Evolution of

Direct Lending
Private Credit Primer

MORGAN STANLEY PRIVATE CREDIT | 2025

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT i

1
OVERVIEW OF
PRIVATE CREDIT

3 8
OVERVIEW OF CHARACTERISTICS
DIRECT LENDING OF DIRECT LENDING
INVESTMENTS

11 16
WHY INVEST IN APPENDIX
DIRECT LENDING?

ii MORGAN STANLE Y INVESTMENT MANAGEMENT | THE E VOLUTION OF DIREC T LENDING

 Overview of Private Credit
Private Credit investing is a form of lending capital outside of the traditional
banking system, whereby lenders work with borrowers to originate and negotiate
privately held loans not traded in public markets. Investor allocation to Private
Credit has grown significantly in recent years, with a total market size
of approximately $1.8 trillion as of the end of 2024 and forecasted to grow
to $2.3 trillion by 2028.1
Historically, corporate borrowers have looked to banks for their lending needs. However, the number
of US banks declined by 53% between 2000 and 2023. Most of that consolidation occurred in the
years following the Global Financial Crisis (“GFC”) in 2008, as regulations and increasingly conservative
lending policies among banks reduced their willingness to lend. As a result of these changes, the market
opportunity for Private Credit has evolved over the last several decades as private lenders have stepped
in to fill the need for capital.
As lenders have sought to address the capital deployment needs of investors with different risk and
return profiles, a number of Private Credit investing strategies have emerged. Direct Lending, which is
discussed in detail in the following pages, now accounts for the largest share of Private Credit assets
under management, making up over one-third of all Private Credit as of March 31, 2024.

DISPLAY 1
Projected and Historic Growth in Private Credit Assets
$2,500
$2.3T

$2,000

$1,500
$ Billions

$1,000

$500

$0
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025E 2026E 2027E 2028E
 Direct Lending  Distressed Debt  Mezzanine  Debt Other

Source: PitchBook. Historical AUM and forecasts generated on April 19, 2024.

1
PitchBook, Private Capital’s Path to $20 Trillion report.
Types of Private Credit
Private Credit is generally made up of six sub-strategies. These sub-strategies are categorized
either by the types of borrowers they lend to (e.g., Distressed or Venture strategies),
the types of loans they make (e.g., Direct Lending or Mezzanine), or the collateral type
(e.g., Asset-Based). Each strategy offers a tradeoff of risk/reward characteristics.

Direct Lending Asset-Based Distressed Debt Mezzanine Special Situations Venture Debt,
strategies provide Finance describes investing is lending Lending provides strategies focus on like venture
credit primarily to a wide range of to companies that borrowers with flexible solutions capital, focuses
middle market, non- strategies that are “distressed” a hybrid of for planned events, on startup or
investment grade target assets because of issues debt and equity such as corporate early-stage
private companies as opposed such as bankruptcy financing. These expansion, or companies
and generally focus to operating or other debt issuances unplanned events looking for
on generating companies. They complications often have equity during periods funding. Debt
current income like include loans on with meeting debt conversion rights of stress, such as financing for
other fixed income real assets, such obligations, with or other types restructurings. these firms
investments. Direct as real estate and the intention of of embedded Also referred to has expanded
lenders typically infrastructure, or generating profit equity options. as opportunistic as early-stage
concentrate their pools of assets post-company Mezzanine debt or structured debt, companies
investment activity such as equipment turnaround. is subordinated to their borrowers look to increase
in first lien and and fleet financing, Distressed debt has first lien debt. start out as their working
unitranche debt, or balance sheet a risk-return profile performing capital or capital
both of which assets of financial similar to equity although some investment
are discussed in intermediaries securities because may transition without issuing
greater detail in the such as student factors specific to to distressed. new and
following pages. loans, credit card the issuer have a dilutive equity.
receivables, or greater effect
account receivables on the debt’s
in general held performance.
by non-financial
companies.

DISPLAY 2
Share of Global Private Credit AUM by Sub-Strategy
1%

7% n Direct Lending
11% n Asset-Based

36%
n Distressed Debt Direct Lending now makes up
11% n Mezzanine Lending 36% of the total Private Credit
n Special Situations
n Multi-Strategy
market, up from 9% in 2010.
17% n Venture Debt
17%
Source: PitchBook, March 31, 2024.

2 MORGAN STANLE Y INVESTMENT MANAGEMENT | THE E VOLUTION OF DIREC T LENDING

Overview of Direct Lending

Direct Lending is a type of Private Credit strategy that makes

direct, illiquid loans to middle market companies. While Direct
Lending usually refers to first lien (including unitranche) loans,
second lien and mezzanine lending similarly lend to middle
market companies and have developed as a result of the
same dynamics as senior first lien Direct Lending investing.
Defining the Middle Market This middle market
Companies within the “middle market” generally fall within a range of approximately
$10 million to $200 million in EBITDA, roughly comparable to medium- and small-
segment represents
cap stocks included in indexes such as the Russell 2000. This middle market segment a major component
represents a major piece of the US economy, approximately one third of private sector
GDP, and continues to grow, experiencing 8% earnings growth in Q3 2024.2 of the U.S. economy,
Middle market borrowers are typically either not within the lending profile of the approximately one-
broadly syndicated loan market or not interested in undergoing the often lengthier
and less flexible process of broadly syndicated loan origination. As such, a large
third of private sector
portion of the middle market is turning to Direct Lending to meet their capital needs. GDP, and continues
In exchange for providing capital to these borrowers, direct lenders can expect to earn
higher interest rates to compensate for the added risk of lending to smaller companies, to grow, experiencing
as well as an illiquidity premium for providing non-publicly tradeable issuances.
These direct loans are often highly negotiated with protective covenants that provide
8% earnings growth
downside protection for lenders. in Q3 2024.2
Size and Scope of the Middle Market

$20M- $10-
$1B $200M 50M
MIDDLE
REVENUE EBITDA MARKET JOBS2

$100M- 33% $13T 2

Golub Capital Altman Index, Q3 2024
US Middle Market Report.
MIDDLE MARKET
$1B BUSINESSES AS
A PERCENTAGE
MIDDLE MARKET
BUSINESSES
3
National Center for the Middle Market,
“Year End 2023 Middle Market Indicator.”
ENTERPRISE OF PRIVATE TOTAL ANNUAL 4
J.P. Morgan, Next Street, “The Middle
VALUE SECTOR GDP3 REVENUE4 Matters: Exploring the Diverse Middle
Market Business Landscape.”

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 3

Direct Lending – Changing Sources of Capital
The increase in demand for Direct Lending to meet the mergers such as Chase Manhattan Bank with J.P. Morgan
needs of middle market companies has been driven by & Co., the number of US banks declined by around 15%,
a decades-long trend of bank consolidation and further while their total assets more than doubled. From 2000
accelerated by regulations following the GFC, as described to 2023, the number of FDIC-insured banks fell by
on page 5 in Direct Lending – Regulatory Impacts. As shown 53%. 5 This consolidation trend has generally resulted
in Display 3, between 1999 and up to the start of the GFC in a smaller number of banks that are more focused
in 2007, a period that included a number of high-profile on lending to larger borrowers.

DISPLAY 3
Number of FDIC-Insured Banks
12,000
9,904 53% Total Decline
10,000

8,000

6,000
4,587
4,000

2,000

0
2000 2004 2008 2011 2016 2020 2023

Source: FDIC, as of December 31, 2023.

DISPLAY 4
Banks’ Declining Share of LBO Loans to PE Borrowers
100

80

60

40

20

0
2019 2020 2021 2022 2023 2024
■ Banks ■ Private Credit
Source: Pitchbook LCD Data, as of September 30, 2024.

5
FDIC, as of December 31, 2023.

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The declining number of bank lenders, coupled with the Direct lenders have emerged as a provider of loans
declining willingness of these institutions to lend, has to the middle market. As shown in Display 4 on page 4,
led to a major shift in the source of funding for certain global banks’ share of the leveraged buyout loan market
borrower types. Private lenders have subsequently hasn’t risen above 50% since 2019 and dropped to as
moved to fill this gap, driving a large part of lending low as 7% in 2023.6
outside the banking system.

Direct Lending – Regulatory Impacts

The post-GFC regulations, which are discussed in detail below, contributed
to a shift in banks’ ability and willingness to issue or hold certain assets, driving
increased demand for Direct Lending.
„ Bank of International Settlements Framework III (“Basel III”): Basel III regulations were formed as a direct response to market-
wide contagion of bank collapses during the GFC. The Basel III framework is based on three target risk measures, requiring banks
to maintain minimum levels of capital, liquidity, and stable funding. Higher and broader minimums were proposed as recently as
2023 after the Silicon Valley Bank failure and the mini-bank crisis that ensued.
„ Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”): Dodd-Frank is legislation that initially
aimed to curb risk concentration of banks. In particular, the Volcker Rule, implemented under Dodd-Frank, restricted banks’
ability to lend to riskier borrowers, creating a gap in funding for private equity transactions. While the Dodd-Frank Act was
rolled back in 2018, its impacts have largely been unchanged, with banks’ overall risk tolerance significantly lower than
pre-GFC, and there are few indications of a potential reverse of this trend.
„ FDIC Leveraged Lending Guidance: In 2013, the Federal Deposit Insurance Corporation (FDIC) updated its guidance
on leveraged financed activities, decreasing risk appetite for banks and increasing the need for stress-testing exposures
and portfolios.

6
Pitchbook LCD Data. Based on deal count.

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 5

 Private Equity Demand – An Additional While Direct Lending had previously been limited in its ability to
Driver of Direct Lending Growth underwrite at the size required to be a viable alternative to the
syndicated loan market, this limitation has eroded significantly
Coinciding with ongoing bank consolidation and retrenchment,
over the past few years. Direct Lending institutions continue
markets have also seen a shift from public equity to private
to raise additional funds and expand the scope of their lending
equity. The number of publicly listed companies in the U.S.
capabilities. The scale at which direct lenders are now able to
has been declining for over two decades, with the total
underwrite debt and partner together makes Direct Lending
number of listed US companies decreasing by 43% from
a much more competitive option for private equity backed
1996 to 2022.7 This reduction is related to several factors,
borrowers. A form of financing once only tapped by smaller,
including regulations such as the 2002 Sarbanes-Oxley
sponsor-backed companies evolved into a market that can meet
Act, which heightened requirements for public company
the financing needs of much larger companies. Private equity
filings and governance. Small and medium companies have
firms are now able to execute debt financings of more than
also increasingly found value in working with private equity
$5 billion for their portfolio companies in the private market.
investors who generally have a longer-term focus on growth
versus public investors who focus heavily on quarterly results. Another potential factor that may contribute to continued
need for Private Credit is the “maturity wall” for middle
To address the growing debt capital need from private equity,
market companies with debt that is coming due. As shown
Direct Lending has become a source of funding for private
in Display 6 below, the combined value of maturing BDC
equity sponsors. The approximately 9% compound annual
and syndicated loans to middle market companies
growth rate (CAGR) in private equity dry powder since
averages $155 billion per year through 2030, and peaks
2014 (Display 5) suggests the demand for Direct Lending
at $210 billion in 2028. The growing amount of maturing
capital will likely continue.
debt suggests that the middle market will remain in
need of financing, and private lenders will likely benefit
from this dynamic.

DISPLAY 5 DISPLAY 6
Global Private Equity Dry Powder Middle Market Debt Maturities Through 2030

$1.7T $250
$1,700

$208 $210
$195
$200
$182
$1,425 $155B
Average
9% Compound
Annual Growth Rate $150
$ Billions
$ Billions

$1,150 $111

$100

$63
$875
$50

$600 $0
2014 2016 2018 2020 2022 2024 2025 2026 2027 2028 2029 2030

Source: PitchBook, as of June 30, 2024. Source: LESG LPC and Morgan Stanley Investment Management. Represents
combined total of BDC and syndicated middle market loan maturities, as of
September 30, 2024.

7
World Federation of Exchanges, data as of December 31, 2022.

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Direct Lending – Attractive Attributes „ More flexibility: Private Credit lenders typically have more
for Borrowers flexibility than public debt lenders to meet a borrower’s
unique needs. Relative to their public counterparts, private
Beyond the supply-side market dynamics discussed herein, lenders are more likely to be willing to negotiate the terms
Direct Lending has a number of advantages that make it of a loan, such as the interest rate structure, the repayment
attractive to middle market borrowers and private equity schedule and the covenants. Additionally, optionality
owners of middle market companies, helping drive demand provided by Private Credit lenders such as committed
for the asset class. Features of Direct Lending can also increase Delayed Draw Term Loans (DDTL) allows borrowers to
alignment between the borrower and lender, which also can request funds after the loan’s initial close for specific
lead to better outcomes for both borrowers and lenders. purposes such as acquisitions or major capital projects.
„ Speed and certainty of transactions: Direct lenders DDTLs are typically available for up to two years post-close
can offer borrowers and private equity sponsors a and allow borrowers to reserve their revolving loan capacity
more nimble underwriting process, leading to a quicker to manage working capital and fund ongoing operations.
turnaround and lower fees than what banks had previously Further, unlike traditional term loans, payment of interest
offered. A smaller number of lenders and a more bespoke on DDTLs is not required until the DDTL is utilized.
process means transactions can close more quickly than „ No ratings requirement: Ratings require additional hurdles
a syndicated loan process. and costs for borrowers. Rated transactions also result
„ No syndication risk: The process of syndication can also in borrowers’ financial results being widely distributed.
introduce risks for borrowers, most notably that a loan’s „ Cost efficiencies: Although Private Credit offers lenders
yield is not guaranteed during the syndication process of an illiquidity premium, the costs to borrowers are often
a transaction; borrowers may end up with a higher rate not significantly higher than public issuances fees. Instead,
on their loan than the underwriters marketed. Likewise, underwriting costs are captured by investors in a private
the syndication process allows for possible changes in deal through original issue discounts and call premiums.
deal terms between arranging and close. „ Direct relationship: In private debt transactions, the
– The scale at which direct lenders are now able lender typically has a direct relationship with the borrower.
to underwrite debt and partner together makes This dynamic means that the lender can work with the
Direct Lending a viable competitive alternative borrower to develop a financing plan that meets their
to the syndicated loan market for private equity- needs, while also monitoring its performance closely.
backed borrowers. As mentioned above, private „ Longer-term focus: Private debt lenders typically have
equity firms are now able to execute $5 billion a longer-term focus than public debt lenders. A patient
or more debt financings for their portfolio companies approach to lending means that direct lenders are more
in the private market. 8 likely to be partnership-oriented with borrowers who
are experiencing temporary financial challenges.

8
Bloomberg, “Private Credit Loans Are Growing Bigger and Breaking Records,” Lisa Lee, John Sage. April 17 2023.

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 7

Characteristics of
Direct Lending Investments

Structural Elements
To understand Direct Lending in greater detail, it is important to understand the structural
elements that define a Direct Lending investment. The below elements are key components
in determining the return and risk profile of a Direct Lending investment.

Direct Lending loans range in their seniority from senior to junior, may be secured
LOAN or unsecured by collateral, and may include equity components. Loan types are
SENIORITY discussed in greater detail on page 9.

Direct Lending investments provide a periodic coupon payment based on the terms of
the loan. Direct Lending investments generally receive a floating rate coupon comprised
of a benchmark return such as the Secured Overnight Funds Rate (SOFR) and a
COUPON
certain “spread” over that benchmark. The total coupon is the benchmark rate plus
the spread over the benchmark rate. For example, if SOFR is 4.00% and
the spread is 5.00%, the coupon is 9.00%.
The term is the length of time over which the loan will be repaid. Direct Lending
TERM/TIME investments generally have terms of two to six years, which is shorter than typical
TO MATURITY fixed income investments, such as broadly syndicated loans.

ORIGINAL Original issue discount (OID) is the difference between the face value of a debt
ISSUE instrument and its issue price. OIDs can be a way for direct lenders to enhance
DISCOUNT their return.

Depending on the loan type, direct lenders may issue collateral-based loans, backed
by current assets, real estate or other non-liquid assets such as intellectual
COLLATERAL property. Direct loans usually also provide for a security interest in the
borrower’s common equity.

Covenants are contractual provisions designated by lenders that reduce lenders’ risk.
COVENANTS They can include minimum financial performance and other operational requirements,
and security interest maintenance mandates.

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Senior, Junior and Unitranche Loan Comparison
When making direct investments, lenders usually make loans either as senior or junior
debt, or a unitranche loan, which is a combination of the two, depending on the specific
risk-return profile they are seeking and a borrower’s capital need.
Senior Debt: Senior debt is the highest-ranking type of debt in a loan structure. Senior debt holders
1 have first claim on the borrower’s assets in the event of a default. Senior debt is typically issued by
banks or direct lenders.

Junior Debt: Junior debt is the second-ranking type of debt in a loan structure. This means that junior debt
2 holders have a claim on the borrower’s assets after senior debt holders have been paid in full. Junior debt
is typically provided by funds raised specifically to invest in junior debt, or other institutional investors who
are willing to take on more risk in exchange for a higher return.

Unitranche: Unitranche is a type of debt financing that combines senior and junior debt into a single loan.
3 This debt structure means that unitranche lenders have a senior claim on the borrower’s assets, but they
also need to accept some of the risks associated with junior debt. Unitranche loans can reduce the borrower’s
burden of holding two loans, coordinating with multiple lenders, and reduce the cross-default risk from
issuing two loans. In return, direct lenders can expect higher rates on unitranche loans relative to senior
debt, as well as a premium for their illiquidity. In recent years, unitranche loans have grown as a popular
stand-alone option for Direct Lending, with global market for unitranche loans expected to reach $1 trillion
by 2025.9 Unitranche loans are the preferred alternative for private equity owners to a syndicated loan
execution with senior and junior debt.

DISPLAY 7
Direct Lending Capital Structure Option Comparison

Lower BIFURCATED DEBT CAPITAL STRUCTURE UNITRANCHE DEBT CAPITAL STRUCTURE

}
Yielding

SENIOR DEBT
UNITRANCHE LOAN
JUNIOR DEBT

EQUITY EQUITY
Higher
Yielding

9
Preqin, Preqin Global Report 2023: Private Debt.

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 9

Increasing Equity Contributions
As Direct Lending has grown, there has also been a trend equity contributions are rising interest rates, increased
toward greater equity contribution in deals and lower loan- regulatory scrutiny and a more cautious approach to risk
to-enterprise value (LTV). There is an inverse relationship by private equity sponsors.
between equity contribution and LTV. This shift means that
The trends discussed above can generally be taken as a
private equity sponsors are contributing greater equity
positive sign for lenders that private equity sponsors believe
to new buyouts and are relying less on debt financing.
they can still generate attractive returns on their investments,
As shown in Display 8, average equity contribution was
even with less debt. Further, on average, private equity firms
49% in 2013 and 61% for the last 12 months, ending
that buy companies with a greater percentage of equity are
September 30, 2024. Correspondingly, as shown in Display 9,
more aligned with lenders in the performance of their portfolio
loan-to-enterprise value in middle market LBO deals has moved
companies. As such, they are more likely to support their
downward consistently since 2015. For the last 12 months ended
portfolio companies with additional equity capital in times
September 30, 2024, average LTV was the lowest level on
of need, which can improve lender recovery rates versus
record. The primary reasons for lower LTVs and higher
non-private equity-sponsored transactions.

DISPLAY 8 DISPLAY 9
LBO Total Equity Contribution for LBO Loan to Value for
Middle Market Loans (%) Middle Market Loans (%)
65% 55%

55%

45%

45%

35% 35%
2013 2014 2015 2016 2017 2018 2019 2020 2021 2017 2023 2024 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Source: LSEG LPC US Sponsored Middle Market Private Deals Analysis. Source: LSEG LPC U.S. Sponsored Middle Market Private Deals
Data as of September 30, 2024. Annual #s based on average across Analysis. Data as of September 30, 2024.
each quarter.

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 Why invest in Direct Lending?

Rationale for Private Credit Portfolio Allocation

Investors should consider an allocation to Private Credit for a number of reasons. In general,
both the attractive return and downside protection elements define the profile of the asset
class. Several characteristics are driving investors to allocate to Direct Lending. While not
comprehensive, investors generally allocate to Direct Lending for the following reasons:
Returns Enhancing Downside Protection
Current Income: Direct Lending offers investors current Inflation Protection: Private Credit may provide investors
income in the form of periodic distributions. with inflation protection by way of the floating rate
coupons associated with the underlying loan.

Illiquidity Premium: Unlike traditional assets such as Diversification: According to Preqin data, diversification
stocks and bonds, Direct Lending investments are less is the most frequently cited reason to add Private Credit
liquid and therefore command a premium associated to a portfolio; more than 70% of surveyed investors
with liquidity risk. Display 10 illustrates the historic indicated diversification as a driver.10
spread above the risk-free rate, and broadly syndicated loans
that direct lending has provided. This premium can enhance Loan Level Protections and Operational Enhancements:
returns for investors whose investment horizon allows them Unlike traditional fixed income, direct loans tend to be
to bear this illiquidity. more highly negotiated, with the opportunity for covenants
and contractual obligations within the loan terms. Direct lenders
Enhanced Risk/Return: As discussed in detail in also may have a more direct relationship with borrowers, allowing
the following section, portfolios including Private for closer alignment and therefore positive outcomes for both
Credit offer enhanced alpha and higher returns borrowers and investors. These factors can potentially reduce
with lower volatility. default risk or increase recovery amounts for the underlying
loans and improve performance for investors.

DISPLAY 10
Historical Yield Differences Between Direct Lending, Broadly Syndicated Loans and T-Bills (2016-Present)
12%
Current Yield % (TTM)

8%

4%

0%
2016 2017 2018 2019 2020 2021 2022 2023 2024
■ Risk-Free Rate (Treasury Bills) ■ Broadly Syndicated Loans ■ Upper Middle Market Direct Loans

Source: Cliffwater Data as of September 30, 2024. Chart provided with permission of Cliffwater. Please see disclosures for further details.
10
Preqin, Global Report 2023, Private Debt.

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Historical Performance
Direct Lending has shown strong returns over time on both $393 billion of direct loans held by public and private BDCs,
an absolute basis and relative basis when compared with fixed Direct Lending has averaged 9.53% annualized gross return
income and a number of other asset classes. One of the ways since index inception in 2004 (Display 11).11
performance of Direct Lending can be measured over time is
Spreads over the floating rate benchmark for Direct
from the performance of a group of investment vehicles know
Lending have maintained a steady margin above syndicated
as Business Development Companies, or BDCs, which are
deals. According to Pitchbook data (Display 12), direct
entities registered under the Investment Company Act of 1940,
lending spreads on LBO loans averaged 178 basis points
with the specialized focus of making investments in small to
above comparably rated syndicated loans for most of
medium sized US companies. According to the Cliffwater
2024. This incremental return is primarily the result of
Direct Lending Index (CDLI), which consists of approximately
the “illiquidity premium” investors receive for providing
direct loans to middle market companies.

DISPLAY 11 DISPLAY 12
Direct Lending Annual Total Return (%) LBO Loan Spreads: Direct Lending vs. BSL
20% 800 250

200
15% 600

150

10% 400

100

5% 200
50

0% 0 0
2019 2020 2021 2022 2023 2024 2018 2019 2020 2021 2022 2023 2024
■ Total Return: Last 4 Quarters Total Return Since Inception  Difference (right axis) BSL spread Direct lending spread
(Annualized) = 9.53%
Source: Cliffwater Direct Lending Index as of September 30, 2024. Source: PitchBook LCD. Data through December 4, 2024. BSL data
Chart provided with permission of Cliffwater. Please see disclosures reflects loans issued to borrowers rated B-minus.
for further details.

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In rising rate environments, Direct Lending’s performance is Middle market loans, the traditional target of Direct
particularly strong relative to its fixed income counterparts, Lending, have exhibited a better ability to repay principal
such as broadly syndicated loans, leveraged loans, and high- over time. As shown in Display 14, when compared with
yield bonds. As shown in Display 13 (left-hand side), when large corporate loans, middle-market loans have shown
measured over seven different periods of high interest rates lower rates of default, higher recovery rates, and lower
between the first quarter of 2009 and the second quarter cumulative loss rates. Over the last 25 years, the average
of 2022, private credit generated average returns of 11.5%, default rate for middle market loans was 1.0% compared
compared with 4.9% for leveraged loans and 6.8% for to 2.1% for large corporate loans.
high-yield bonds.11 Likewise, the strategy has performed well
On the whole, these metrics suggest Direct Lending can
during periods of volatility, such as the Global Financial Crisis,
provide an attractive current yield across multiple market
and more recently, the COVID-19 pandemic.
environments, with potentially greater downside protection
than traditional fixed income investments.

DISPLAY 13
Direct Lending, Leveraged Loans, High Yield Bond Return Comparisons
Average Returns Over High Interest Rate Environments Annualized Returns Divided by Volatility
11.5% 1.1x

0.8x 0.8x
6.8%
4.9%

Direct Lending Leveraged Loans High Yield Bonds Direct Lending Leveraged Loans High Yield Bonds

Source: “Direct Lending” is represented by the Cliffwater Direct Lending Index (CDLI) and is calculated from quarterly data, which has been annualized.
“Leveraged Loans” is represented by the Morningstar LSTA U.S. Leveraged Loan Index calculated from annualized monthly data. “High Yield Bonds” is
represented by the ICE BofA High Yield Index calculated from annualized monthly data. High-rate environments are defined as periods of uninterrupted
monthly increases in the 10-year US Treasury yield of 75 basis points or more. Return comparisons are based on the average of annualized monthly returns
during seven such periods between 4Q’08 and 1Q’23. Volatility is measured using the standard deviation of annualized monthly returns. Ratios are based
on the average of all monthly data between Q1’08 and Q4’22.

DISPLAY 14
Cumulative Default, Loss, and Recovery Rates on Large Corporate vs. Middle Market Loan Sizes (1998-2023)
CUMULATIVE DEFAULT RATE12 CUMULATIVE RECOVERY RATE13 CUMULATIVE LOSS RATE14

5.4% 2.1%
68.3%
61.0%

3.1%
1.0%

Middle Market Large Corporate Middle Market Large Corporate Middle Market Large Corporate

Notes: Middle-market is defined as facility size of $250M or less. Large corporate loans defined as facility size greater than $250M.
11
Please see notes to Display 13.
12
PitchBook LCD data. Based on the cumulative total of defaults between 1998 and 2023 on broadly syndicated institutional loans (12,223 issuers).
13
S&P Credit Pro data. Based on cumulative recovery on defaulted loans in the broadly syndicated institutional market between 1995 and 2023.
14
Cumulative loss rate is calculated using the following formula: Loss Rate = Default Rate x (1 – Recovery Rate).

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 13

Where Does Direct Lending
Fit Into a Portfolio?
As Private Credit markets have matured, Direct Lending According to an analysis conducted by Preqin, Private
has become a standard allocation across many institutional Debt consistently enhanced the Sharpe ratio (return
and individual investor portfolios through a variety of divided by volatility) across a broad range of scenarios
vehicle types. Managers have continued to build out their when included in a portfolio of public assets (1.29 to 1.72)
Direct Lending platforms, widening the range of options versus the same portfolio without Private Debt (1.03
to access Direct Lending. As highlighted in Displays 15 to 1.23). Moreover, the analysis concluded that Private
and 16, institutional investors, such as pension funds, Debt can reduce portfolio tail risk during periods of
endowments, and insurance companies, have been exceptionally high volatility.15
allocating a greater portion of their portfolios to private
credit strategies to capture higher yields and enhance
their overall portfolio performance.

DISPLAY 15
Investor 12-Month Allocation Expectations for Alternative Asset Classes

Private debt

Private equity

Infrastructure

Real estate

Venture capital

Hedge funds

Natural
resources
 More capital  Same amount of capital  Less capital
Source: Preqin Investor Survey, June 30, 2024.

15
Preqin Global 2023 Report: Private Debt, January 1, 2023.

14 MORGAN STANLE Y INVESTMENT MANAGEMENT | THE E VOLUTION OF DIREC T LENDING

 Asset allocation data suggests optimized portfolios should As shown in Display 16, according to a 2024 poll by Preqin,
include a 10-20% exposure to Direct Lending, which surveys 53% of investors planned on boosting their commitment to
indicate is the direction many investors are following. private credit, up from 48% in 2022. Private credit led all
Specifically, Cliffwater found the optimal portfolio allocation other alternatives as an area of increased allocation in the year
to unlevered Direct Lending to be 11% and the optimal portfolio ahead. Overall, we expect the appetite for Direct Lending
allocation for a 1:1 levered Direct Lending strategy to be 20%.16,17 to grow, as it becomes a more standard allocation tool
for investors of all sizes.

DISPLAY 16
Institutional Investor Plans to Allocate to Private Credit (2022 – 2024)
100% 7% 6%
1%

80%
46%
45% 43%
Proportion of Respondents

60%

40%

51% 53%
48%
20%

0% 2022 2023 2024

■ Increase allocation ■ Maintain allocation ■ Decrease allocation
Source: Preqin Investor Surveys, June 2022 – 2024

16
Range of 8% to 14% based on risk tolerance.
17
Assumes no more than 40% allocation to illiquid assets and no more than 20% to any individual asset class.

THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 15

Appendix

GLOSSARY DEFINITIONS DISCLOSURES

Bloomberg Barclays US Aggregate Bond Index – represents securities that The views and opinions and/or analysis expressed are those of the author
are SEC-registered, taxable, and dollar denominated. The index covers the or the investment team as of the date of preparation of this material and
U.S. investment grade fixed rate bond market, with index components for are subject to change at any time without notice due to market or economic
government and corporate securities, mortgage pass-through securities, conditions and may not necessarily come to pass. Furthermore, the views will
and asset-backed securities. These major sectors are subdivided into more not be updated or otherwise revised to reflect information that subsequently
specific indices that are calculated and reported on a regular basis becomes available or circumstances existing, or changes occurring, after the
Bloomberg Barclays US Corporate Bond Index – measures the investment date of publication. The views expressed do not reflect the opinions of all
grade, fixed-rate, taxable corporate bond market investment personnel at Morgan Stanley Investment Management (MSIM) and
Bloomberg Barclays US Corporate High Yield Index – measures the USD- its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected
denominated, high yield, fixed-rate corporate bond market. Securities are in all the strategies and products that the Firm offers.
classified as high yield if the middle rating of Moody’s, Fitch and S&P is Forecasts and/or estimates provided herein are subject to change and may
Ba1/BB+/BB+ or below. not actually come to pass. Information regarding expected market returns
BSL – Broadly syndicated loans and market outlooks is based on the research, analysis and opinions of the
authors or the investment team. These conclusions are speculative in nature,
Call protection – bond provision that prohibits the issuer from buying it
may not come to pass and are not intended to predict the future performance
back for a specified timeframe
of any specific strategy or product the Firm offers. Future results may differ
EBITDA – Earnings before interest, taxes, depreciation and amortization significantly depending on factors such as changes in securities or financial
First Lien (also referred to as senior debt) – Secured debt with first markets or general economic conditions.
priority lien on borrower assets This material has been prepared on the basis of publicly available information,
Leveraged Loan – Loan provided to issues that already have high levels internally developed data and other third-party sources believed to be
of debt reliable. However, no assurances are provided regarding the reliability of such
Loan to Value – the relationship between the loan amount and the information and the Firm has not sought to independently verify information
market value of the asset securing the loan taken from public and third-party sources.
Mezzanine – debt between secured senior debt and equity Forward looking statements are by their nature inherently uncertain insofar as
Middle-Market Companies – companies that, in general, generate annual actual realized returns or other projected results can change quickly based on,
EBITDA in the range of approximately $15 million to $100 million among other things, unexpected market movements, changes in interest rates,
OID – original issue discount legislative or regulatory developments, acts of God, and other developments.
Past performance is not indicative of future results. All forecasts are subject
Morningstar/LSTA Leveraged Loan Index – is a market value-weighted
to change at any time and may not come to pass due to changes in market
index designed to measure the performance of the US leveraged loan
or economic conditions. Certain information contained herein constitutes
market based upon market weightings, spreads and interest payments.
forward-looking statements, which can be identified by the use of forward-
Second Lien (also referred to as junior debt) – Secured debt with looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,”
second priority lien on borrower assets “project,” “estimate,” “intend,” continue” or “believe” or the negatives thereof
Special Situations – investments in companies involved in a takeover or other variations thereon or other comparable terminology. Due to various
or financial difficulty risks and uncertainties, actual events or results may differ materially from
Sponsor – Private equity firm acquiring the majority of target those reflected or contemplated in such forward-looking statements.
company’s equity No representation or warranty is made as to future performance or such
The Cliffwater Direct Lending Index (CDLI) – seeks to measure the forward-looking statements.
unlevered, gross of fee performance of U.S. middle-market corporate loans, Alternative investments typically have higher fees and expenses than other
as represented by the asset- weighted performance of the underlying assets investment vehicles, and such fees and expenses will lower returns achieved
of Business Development Companies (BDCs), including both exchange- by investors. Alternative investment funds are often unregulated, are not
traded and unlisted BDCs, subject to certain eligibility requirements. subject to the same regulatory requirements as mutual funds, and are not
UBTI – Unrelated business taxable income required to provide periodic pricing or valuation information to investors.
Unitranche – hybrid loan structure that combines senior and subordinated debt The investment strategies described in the preceding pages may not be
suitable for the recipient’s specific circumstances; accordingly, you should
Venture Debt – loans extended to startups or fast-growing companies consult your own tax, legal or other advisors, both at the outset of any
transaction and on an ongoing basis, to determine such suitability.

16 MORGAN STANLE Y INVESTMENT MANAGEMENT | THE E VOLUTION OF DIREC T LENDING

This material is a general communication, which is not impartial and all Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo
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educational purposes and does not constitute an offer or a recommendation to (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 1 1096HA,
buy or sell any particular security or to adopt any specific investment strategy. Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008
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consequences, before making any investment decision. NOT A DEPOSIT.
The Firm does not provide tax advice. The tax information contained herein Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for
is general and is not exhaustive by nature. It was not intended or written to use in Hong Kong and shall only be made available to “professional investors”
be used, and it cannot be used by any taxpayer, for the purpose of avoiding as defined under the Securities and Futures Ordinance of Hong Kong (Cap
penalties that may be imposed on the taxpayer. Each Jurisdiction tax laws are 571). The contents of this material have not been reviewed nor approved by
complex and constantly changing. You should always consult your own legal or any regulatory authority including the Securities and Futures Commission
tax professional for information concerning your individual situation. in Hong Kong. Accordingly, save where an exemption is available under the
Charts and graphs provided herein are for illustrative purposes only. Past relevant law, this material shall not be issued, circulated, distributed, directed
performance is no guarantee of future results. at, or made available to, the public in Hong Kong. Singapore: This material
The indexes are unmanaged and do not include any expenses, fees or sales is disseminated by Morgan Stanley Investment Management Company and
charges. It is not possible to invest directly in an index. Any index referred to should not be considered to be the subject of an invitation for subscription
herein is the intellectual property (including registered trademarks) of the or purchase, whether directly or indirectly, to the public or any member of
applicable licensor. Any product based on an index is in no way sponsored, the public in Singapore other than (i) to an institutional investor under section
endorsed, sold or promoted by the applicable licensor and it shall not have 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii)
any liability with respect thereto. to a “relevant person” (which includes an accredited investor) pursuant
This material is not a product of Morgan Stanley’s Research Department to section 305 of the SFA, and such distribution is in accordance with the
and should not be regarded as a research material or a recommendation. conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to,
and in accordance with the conditions of, any other applicable provision of
“Cliffwater,” “Cliffwater Direct Lending Index,” and “CDLI” are trademarks of
the SFA. This publication has not been reviewed by the Monetary Authority
Cliffwater LLC. The Cliffwater Direct Lending Indexes (the “Indexes”) and all
of Singapore.
information on the performance or characteristics thereof (“Index Data”) are
owned exclusively by Cliffwater LLC, and are referenced herein under license. Australia: This material is disseminated in Australia by Morgan Stanley
Neither Cliffwater nor any of its affiliates sponsor or endorse, or are affiliated Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No.
with or otherwise connected to, Morgan Stanley, or any of its products or 314182, which accept responsibility for its contents. This publication, and any
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implied. Cliffwater and its affiliates do not accept any liability whatsoever 157 434 is regulated by the U.S. Securities and Exchange Commission under
for any errors or omissions in the Indexes or Index Data, or arising from any U.S. laws which differ from Australian laws. Calvert Research and Management
use of the Indexes or Index Data, and no third party may rely on any Indexes is exempt from the requirement to hold an Australian financial services licence
or Index Data referenced in this report. No further distribution of Index in accordance with class order 03/1100 in respect of the provision of financial
Data is permitted without the express written consent of Cliffwater. services to wholesale clients in Australia
Any reference to or use of the Index or Index Data is subject to the further Japan: For professional investors, this document is circulated or distributed for
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This is not for the purpose of a recommendation or solicitation of transactions
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THE E VOLUTION OF DIREC T LENDING | MORGAN STANLE Y INVESTMENT MANAGEMENT 17

About Morgan Stanley Private Credit
Morgan Stanley Private Credit, part of Morgan Stanley
Investment Management, is a private credit platform
focused on Direct Lending and opportunistic private
credit investment in North America and Western
Europe. The Morgan Stanley Private Credit team invests
across the capital structure, including senior secured
term loans, unitranche loans, junior debt, structured
equity and common equity co-investments.
For further information, please visit the website:
www.morganstanley.com/im/privatecredit.

morganstanley.com/im/privatecredit
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