StepStone expects defaults in the direct lending market to increase over the next few quarters, arguing that this is part of a normalisation process and nothing to be concerned about.
In its latest paper, the private markets investment and advisory group said an increase in defaults should be viewed as a normalisation from “exceptionally low post-Covid levels” rather than early signs of broader stress within the direct lending market.
Recent media coverage has focused on “shadow” default rates, payment-in-kind (PIK) toggles and redemption pressure in business development companies (BDCs) as signs that the direct lending market is under pressure.
However, StepStone argues that the middle-market remains in good health and must be distinguished from adjacent segments.
Read more: Defaults rise as credit quality weakens in Q1 2026
Tackling “shadow” defaults
The paper points to a rise in “shadow” defaults, which refers to loans that have undergone amendments such as maturity extensions, covenant resets or PIK activation. However, StepStone points out that these situations do not represent actual defaults.
“Rather they are proactive measures taken to address temporary underperformance or liquidity pressure and to stabilise borrowers,” the report said. “Nonetheless, some may regard the shadow default rate as an omen of future defaults. To date, though, there is limited evidence to support this claim.”
StepStone notes that payment defaults have only risen slightly from 2022 levels, when government support during the pandemic helped to keep defaults down.
“This suggests that the tools commonly used by private lenders, such as amendments, extensions, or PIK, have, in several cases, helped borrowers stabilise and avoid costly bankruptcy proceedings,” the group noted.
In StepStone’s opinion, the direct lending market continues to benefit from a positive macroeconomic environment.
While media coverage has highlighted the perceived risks associated with PIK interest payments in direct lending, the paper notes that PIK toggles are typically concentrated among larger, more established issuers. They are generally not available to smaller or more highly leveraged borrowers.
“We also note that PIK optionality is not costless. Electing to PIK interest typically increases the spread, compensating lenders for the additional risk and discouraging indiscriminate use by borrowers.
“Available evidence suggests that only a small proportion of companies with PIK optionality in their loan documentation actually use it, indicating that its presence does not necessarily translate into widespread utilisation,” the paper explained.
Read more: Private credit defaults to stabilise as PIK use increases
BDC redemptions
StepStone also argues that outflows from selective BDCs should not be viewed as a sign of stress. The group notes this only captures part of the picture, as most BDCs have reported positive net flows overall, supported by ongoing investor demand and new subscriptions.
“Importantly, most redemption requests have been met in full – at times exceeding the typical quarterly threshold of 5% of NAV. Several managers have demonstrated their ability to accommodate higher redemption levels without resorting to forced sales of private assets or materially impacting portfolio performance,” StepStone explained.
It describes these events as a “real-time stress test of the BDC model”, providing evidence that liquidity is being managed effectively within the semi-liquid structure.
Direct lending market in good health
In 2025, StepStone pointed out the direct lending market showed resilient fundraising and tight lending terms.
“Capital raising remained solid, supported by a recovery in European fundraising and strong growth in evergreen structures. At the same time, the resulting capital overhang reinforced a competitive, borrower-friendly environment and drove further compression in gross spreads,” the paper noted.
StepStone points to recent transaction data which suggests a gradual pick-up in M&A activity, which could help rebalance supply and demand dynamics through higher deal flow in 2026.
Returns in 2025 were lower than the previous year, which StepStone puts down to lower base rates and tighter spreads.
“Importantly, gross asset yields remain above long-term historical averages and are expected to remain supportive into 2026,” the paper noted.
“Base rates, while easing, are still elevated relative to the past decade, spreads appear to be stabilising, and a recovery in transaction activity could even create scope for modest spread widening in the year ahead.”
While “selective pockets of risk warrant continued discipline”, StepStone believes the asset class can continue to deliver a stable income and “compelling” risk-adjusted returns, supported by gradually improving borrower fundamentals and a benign default environment.
Read more: Competition between private credit and BSL intensifies as debt supply outstrips demand
