Alternatives

Staying Selective as Deal Volumes Decline

Michelle Handy

Senior Managing Director and Chief Investment Officer of Direct Lending, Napier Park Global Capital

Direct lending deal volume slowed to a three-year low during the third quarter, as leveraged buyout (LBO) and add-on merger and acquisition (M&A) activity were both weak; at $152 billion year-to-date, volume is running 31% short of 2025’s pace.1

Additionally, some of the margin expansion within the core and upper middle markets from the first half of 2026 made its way to the lower middle market, where spreads widened by 11 basis points in the quarter. While core and upper middle market spread expansion was likely driven by software exposure—which continued to see the most default activity—we believe the widening of lower middle market spreads reflected a general market correction of the underpriced illiquidity premium for smaller borrowers. Spread per turn of leverage, in contrast, narrowed to its lowest level since August 2025.2

Covenant-lite structures accounted for 17% of direct lending deals through third quarter 2026—up from 14% in 2025—concentrated in the upper middle and large cap markets; cov-lite structures represented less than 3% of deal flow in core and lower middle market loans. Lower middle market default rates over the past 12 months, at 1.8% by dollar amount and 1.5% by deal count, declined since last quarter and remain below 2025 levels.3

Despite the recent rate increase, we anticipate that deal flow could continue to improve through year end, allowing for deployment in an attractive yield environment. We remain focused on selectivity as we evaluate opportunities across industries and subsectors. However, we are skeptical of market lending trends—such as data centers—as we continue to target essential service businesses, which we believe are more insulated from artificial intelligence (AI). We have also pulled back slightly on healthcare given longer hold periods within certain subsectors, and we continue to be cautious on software.

1 Source: KBRA DLD Research; data as of October 14, 2026.
2 Source: KBRA DLD Research; data as of October 14, 2026.
3 Source: KBRA DLD Research; data as of October 14, 2026.

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Direct lending refers to a loan agreement negotiated between a borrower and single or small group of nonbank lenders. Direct lending can also be referred to as “private credit” or “private lending.”

A leveraged buyout (LBO) is the acquisition of one company by another using a significant amount of borrowed capital to meet the cost of acquisition.

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