Direct Lending: Strong Fundamentals, Shifting Dynamics

Direct lending remains fundamentally healthy, but higher rates, AI disruption and widening dispersion are making borrower and sector selection more important.

• Private credit includes assets historically held on bank balance sheets, while direct lending is its sub-investment-grade segment; the direct-lending market now exceeds $2 trillion in AUM.
• Most of the market's growth over the past three years occurred during relatively benign conditions, showing that private-credit expansion is driven by structural borrower and investor demand rather than stress alone.
• Second-quarter revenue growth in the public loan market was about 11% and EBITDA growth about 7%, among the strongest readings in roughly three years; default rates across public and private credit remain very low.
• Technology-sector returns have lagged because investors are reassessing the future competitive advantages of software and technology-enabled businesses, even though current fundamental performance remains broadly strong.
• Three-month SOFR is slightly above 4%, forward rates imply an additional 75–80 basis points over the next three to four years, and current all-in yields on new assets are around 9%; higher labor and input costs may be a greater threat to cash flows than rates alone.
• Apollo says it reduced exposure to the sectors most vulnerable to AI disruption, emphasized diversification, and plans to increase leveraged exposure as spreads widen from post-global-financial-crisis lows.

Takeaway: Investors should focus on downside analysis, diversification and borrower liquidity rather than treating direct lending as a homogeneous asset class; widening spreads may improve entry points, but higher rates and AI-related disruption require selective underwriting.