What’s your outlook for 2026?
After several years of rising interest rates, slowing growth and high inflation, coupled with an uncertain M&A pipeline, the market is settling into a more predictable environment. For managers and investors, this should present an attractive mix of increased deal flow, lower economic turbulence and yields that are attractive when compared with pre-Covid levels.
Clearly, there will still be challenges on the horizon. Deployment will remain competitive on the back of a cycle of strong fundraising which has led to a great deal of dry powder in the market. Some unitranche direct lenders, with higher returns targets, will seek to compete by providing aggressive loan terms to borrowers – which could mean we continue to see aggressive structures appearing in the market. But also, borrowers that have struggled to cope with a higher interest rate and a slower growth environment over the past few years may find it harder to meet covenant tests, which are now getting tighter as the loans come nearer to maturity. As a result, we expect default levels will increase over the next year.
How will interest rates affect the market?
By 2026, we expect interest rates in Europe to be lower than the highs of 2023, even if they don’t come back to the ultra-low levels of the previous decade. This will be the sweet spot for direct lending. Borrowers will get the benefit of lower interest costs, reducing the pressure on their cashflows, while investors will continue to make attractive risk-adjusted returns on their investment. The reduction in interest rates will also encourage private equity to restart investing, after a quiet period over the last couple of years.
One of the defining features of 2024/25 was the buildup of unsold private equity assets. Many sponsors held on to assets longer than usual, waiting for valuations to stabilise. This backlog will clear in 2026 and should lead to a firmer pipeline of transactions – buyouts, add-ons, and refinancings – which will feed directly into mid-market direct lending volumes.
How restrictive will lending be in 2026?
While some lenders will try to compete with more aggressive loan terms, lending discipline will continue to be of utmost importance, particularly as European economic growth is likely to remain modest. As a result, direct lenders should continue favouring non-cyclical sectors. Similarly, documentation will generally remain tighter than it was pre-Covid. However, with interest rates falling, we expect to see a return to complementary loan products in the market. Traditional senior secured loans and unitranche will remain the core products, but we are likely to see increased use of delayed draw facilities, second lien, and junior payment-in-kind (PIK) instruments to facilitate acquisition strategies. With the total cost of borrowing having come down, borrowers will be able to use these complementary loan instruments with much better effect. This will mean that strategies like credit opportunities will become much more popular with investors.
What regulatory changes could come into effect in the coming year?
The year ahead will see increased regulatory scrutiny for direct lenders. This will be centred on valuation practices, liquidity management of semi-liquid structures, and the levels of leverage offered in transactions. While we don’t expect any restrictive rules to be implemented in Europe, rising scrutiny could increase reporting requirements and slow down deal execution as managers deal with regulatory demands. Well-established managers with strong governance and transparent processes, and in-house reporting teams should benefit.
We expect 2026 to be an exciting year as the market slowly comes back to life. Managers who have stayed disciplined and adopted conservative lending strategies in the past will benefit in this new market and will be able to deploy loans to the many new lending opportunities that will be bought to market. Those who have been aggressive and reckless in the past will be busy dealing with issues in their existing portfolios.
