Over the past decade, private credit lending fuelled a striking growth of software and SaaS (software as a service company). Software and technology now represent one of the single largest sector concentrations across both private credit portfolios and publicly traded business development companies (BDCs). Many of these deals were struck during a time of peak valuations, in the immediate aftermath of the COVID-19 pandemic. They are now under scrutiny, as developments in the artificial intelligence (AI) space lead some investors to question whether we are on the cusp of another ‘Dot-Com bubble’, where investments in infrastructure by tech firms are vulnerable to being leapfrogged by newer technologies. After a series of high-profile defaults, some borrowers are under pressure from narrowing margins, deteriorating interest coverage, and increased use of payment-in-kind mechanisms, while valuations have compressed and venture capital funding has moderated.
Clearly, there is a vital need for selectivity and due diligence, but also substantial opportunity. How can investors navigate this environment; and aim to avoid the pitfalls but capture the upside? We address this in our manual for markets, below.
Beyond the headlines: today’s default landscape
Leveraged loan defaults are often used as a proxy for private credit defaults, because private credit data is notoriously fragmented, delayed and hard to consolidate. Currently, payment defaults in the leveraged loan market sit below the long-term average of around 2 %, compared to the broader universe’s 20-year average. In this space, definitions matter. Some data providers include distressed exchanges under ‘defaults’, which pushes rates to around 5%. But even that figure peaked in 2024 and has since declined.
Figure 1: Devil’s in the detail; recent defaults with and without distressed exchanges
Source: Pitchbook; LCD. LSTA leveraged loan index data, as of 30 April 2026. Past performance is not indicative of future results.
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What’s more, the choice of methodology is critical to understanding the full picture – and making sense of recent negative media coverage. Not all default rates are created equal, as some market participants include soft defaults such as covenant, or distressed exchange activity as a default. We think this leads to many headline defaults being misattributed to direct lending. High-profile cases may involve large-cap broadly-syndicated-loan (BSL) borrowers, asset-based lending structures, or non-sponsored companies — not the sponsored middle-market deals that constitute core direct lending. It's important to distinguish between defaults and losses as the two are not synonymous. A comparison of the Cliffwater Direct Lending Index (CDLI) — a proxy for middle market direct lending — against the JPMorgan broad leveraged loan and high yield bond indices illustrates how recovery rates, not just default rates, might shape the investor experience.
Over the last 21 years, leveraged loans and high yield bonds have posted average default rates of 2.32% and 2.19%, respectively — broadly comparable to middle market lending. Yet their credit loss profiles diverge meaningfully once recovery rates are applied. Leveraged loans benefited from an average recovery rate of 59%, reducing gross defaults to a net credit loss of 1.01%. High yield bonds fared worse on recoveries — averaging just 41% — translating to a higher net loss of 1.45%. Middle market direct lending, as measured by the CDLI, delivered a broadly similar average credit loss of 0.99% over the same period, despite the absence of the public market liquidity.
Periods of stress are particularly instructive. In 2009, leveraged loan default rates spiked to 12.80%, but a recovery rate of just 48% meant net losses of 6.62% — while the CDLI registered 6.91%, suggesting broadly comparable downside even in severe dislocation. More revealing, however, is the post-2021 experience: recovery rates on leveraged loans have compressed sharply, averaging just 44% in 2024 against a long-run average of 59%, as the broadly syndicated market has seen progressive covenant erosion and weaker structural protections. Middle market direct lending, by contrast, retains the lender-friendly features — tight covenants, first-lien security, board observation rights, and direct borrower relationships — that give lenders both early warning of credit deterioration and meaningful influence over workout outcomes. It is precisely these protections that may potentially support recovery rates when defaults do occur, and help explain why middle market credit losses have remained relatively contained even as broadly syndicated recoveries have deteriorated. According to S&P’s historical default and recovery data, there is almost a 10% difference between term loan recoveries with covenants and those without (Figure 2). In an environment of tighter financial conditions, the structural integrity of the loan documentation may prove as important as the default rate itself.
Figure 2: Under the hood, loan recoveries on leveraged loan segments
Source: S&P Global Ratings; Default, Transition, and Recovery Study, as of 17 December 2025. Past performance is not indicative of future results.
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Lastly, valuation markdowns have historically exceeded actual realised losses by 1.7–2.5 times, indicating conservative mark-to-market practices — meaning the ‘unrealised loss’ numbers the media focuses on may overstate actual economic damage.
Investing in the future
What should investors keep top-of-mind when approaching this space in the future?
1. Selectivity is key: there is more to private credit than software and AI
AI and technology disruption currently dominate the discussion about private credit, but the opportunity set is significantly wider than just those two sectors. Technology and AI-related borrowers represent only a fraction of the middle market direct lending universe — roughly 20% by some estimates1 — so over three quarters of the market sits entirely outside the sectors currently generating the most anxiety. Investors who allow the headline risk to colour their entire view of the asset class may be missing compelling openings.
2. Concentration is a real problem – but not all the market is equally at risk
The risk is not trivial: in a scenario where AI tools accelerate the commoditisation of software functionality, revenue assumptions underpinning many of these loans could prove optimistic. Stress in the asset-light SaaS model is particularly concerning from a credit perspective, as recoveries in a distress scenario may be materially lower than for businesses backed by hard assets.
Figure 3: Tech deals favoured upper end of market
Source: KBRA DLD Research.
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What's more, the stresses are beginning to surface. Covenant default rates have risen, payment-in-kind activity has increased across the sector, and several retail-facing private credit vehicles have faced redemption pressure. The market is moving from a broadly supportive "rising tide" environment to one characterised by growing dispersion — and software-heavy portfolios are feeling it first. In particular, the core middle market is less exposed versus the upper middle market (Figure 3).
3. Opportunity in the ‘old economy’
The converse of the concentration risk we’re seeing is the relative value available elsewhere in the market. Businesses anchored in the physical economy, with stable recurring demand, and limited technological disruption risk — what some have termed "hard asset, low obsolescence" businesses — look increasingly attractive on a relative basis. Healthcare services, industrials, business services, food and beverage, distribution, and infrastructure-adjacent sectors represent a substantial share of middle market borrowers and can offer the kind of fundamental credit quality that typically underpins durable lending returns.
These ‘old economy’ borrowers are not immune to macro pressures like rising input costs, tariffs, and tighter financial conditions, but their credit risk can be analysed through traditional frameworks. Cash flows are tangible, assets provide genuine recovery support, and the competitive dynamics are well understood. For disciplined lenders willing to do the work, this segment offers fundamental value that the current AI-dominated narrative is leaving underappreciated.
4. Not all software is equally exposed
A nuanced approach is equally important when assessing the tech and software portion of the market. The key distinction is between businesses that are deploying AI to enhance and entrench their competitive position versus those whose core product is being displaced by it. Mission-critical enterprise software with deep customer integrations, high switching costs, and strong pricing power is a different credit proposition than a point-solution, commoditised SaaS product.
Put simply: not all software will face existential disruption, and indiscriminate avoidance of the sector is as much a mistake as indiscriminate concentration within it. The question is whether the borrower is ahead of the curve on AI adoption — using it to widen its moat — or behind it, facing margin pressure and customer attrition.
5. Look under the hood: first- and second-order
Perhaps the most important implication for investors is the need to look beyond headline sector labels. A portfolio may report limited direct exposure to software, but second-order exposures can be equally significant. A business services company whose primary customers are private equity-backed SaaS firms, or a staffing business reliant on technology sector hiring, may carry substantial indirect exposure to AI disruption. Similarly, a company reliant on a single software tool for its own operations may face cost or operational risk if that tool's vendor comes under pressure.
Rigorous due diligence must therefore extend beyond the borrower's own income statement. Understanding customer concentration, supply chain dependencies, and the technology stack embedded in a business model is now an essential component of credit underwriting, not an optional overlay.
For structured debt, funds tightening underwriting could include more stringent coverage tests, more conservative loan-to-value ratios on new acquisitions, and less appetite for hyper-growth structures with negligible earnings before interest, taxes, depreciation, and amortisation (EBITDA).
Flows and the client perspective
The middle market lending investor universe is far from uniform, and different segments show varying levels of exposure, but also sensitivity, to recent events. How have the AI headlines affected diverse investors, and which parts of the market may stand to gain from recent events? Here, we examine the position from a client perspective.
1. Retail exodus has dried up capital, but not much
Liquidity concerns are primarily coming from retail flows out of BDCs and interval funds. Activity within this section of the market is more influenced by the news cycle, and now comprises just under 20% of direct-lending assets.2 As this money exits the market, we anticipate that dispersion will potentially create investment opportunity.
2. Larger institutions have a will and a way
In contrast to their retail counterparts, larger institutions continue to have strategic allocations to private credit and direct lending, a trend we don’t expect to see waning anytime soon. Over 50% of capital raised in 2024 was led by this segment of the market.3 Those with institutional capital may have the flexibility to invest throughout the market cycle and take advantage of capacity as it opens up.
3. Standards have suffered to maintain deployment
As capital has poured into the market since 2024, consistent deployment has become one of the main metrics for allocators, and some BDCs have raced to keep up with the targeted levels of fund leverage (debt to equity). Against this backdrop, it has been challenging for some to maintain underwriting standards. Some peers have been a victim of their own success, loosening lending criteria and reducing diversification to maintain deployment.
4. Refocusing on ‘core’
In recent years, we have seen a lot of investor focus on the upper middle market and BSL market due to perceived safety in size.
After the BSL market reopened in mid-2025 after it effectively froze during the tariff turmoil of April 2025. Larger borrowers exploited the glut of yield-chasing money available by playing off BSL and upper middle market direct lenders. This led to a race to the bottom for upper-middle-market credit spreads, alongside continuous threats to lender security as covenant-lite or loans without covenants grew in popularity. This was compounded by elevated levels of debt in this portion of the market, and greater latitude for borrowers to defer interest payments or add more leverage.
Conversely, in the core middle market, many deals maintained key covenants, such as net leverage ratios. This devolves greater control to lenders, as well as the ability to collaborate with borrowers and sponsors to anticipate defaults, insolvencies and other restructuring events.
We are now seeing institutional investors refocus attention on the core middle market given the protections outlined above, as well as stable fundamentals.
5. New investors have spied the opportunity set
More nascent client markets for direct lending increasingly view the core middle market as a natural entry point versus the upper middle market, given the domestic focus of holding companies and the greater protection afforded. The attributes that originally drew investors to direct lending – solid covenants, lender safety and solid fundamentals – have proven more durable in the core middle market.
Conclusion: back to basics
In all areas of this market, it’s imperative to look beyond the surface. This includes: parsing the varying definitions of defaults, culling the software companies that could be negatively or positively impacted, searching for other sources of alpha in the rest of the market and digging into possible second-order effects on sectors that may have otherwise seemed immune to the primary risks.
Due diligence should be the order of the day for investors. Insisting on covenants, capital structure superiority and robust coverage ratios mean a return to the core fundamentals of private credit investing. In our view, this more traditional opportunity set is more readily captured in the core middle market.
1. Source: Pitchbook – “Peek under the Hood: An analysis of private credit loans in top public BDCs”, 28 April 2026.
2. Retail Outflows in Private Credit Funds to Continue - Traders Magazine
3. Private Credit Laws and Regulations 2026 | USA
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