Key points
For most of the past decade, direct lending looked like the sensible middle ground of private credit. It sat between broadly syndicated loans and more complex asset-backed strategies. Investors got senior exposure to real operating companies, floating-rate income and regular interest payments, without daily price swings. Banks stepped back from lending to mid-sized companies, private lenders stepped in, and borrowers paid for speed and certainty.
Over time, that exposure came to be treated as the stable centre of private credit rather than a cyclical strategy. Higher rates, slower deal activity and a tighter refinancing market are now testing the assumption. Risks that once felt remote have become operational, and investors are examining how these loans behave when conditions tighten.
This article sets out the main risks of direct lending to companies today, how they show up, and what investors should check before adding to the strategy.
Why direct lending became the core allocation
Direct lending earned its place by appearing balanced. Senior ranking, floating coupons and steady income made it a natural replacement for public credit, and returns held up even as spreads narrowed. When public markets froze, private lenders could still transact. Borrowers valued certainty of execution, and investors saw continuity of income.
The market is now roughly $2 trillion, about 5% of global lending excluding investment-grade bonds and real estate, and buyout financing makes up around half of origination, according to William Blair. For an overview of where direct lending sits in the wider asset class, see What Is Private Credit?
What are the main risks of direct lending?
| Risk | How it shows up | What investors should check |
|---|---|---|
| Single-company exposure | One borrower's performance drives repayment | Borrower count and top-ten exposures |
| Convergence with public credit | Spreads compress; loans move between markets | Pricing against syndicated loans of similar risk |
| Payment-in-kind | Interest accrues instead of being paid in cash | Share of income paid in kind, and when PIK was added |
| Refinancing | Loans assume a refinancing at maturity | Maturities by year and leverage at refinancing |
| Weak documentation | Covenants and control rights erode in competition | Covenant package, lender consent rights, security |
| Illiquidity | Thin secondary market, transfers need consent | Liquidity terms and exit options |
Single-company exposure: where the core risk sits
A direct loan is exposure to a single business. Interest and capital repayment depend on that company continuing to perform. There is no separate pool of assets producing cash alongside it. The lender is underwriting management, strategy and balance sheet strength all at once.
That concentration is often understated. Even portfolios with many names can share the same sponsors, sectors and refinancing assumptions, a problem we examine in concentration risk in mid-market private credit. Portfolios that lean heavily on single-name direct exposure can end up replicating mid-market beta rather than earning a genuine private credit premium, as we argue in the mid-market allocation trap.
Convergence with the syndicated loan market
Direct lending once offered something distinct from public credit. That gap is narrowing. Borrowers now refinance freely in both directions: in 2025, about $37bn of broadly syndicated loans were refinanced into direct lending and about $34bn moved the other way, according to McKinsey's analysis of PitchBook LCD data cited by ABF Journal.
Pricing has converged too. Median spreads on new direct loans fell from 716 basis points in March 2023 to 544 at the end of 2025, and all-in yields fell from about 10.5% to 9.3%. As the two markets compete for the same borrowers, direct lending outcomes are more closely tied to wider credit conditions than many investors expected. It still differs from public credit in form, but when liquidity tightens or risk appetite shifts, correlations rise quickly.
Payment-in-kind and the hidden default rate
Payment-in-kind (PIK) interest lets a borrower add interest to the loan balance instead of paying cash. Agreed at the outset, it can be a sensible feature for a growing company. Added later, it is often a sign of strain.
Lincoln International, which values private loans for lenders and investors, found that 11% of loans paid some PIK interest in 2025, against 7% in 2021, and that 58% of those had switched to PIK after closing. Lincoln treats this "bad PIK" as a shadow default rate.
That is why headline default figures vary so widely. KBRA's direct lending index, which counts more traditional defaults, showed a trailing default rate of 2.3% in June 2026. Fitch, which also counts interest deferrals, PIK substitutions and distressed maturity extensions, put its US private credit default rate at 6.3% in August 2026, with those softer events making up 88% of defaults. Investors should ask which definition a manager uses.
Refinancing risk and the maturity wall
Most direct loans are written on the assumption that the borrower will refinance at maturity rather than repay from cash flow. When refinancing markets are open and rates are falling, that works. When they close, or pricing moves against the borrower, lenders face extensions, amendments or restructurings, and capital stays tied up longer, often at higher risk.
William Blair flags 2028 as the year refinancing pressure builds for loans originated in 2020 and 2021, when rates were low and leverage was high. Software borrowers, around 20% of direct lending, are a particular concern, with net debt often near eight times EBITDA. Fitch's data shows the strain already landing on smaller companies: borrowers with EBITDA below $25m defaulted at 12% over the year to August 2026.
Covenants, control rights and recoveries
When a loan goes wrong, outcomes depend less on models and more on documentation, control rights and execution. Competition for deals has weakened covenant packages in parts of the market, giving lenders fewer early warnings and less leverage in negotiations.
Recovery then depends on what the lender can enforce, where and how quickly. Security over shares or assets, intercreditor terms and the jurisdiction of the borrower all matter. KBRA expects recovery rates on defaulted direct loans to keep declining, with the sharpest falls among smaller and mid-sized borrowers. Understanding where a loan sits in the capital stack, and what sits beneath it, is the first line of defence.
Liquidity: held to maturity by necessity
Most direct loans are held to maturity because there is little choice. Secondary markets are thin, pricing is opaque and transfers usually need consent. Investors who need to exit early tend to do so at a discount. The 2026 redemption queues at several evergreen private credit funds showed what happens when that illiquidity is wrapped in a vehicle that promises periodic exits, as we discuss in Has Private Credit Gone Public?
What this means for investors
Direct lending still deserves a place in most private credit allocations, sized and assessed with more precision. Single-name risk should be priced properly, refinancing risk treated as central, and PIK and default definitions examined closely.
Many investors are now reassessing how risk is structured and distributed, with growing interest in approaches that define credit exposure more tightly or spread it across pools of assets rather than single companies. Our articles on private credit through structured credit and diversification in private credit explore those alternatives. At Kingsbury & Partners, we lend to lenders through senior secured facilities backed by pools of underlying loans, which is one way to replace single-company risk with many small borrowers. Direct lending will remain a core allocation for many investors. Those who understand its newer, more correlated risks will be better placed to decide when direct exposure is appropriate and when structure needs to carry more of the protection.
Frequently Asked Questions
What are the risks of direct lending?
The main risks are single-company exposure, refinancing risk at maturity, rising use of payment-in-kind interest, weaker covenants, limited liquidity and falling recoveries when borrowers default.
What is payment-in-kind (PIK) interest?
PIK interest is added to the loan balance instead of being paid in cash. When it is introduced after a loan is made, it often signals that the borrower is struggling to meet cash interest.
Why do private credit default rates differ between sources?
They use different definitions. Some count only missed payments and bankruptcies, while others, such as Fitch, also count interest deferrals, PIK substitutions and distressed maturity extensions.
Is direct lending correlated with public credit?
Increasingly so. Borrowers now refinance between direct lending and the broadly syndicated loan market in both directions, and spreads have converged, so direct lending is more exposed to wider credit conditions.
What is the private credit maturity wall?
It is the large volume of loans due to be refinanced in a short period. For direct lending, pressure is expected to build from 2028 for loans written in the low-rate years of 2020 and 2021.
How can investors reduce direct lending risk?
By limiting single-name and sector exposure, checking PIK use and covenant quality, preferring first-lien senior secured positions, and combining direct lending with asset-backed strategies that depend on different drivers.