sector-specific disruption risks. AI developments pose a competitive threat to legacy enterprise software companies that have received direct lending financing. More acutely, default and non-accrual rates have risen substantially among lower-middle-market borrowers, particularly those with loans originated during 2021-22, a vintage cohort that accumulated exposure during favorable lending conditions and is now struggling under the interest rate environment. According to Fitch data referenced by UBS, the default rate in Q4 2025 reached 11.7% for companies with EBITDA below $25 million, compared to only 2.4% for those above $100 million. Approximately half of new non-accruals recorded in 2025 came from the 2021-22 vintage loans, underscoring their vulnerability to rate increases implemented in 2022-23. Structural stress is evident in the market: several evergreen funds have restricted redemptions to protect asset valuations.
In response to these late-cycle dynamics and an increasingly bifurcated market, UBS has recommended since September that investors adopt a more selective approach. Those biasing exposure toward direct lending should prioritize funds focusing on senior, sponsor-backed, upper-middle-market loans in non-cyclical sectors, which have proven more resilient. For investors with overall overallocations to direct lending, UBS suggests broader diversification across alternative asset classes, including private infrastructure, alongside hedging strategies or portfolio rebalancing away from high-yield credit and equities toward quality bonds or low-correlation hedge funds. This tactical reallocation is intended to balance portfolio risks amid persistent macroeconomic uncertainty.
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