Direct Lending: Separating Signal from Sentiment

A Q&A with Michael Occi, Jeff Day & Christopher Remington

Direct lending enters 2026 with a notably supportive backdrop, underpinned by firm monetary and fiscal policy, deregulatory tailwinds, easing inflation, ample liquidity, and solid earnings. Despite recent volatility, 2025 featured healthy credit fundamentals and strong issuance in private direct lending. AI-related headlines have introduced fresh uncertainty, particularly among software borrowers, but much of the recent volatility appears sentiment-driven. In this Q&A, the North American Private Credit investment team cuts through the noise and outlines why they believe disciplined capital deployment, deep sponsor relationships, and a defensive focus on the middle market position their platform well for the year ahead.

Topics of Discussion:

• Direct Lending Market Update
• Soft, Where? AI & Implications for Software
• Investment Strategy & Positioning
   

Direct Lending Market Update

Q: How would you describe the direct lending environment as we enter 2026

Christopher Remington:
We come into 2026 with a constructive backdrop, even if recent volatility in public markets has drawn attention. Through the end of 2025, equities and credit markets were signaling stability—tight spreads, resilient earnings, and strong private credit issuance. More importantly, we believe the underlying macro forces have remained supportive.

Monetary easing has stabilized, which reinforced borrower credit metrics while sustaining attractive floating rate income for lenders. Fiscal dynamics continue to provide meaningful support through elevated deficits and ongoing public investment, helping underpin corporate earnings. We are also seeing early signs of deregulatory momentum, particularly around capital formation and financial intermediation, which tends to benefit private markets over time.

Against that backdrop, we believe that direct lending continues to offer compelling advantages for investors compared with public markets. Higher spread premiums, generally lower mark-to‑market volatility, and limited exposure to duration and curve risk are especially attractive in today’s environment.

Q: Activity levels were strong last year. What stands out as we look ahead?

Michael Occi:
2025 was one of the strongest years for private direct lending issuance on record. While activity moderated modestly in the second half of the year, that reflected normalization following a period of rapid growth rather than a sharply weakening demand picture. Sponsor and borrower sentiment has been improving as the policy backdrop became more certain, rate volatility has eased, and private equity dry powder remains elevated.

We’re seeing momentum across several fronts, including sponsor-led refinancings, LBO activity, and early signs of a pickup in exits. Many companies extended maturities during the rate hiking cycle, which gave them flexibility. With greater visibility into the rate environment, those borrowers are now reengaging the market. Taken together, we believe this looks like the early stages of a multi-year expansion in deal supply.

Q: How should investors think about the role of direct lending in portfolios today?

Christopher Remington:
This is a particularly important question in the current environment. With inflation still elevated, traditional portfolio construction has become more challenging. One of the key dynamics that investors are navigating is that stocks and bonds tend to move together when inflation sits above 3%, reducing the diversification benefits investors have historically relied on.

At the same time, longer term interest rates face upside risk driven by large fiscal deficits, heavy Treasury issuance, and reduced foreign participation. That creates challenges for fixed rate bonds with meaningful duration exposure.

We believe that direct lending sits in an attractive position within this context. Floating‑rate coupons can help preserve income as base rates remain elevated. Low duration reduces sensitivity to rate volatility. And because private loans are not marked to market daily, return profiles tend to be far more stable. We view direct lending as a core component of the alternatives allocation and a complementary extension of traditional fixed income, emphasizing income, capital preservation, and diversification.

Q: How are borrower fundamentals holding up?

Jeff Day:
Borrower fundamentals remain relatively stable and have improved in many cases. What we have seen is that earnings growth has been resilient, margins have held up, and leverage levels have remained manageable. The reduction in base rates and some of the spread contraction that occurred over the past couple of years has resulted in increased borrower liquidity and improved interest coverage ratios across our core middle market exposure. Loan-to-value ratios generally remain in the 40% range, providing meaningful insulation for senior secured lenders.

Where stress exists, it has been idiosyncratic rather than systemic. Pressure tends to concentrate in specific business models rather than as thematic pressure across entire industries. Our borrowers are commonly able to afford capital structures that result in a strong ability to pay our principal and interest in cash. This is different than the lower middle market where PIK usage has been more prevalent.

Q: What are you seeing on the demand and technical side?

Michael Occi:
Demand for direct lending remains strong across institutional and retail channels alike. While non‑traded BDC flows moderated somewhat late last year, they remained positive, and redemption requests have been met without forced selling. That’s an important validation of these structures and reflects prudent liquidity management across the industry.

The growth of alternatives allocations in client portfolios appears to have continued momentum. The democratization of direct lending and other asset classes has extended through product development efforts and broker dealer platform buildouts in ways that foster more types of products in more places.

Q: Where do you see the clearest relative advantages versus public credit?

Jeff Day:
We believe these advantages show up in several ways. The first is carry. Even after some tightening in spreads, private credit continues to offer attractive income compared to public markets.

The second is structure. Senior secured positioning, conservative leverage, and tighter documentation can potentially provide a level of downside protection that is difficult to replicate in liquid markets.

The third is volatility, or lack of it. Reduced mark-to‑market exposure and limited curve risk help stabilize portfolio outcomes in periods of macro uncertainty. When combined with a recovering M&A cycle, direct lending looks well positioned into 2026.

Soft, Where? AI & Implications for Software

Q: Software has been volatile recently. What’s really driving that?

Christopher Remington:
We believe the sell-off that started in software and is now bleeding into other sectors reflects a growing recognition that AI is not just an opportunity but potentially a disruptor, challenging business models across the corporate landscape. That said, while headlines around AI have prompted investors to reprice perceived risks quickly, but we haven’t seen widespread deterioration in cash flows or liquidity across enterprise software businesses.

It’s important to distinguish between equity narratives and credit realities. Equity markets react to shifts in growth expectations and valuation multiples. Credit outcomes are driven by cash flow durability, liquidity, and potential downside protection, all of which we believe remain intact across most of the software landscape that we’re exposed to.

Q: From a lender’s perspective, which software businesses appear most resilient?

Jeff Day:
We focus on mission critical, system of record platforms such as Enterprise Resource Planning (ERP) systems, workflow engines, infrastructure software, and deeply embedded vertical SaaS. These businesses have long sales cycles and sit at the core of customer operations. They often house proprietary data, operate in complex or regulated environments, and carry high switching costs.

Replacing these systems is highly disruptive and thus are rarely undertaken lightly. As a result, revenue tends to be sticky, renewal rates are high, and cash flows are durable. These are often the last pieces of software a company would consider replacing.

Q: How does AI change the competitive landscape within software?

Michael Occi:
We believe AI tends to reinforce the advantages of scaled incumbents rather than undermine them. Distribution matters enormously. Established vendors have long‑standing customer relationships, procurement approvals, and embedded sales channels that new entrants cannot easily replicate.

Data is another key differentiator. Large language models are increasingly commoditized; what matters is context. Incumbent platforms control proprietary historical data that AI tools need to deliver meaningful value. Workflow integration is also critical. The most powerful AI applications are not standalone tools, but those that are embedded directly into existing systems.

Security and governance further tilt the playing field. Enterprise customers demand reliability, compliance, and control. For established vendors, AI becomes a feature layer that enhances products, supports pricing, and improves retention.

Q: Are there areas in the software industry you are more cautious about?

Christopher Remington:
There are segments where caution is warranted, particularly single function tools and lightweight workflow applications that can be replicated by generic AI models. These businesses often lack proprietary data, deep integration, or meaningful switching costs.

That said, these are not areas we concentrate capital. Our underwriting is intentionally designed to avoid software categories that are more discretionary or easy to replace.

Q: How does Morgan Stanley incorporate AI-related risks into underwriting and monitoring?

Jeff Day:
AI risk assessment is embedded as part of our investment process and has been for many years. During our underwriting process, we evaluate many attributes including data ownership, pricing model resilience, margin sustainability, and customer retention dynamics. We also assess how management teams adapt their products and strategies to AI developments. Once we make a loan to a software company, as part of our quarterly review process, we look at each borrower’s underwriting using several metrics including solution complexity and switching barriers, access to data, end-market exposure, cost structure stability, and revenue model vulnerability. This allows us to regularly monitor shifts in trends and manage them proactively.

We believe one advantage of private credit is visibility. Robust credit agreements, detailed reporting, and ongoing engagement with sponsors and management teams provide us with early warning signals, and often allow issues to be addressed before they become impairments.

Q: Do you believe this environment creates opportunities in software lending?

Michael Occi:
Yes. Periods of heightened volatility often create dislocations. Some software companies may find public financing channels less accessible, increasing the demand for private solutions. Lower valuations can also support addon acquisitions or take private transactions, particularly for sponsors focused on durable, cash flow generating platforms. Historically, these environments have produced attractive vintages for disciplined private credit lenders.

A key reality to consider: For all the outstanding private software debt, there is nearly double the private equity capital invested in these companies. This is critical. A typical loan to a sponsor-backed software company is 25-40% LTV – material impairments would require vaporizing the private equity, something sponsors are keen to avoid. The impairments priced into today’s markets appear unlikely to materialize.

With disciplined underwriting and a focus on mission critical platforms, we believe software continues to offer attractive risk-adjusted returns.

Q: How should investors think about software exposure within private credit today?

Christopher Remington:
A few thoughts come to mind. First, it’s worth understanding the context of the sizing of this exposure compared to overall portfolios. A client allocating 5% to a direct lending strategy with 20% of that in software-related issuers – roughly the industry average – has a 1% exposure to this space, all else being equal.

Second, we believe that software remains one of the most durable sectors within direct lending. Recurring revenue models, sticky customer relationships, and high switching costs support stability. Even in downside scenarios, software assets tend to retain value through their intellectual property, code, and customer bases. This makes software an effective diversifier compared to the many other industries in the direct lending market.

To be sure, this should not be seen as a blanket “all clear” in the software space. Although we see the current pessimism about AI disruption as likely overdone, our message to investors is that positioning and manager selection matter a lot. We are focused on mission critical, deeply embedded enterprise software – areas that have strong structural moats. We see AI not as a direct replacement but rather a margin-accretive lever for firms that already own the customer and the data. The threat is not that software disappears altogether, but that economics evolve and winners and losers emerge, emphasizing the importance of credit selection, and thus manager selection.

Investment Strategy & Positioning

Q: What differentiates North America Private Credit’s positioning as we head into 2026?

Michael Occi:
Discipline is at the core of our approach. We believe we have deployed capital prudently, maintained a disciplined leverage profile, and managed exposure to broadly syndicated loans carefully. Our origination funnel is wide and supported by deep sponsor relationships, which allows us to be highly selective. Morgan Stanley also boasts a highly regarded software advisory business which, subject to the firm’s policies, we are able to tap into as part of our due diligence process.¹ We believe this enables us to make better, more informed credit decisions.

Q: Where do you see the most attractive opportunities emerging?

Jeff Day:
We believe that the core middle market remains a sweet spot. The lower middle market could face more structural challenges as smaller companies tend to be more fragile. Upper middle market companies are highly competitive as very large borrowers have access to the broadly syndicated loan market where pricing is much tighter and terms are far more aggressive. In the core middle market where we focus, we can secure tighter documentation, stronger collateral packages, and more lender-friendly terms.

Final thoughts
Direct lending continues to demonstrate resilience and relevance. We believe that in an environment defined by elevated rates, shifting correlations, and macro uncertainty, floating rate, senior secured exposure offers a compelling combination of income and stability.

With supportive macro conditions, a recovering M&A cycle, and disciplined underwriting, we believe the opportunity set heading into 2026 is attractive, and we feel well-positioned to navigate it on behalf of our clients.