Key Takeaways
- • UBS CIO recommends a Neutral stance on direct lending, citing balanced but moderate near-term risk-return outlook amid rising concerns about AI disruption to legacy software borrowers and elevated defaults in lower-middle-market segments.
- • Private credit default rates have diverged sharply by borrower size: Fitch data shows 11.7% defaults for companies with EBITDA below $25 million versus 2.4% for those above $100 million in Q4 2025, with 2021–22 vintage loans accounting for roughly half of new non-accruals in 2025.
- • UBS advises investors with overallocations to direct lending to consider rebalancing toward senior, sponsor-backed, upper-middle-market loans in non-cyclical sectors, or to diversify into private infrastructure, hedge funds, and quality bonds to mitigate concentration risk.
- • Evergreen funds have begun restricting redemptions to protect asset values, signaling stress in the direct lending market and reinforcing the case for broader alternative asset diversification rather than concentrated exposure.
Summary
UBS's Chief Investment Officer has adopted a Neutral outlook on direct lending, signaling a shift toward more selective positioning as the private credit market enters late-cycle dynamics marked by divergent performance across borrower tiers. The recommendation reflects mounting headwinds: AI disruption threatens legacy enterprise software companies that are material borrowers in direct lending portfolios, while loans originated during the 2021–22 period have proven vulnerable to the 2022–23 rate hiking cycle, generating disproportionate defaults and non-accruals.
The bifurcation in credit quality is stark. According to Fitch data cited in the analysis, private credit default rates in the fourth quarter of 2025 reached 11.7% for smaller companies with EBITDA below $25 million, compared to just 2.4% for companies with EBITDA exceeding $100 million. This concentration of stress among lower-middle-market borrowers underscores structural weaknesses: 2021–22 vintage loans accounted for approximately half of all new non-accruals recorded in 2025, highlighting the extended deterioration lag from the Federal Reserve's aggressive monetary tightening. Simultaneously, several evergreen funds have imposed redemption caps to preserve net asset values, a defensive signal that reinforces concerns about asset quality and liquidity.
In response to these dynamics, UBS recommends investors reassess portfolio construction. Since September, the firm has favored a bias toward senior, sponsor-backed loans in upper-middle-market segments, particularly in non-cyclical sectors demonstrating greater durability. More broadly, UBS advises investors carrying overweight allocations to direct lending to consider diversifying into alternative strategies including private infrastructure, low-correlation hedge funds, and quality fixed income, or to deploy proxy hedges by reducing exposure to high-yield credit and equities. This approach acknowledges that while direct lending continues to offer long-term yield and diversification benefits, the near-term risk-return profile has become less attractive, warranting a more balanced and diversified alternative asset allocation strategy.
The bifurcation in credit quality is stark. According to Fitch data cited in the analysis, private credit default rates in the fourth quarter of 2025 reached 11.7% for smaller companies with EBITDA below $25 million, compared to just 2.4% for companies with EBITDA exceeding $100 million. This concentration of stress among lower-middle-market borrowers underscores structural weaknesses: 2021–22 vintage loans accounted for approximately half of all new non-accruals recorded in 2025, highlighting the extended deterioration lag from the Federal Reserve's aggressive monetary tightening. Simultaneously, several evergreen funds have imposed redemption caps to preserve net asset values, a defensive signal that reinforces concerns about asset quality and liquidity.
In response to these dynamics, UBS recommends investors reassess portfolio construction. Since September, the firm has favored a bias toward senior, sponsor-backed loans in upper-middle-market segments, particularly in non-cyclical sectors demonstrating greater durability. More broadly, UBS advises investors carrying overweight allocations to direct lending to consider diversifying into alternative strategies including private infrastructure, low-correlation hedge funds, and quality fixed income, or to deploy proxy hedges by reducing exposure to high-yield credit and equities. This approach acknowledges that while direct lending continues to offer long-term yield and diversification benefits, the near-term risk-return profile has become less attractive, warranting a more balanced and diversified alternative asset allocation strategy.
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.