Investment Strategy

Is Private Credit – Direct Lending growing too big?

Industry analysts have suggested the rapid growth of Direct Lending may result in a significant deterioration in deal quality as an ever-larger supply of capital competes for existing borrower demand. Private Credit – Direct Lending has experienced tremendous growth over the past two decades as banks steadily reduced the scale of their middle market lending business following the Global Financial Crisis (GFC). The subsequent migration of middle market lending from banks to asset managers was in part due to the increased regulatory requirements in the post-GFC era.

Direct lenders typically make loans to small and mid-sized private businesses. Many businesses in this large (and expanding) universe fly under the radar of the public debt providers. These businesses are often too small to access the public debt markets, yet as a group provide significant demand for new loans. The diverse group of borrowers span a wide array of industries, and they have shown resilience in the past two decades, with loan loss rates similar to their public market peers.¹ While the higher-for-longer interest-rate environment may negatively impact a subset of the lowest quality borrowers through higher debt servicing costs, we do not anticipate a broad-based loosening of credit standards due to the growing investor capital in the asset class. Though certain asset managers may lack the access to the highest quality deals or possess the underwriting discipline to avoid pitfalls, we believe the best-in-class lenders should continue to originate loans at attractive terms to companies with solid fundamentals.

We have identified several factors that suggest the market may still have capacity for further growth in the coming decade and beyond, including:

• The size of direct lending market remains small relative to public debt markets.
  While direct lending has experienced what we view as exponential growth in recent years, the market remains below the high yield and leveraged loan market and is fraction of the size of the investment-grade corporate bond market (see Chart 1).

Chart 1: U.S. Direct Lending assets remain low relative to other fixed income and global private equity marketsSources: Direct Lending from Pitchbook, Cliffwater, and Wells Fargo Investment Institute. High Yield and Leveraged Loan market pools are from Bloomberg U.S. Corporate High Yield Bond Index and S&P UBS Leveraged Loan Index, respectively. Investment Grade Corporate from Bloomberg U.S. Corporate Statistics Index. Global Private Equity includes funds that report to the Pitchbook database that are categorized as Private Equity, Venture Capital, and Fund of Funds. Data as of December 31, 2024. An index is unmanaged and not available for direct investment.

• The size (and growth) of private equity markets suggest to us that private debt demand will remain robust.
  The $11.4 trillion global private equity market has experienced a similar growth trajectory. As the increasingly preferred debt provider for buyout deals (see Chart 2), we believe direct lenders should have opportunities to expand loan portfolios without sacrificing credit quality.
• Direct Lending continues to grow market share.
  As direct lending is increasingly viewed as a viable alternative to public debt markets (broadly syndicated loans) according to Pitchbook, the asset class has garnered a greater share of the overall debt deals. As shown in Chart 2, Private Credit – Direct Lending has grown market share for Private Equity – Buyout deals from 56% in the first quarter of 2021 to over 83% in the second quarter of 2025.

Chart 2. Percent of private equity buyouts financed by private credit versus broadly syndicated loan (BSL) marketsSources: Pitchbook and Wells Fargo Investment Institute, data as of June 30, 2025. See definitions section on page 8 for Pitchbook data methodology.

For qualified investors, we believe the asset class can be a complement to a well-diversified portfolio, and has historically generated income that has exceeded its public market peers (such as leveraged loans or high yield bonds).² Yet, investors must also be aware of Private Credit - Direct Lending asset class’s inherent risks, which are significantly higher than an investment-grade corporate bond portfolio. Small and middle market companies carry significant credit risk and could be impacted by a prolonged downturn or recessionary environment.

While our current outlook maintains that a gradual recovery will likely occur in 2026, we expect to remain neutral on Private Credit Direct Lending until the economic uncertainty recedes further and the expected recovery gains momentum. Moreover, we expect the Private Credit – Direct Lending market to continue to grow over time as we anticipate borrower demand to be robust from private equity markets that we expect will gain prominence.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

¹ Cliffwater and JP Morgan. CDLI index loss rate over past 10 years registered 1.04%, versus 0.85% for Leveraged Loans and 1.45% for high yield bonds. Data as of December 31, 2024.

² Based on the Cliffwater Direct Lending Index. Data as of March 31, 2025.

Powering the U.S. economy

Growth in U.S. power consumption bounced around 0% for over a decade. This, however, appears to be changing. We believe this shift is driven by several factors, including reshoring of manufacturing and supply chains, broad electrification across the economy, increased electric vehicle penetration, and the rising demand from data centers. Power demand is now projected to grow into the 2.0% to 2.5% range over the intermediate term.

To meet this increase in demand, we foresee an all-of-the-above approach by utilities in adopting a diversified strategy for deploying generation assets. In our view, renewable power will continue to grow given speed-to-market advantages as components and equipment are readily available. Natural gas-fired facilities will continue coming online. The main hinderance to even greater natural gas-fired deployment is a lack of turbines. We see nuclear power largely holding share as uprates and a couple facilities enter (or more accurately, re-enter) service. One of the most notable recent developments fits squarely in the all-of-the-above approach. Coal-fired units, many of which had their retirement dates pulled forward to meet environmental goals or avoid costly equipment upgrade requirements, will likely continue to shrink, albeit at a slower pace than predicted previously as retirement dates get pushed back out. Deployment of energy storage (batteries) is also expected to continue.

Looking ahead, our best guess on deployment is that renewable power will likely lead until 2030, when current tax incentives are set to expire. After that point, renewable generation may lose some of its economic advantages, particularly for sub-scale developers. Also 2030 happens to be the expected delivery date for new orders of natural gas turbines, potentially increasing availability and, therefore, deployment of natural gas units to fill the void left by renewables. Consequently, we are favorable on Electric Utilities and Independent Power & Renewable Electricity Producers, sub-sectors we expect to benefit.

U.S. power consumption and growthSources: U.S. Energy Information Administration and Wells Fargo Investment Institute. Data as of July 29, 2025.

Federal policies make portfolio diversification more vital

Portfolio diversification has long been a cornerstone of resilient investment strategies. However, we believe recent shifts in federal policy have heightened the need for investors to diversify their municipal-bond portfolios more thoughtfully. Under the Trump administration, proposed reductions in funding for programs, like Medicaid and the Federal Emergency Management Agency (FEMA), pose emerging credit risks.

For instance, FEMA reductions would potentially mean that bondholders can no longer assume FEMA will provide the same level of post-disaster financial support. Historically, FEMA support helped communities rebuild and protect bondholders. However, FEMA funding cuts could lead to decreased investment in mitigation infrastructure and disaster response, increasing the risk of credit disruptions for certain issuers following natural disasters. While historical and scientific data can help identify regions more susceptible to event risk, recent natural disasters, such as Hurricane Helene, damaged regions previously considered less vulnerable to hurricane damage.

Similarly, we view reductions in Medicaid as credit negative for the state and municipal healthcare sectors. Specifically, states and hospitals with higher exposure to Medicaid eligible patients (including rural, safety-net, and children’s hospitals) may be vulnerable to revenue reductions, weakened financial-operating results, and potential closures.

As sector-specific risks and event risks evolve, spreading investments across a wider array of municipal names and sectors becomes increasingly critical. Given the nature of the changes, these emerging risks have the potential to be unpredictable and, at times, material. Therefore, in today’s evolving policy landscape, we believe diversification ahead of any unforeseen credit events is not just prudent, it is essential.

The contrarian investment case for Energy

Investor sentiment toward the Energy sector has generally been unenthusiastic throughout 2025, driven by concerns of global oil supply growth against a mixed macroeconomic backdrop. We believe the Energy sector presents attractive value and that exposure has an important role in equity portfolios as an effective hedge against geopolitical risk and inflation.

Oil prices are an important driver of earnings and sector performance, and our Commodities outlook forecasts oil prices remaining largely range bound through the end of 2026. However, the Energy sector is currently benefiting from various favorable trends that are partially offsetting the impact of lower oil prices on the broader sector. Natural gas prices are significantly higher year over year, refining margins have been strong³, and we believe midstream energy companies are benefiting from an improved growth outlook driven by increasing demand for natural gas infrastructure. Our guidance has consistently emphasized the importance of diversification for Energy sector positioning, which underscores our favorable views on the Integrated Oil and Midstream Energy sub-sectors.

We would also like to remind investors that the Energy sector has reduced leverage considerably since the pandemic and generally has continued to prioritize shareholder returns (dividends and share repurchases) as a use of excess capital, with a focus on resiliency throughout commodity cycles. The chart below illustrates the growth in shareholder returns that has occurred since 2022, with shareholder returns expected to remain strong in 2025. The Energy sector currently offers a dividend yield of 3.4%, and current consensus forecasts estimate that companies within the Energy sector will repurchase $57 billion worth of shares in 2025, representing 3.3% of the Energy sector’s market capitalization.

Energy sector shareholder returnsSources: FactSet and Wells Fargo Investment Institute. Data as of July 21, 2025. West Texas Intermediate (WTI) oil price is the average year-to-date price. E = estimate. Dividends paid include variable and special dividend payments. Energy sector represented by S&P 500 Energy Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

³ According to industry benchmarks and company reports.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, August 4, 2025.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Please see end of report for important definitions and disclosures.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions.

Alternative investments, such as private credit, hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.

Bloomberg U.S. Corporate Bond Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.

Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt.

Bloomberg U.S. Corporate Statistics Index measures the performance of the investment-grade, fixed-rate, taxable corporate bond market in the United States.

Cliffwater Direct Lending Index (CDLI) measures the performance of U.S. middle market corporate loans as represented by the unlevered, gross of fees performance of these loans, as reflected by the underlying assets of Business Development Companies (BDCs).

S&P 500 Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.

S&P UBS Leveraged Loan Index measures the market-value-weighted performance of the investable universe of USD-denominated leveraged loans.

An index is unmanaged and not available for direct investment.

Pitchbook data methodology:

• Unless otherwise noted, data reflects new-issue direct lending transactions as tracked by PitchBook LCD. Except for BDC analysis, charts reflect new transactions in the US direct lending market, including both private-equity-backed borrowers and non-backed borrowers, as covered by LCD News.
• We define direct lending as directly originated loans to corporate borrowers that are not broadly syndicated. These borrowers are typically unrated and tend to be small to midsized companies. However, in recent years, larger borrowers have also issued this type of financing. This type of financing is typically provided by a non-bank lender, or a small “club,” or group, of lenders. These loans are generally not tradeable as broadly syndicated loans are. Lenders usually provide the financing with the intention of holding the debt to maturity.
• BDC analysis is based on quarterly filings of over 100 BDC portfolios as tracked by PitchBook LCD.
• Given the opaque nature of the direct lending market, deal size is not available for every transaction. To calculate overall volume, LCD estimates deal size where it is not available using historical averages within our dataset.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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