European direct lending is entering what managers describe as a sweet spot: interest rates falling from their 2023 peaks but still well above the ultra-low levels of the previous decade. That combination is expected to deliver attractive risk-adjusted returns for investors while easing cashflow pressure on borrowers, according to a 2026 outlook published by Hermes Investment Management.

After several years of rising rates, slowing growth, high inflation and an uncertain mergers and acquisitions 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, the firm notes.

A defining feature of 2024 and 2025 was the buildup of unsold private equity assets. Many sponsors held on to assets longer than usual, waiting for valuations to stabilise. That backlog is expected to clear in 2026 and should lead to a firmer pipeline of transactions including buyouts, add-ons and refinancings, which will feed directly into mid-market direct lending volumes.

The reduction in interest rates is also expected to encourage private equity to restart investing after a quiet period over the last couple of years. Deployment, however, 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, the outlook cautions.

Some unitranche direct lenders with higher return targets are expected to compete by providing aggressive loan terms to borrowers, which could mean aggressive structures continue to appear in the market. At the same time, borrowers that have struggled to cope with higher interest rates and a slower growth environment over the past few years may find it harder to meet covenant tests, which are now getting tighter as loans come nearer to maturity. As a result, default levels are expected to increase over the next year.

While some lenders will try to compete with more aggressive terms, lending discipline will continue to be of utmost importance, particularly as European economic growth is likely to remain modest. Direct lenders are expected to continue favouring non-cyclical sectors, and documentation will generally remain tighter than it was pre-Covid.

With the total cost of borrowing having come down, borrowers will be able to use complementary loan instruments with much better effect. Traditional senior secured loans and unitranche will remain the core products, but increased use of delayed draw facilities, second lien and junior payment-in-kind instruments is expected to facilitate acquisition strategies. This is expected to make strategies like credit opportunities much more popular with investors.

The year ahead will see increased regulatory scrutiny for direct lenders, centred on valuation practices, liquidity management of semi-liquid structures and the levels of leverage offered in transactions. While no restrictive rules are expected 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, transparent processes and in-house reporting teams are expected to benefit.

Managers who have stayed disciplined and adopted conservative lending strategies in the past are positioned to benefit in this new market and will be able to deploy loans to the many new lending opportunities expected to be brought to market. Those who have been aggressive and reckless in the past are expected to be busy dealing with issues in their existing portfolios, the outlook concludes.