Middle Market Leveraged Finance Report – Q3 2025

Credit Market Conditions

Favorable Lending Conditions Prevail Heading Into Year-End 2025

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As we approach year-end 2025, the Middle Market Debt market remains quite “borrower friendly” and characterized by heightened competition amongst lenders for a limited set of lending opportunities, tightened secured overnight financing rate (SOFR) spreads, and unusually aggressive lending terms.

Today’s favorable market conditions have been driven by a pronounced technical supply/demand imbalance that has emerged over the past several years: simply too much capital (supply) chasing too few deals (demand). Limited partner (LP) investment capital has continued to pour into the Private Credit (PC) market, particularly the larger credit funds, resulting in drastically rising assets under management (AUM) and dry powder reserves awaiting deployment into new opportunities.

While some green shoots have started to emerge, loan transaction volumes in the PC market have been declining for the past five quarters, driven by continued lackluster merger and acquisition (M&A) deal flow within the middle market, the disruption caused by new tariff policies, and growing macroeconomic concerns. However, with the Federal Reserve’s (Fed) 25 basis point (bps) rate cut in September, anticipated future cuts, and better visibility on tariff policy, M&A activity is finally inching upward.

Private Credit Fundraising & Dry Powder

The past decade has witnessed a substantial amount of investment capital flowing into the PC and Direct Lending markets and a surge in loans being deployed by more than 100 credit funds that focus on the middle market. Not only has the number of new credit funds entering the market increased over the past five years, but the average fund size has risen dramatically as well. The average fund size in H1 2025 exceeded $900 million, up more than 50% from 2020 levels, according to the Private Debt Investor.¹ Funds raised have exceeded funds deployed, which has led to increased competition among lenders, a reduction of SOFR spreads throughout the market, and a buildup of dry powder available for new lending opportunities. Dry powder within U.S. direct lending funds exceeded $150 billion in 2024, according to PitchBook LCD.²

Loan Market Volume

Deal activity in year-to-date (YTD) 2025 has fallen short of expectations from late 2024, when lenders hoped that the second Trump administration would unleash a boom of M&A and buyout activity. This has failed to materialize, though deal flow has picked up modestly in recent months. Many lenders reported that while deal volume had begun to improve at the start of Q4 2025, YTD pace has still lagged that of 2024 levels by ~15% on both count and volume metrics due in large measure to April’s “Liberation Day” tariff shock that brought new-loan issuance to a halt. PC loan volume for the three months ending October 31 stood at $63 billion across 211 deals, slightly above Q3 2025 totals, according to PitchBook LCD.³ The modest uptick has been driven by greater visibility of U.S. trade policy and the direction of U.S. interest rates. Business development companies (BDCs) have reported a noticeable acceleration in the volume of transactions under initial review (a metric often considered a leading indicator for loan volume), according to PitchBook LCD.

Most of the M&A action lately has been concentrated in the mega-deal end of the market; the core and lower middle markets have yet to witness a credible uptick in buyout activity during H2 2025. While this portion of the market awaits the return of normalized M&A activity, “opportunistic loans” (refinancings and dividend recaps) have continued to dominate the Debt market—driven by strong lender demand, lower rates, and an easing monetary policy outlook.

The Healthcare and Technology sectors have attracted the most attention from lenders, garnering ~40% of overall new-deal direct lending deals (by count) through October 2025, while the Consumer & Retail, Chemicals, and Oil & Gas sectors have been underweighted thus far in 2025, according to PitchBook LCD.⁴

Interest Rates Declining

The Fed has undertaken two quarter-point rate cuts to date in 2025, which has helped stimulate M&A activity and offered much-needed relief to private equity (PE) sponsors navigating a difficult exit environment. The market predicts further rate cuts are coming, with the forward curve suggesting that SOFR will bottom out at just over 3% by March 2027, according to Chatham Financial.⁵

Given the middle market leveraged finance and broader Credit market’s supply/demand imbalance, SOFR spreads have tightened considerably over the past three years for corporate borrowers of all sizes. SOFR spreads vary principally by borrower size with large-cap unitranche loans pricing today in the SOFR + 4.5%-5% context and middle market loans pricing some 50-75 bps wider, according to New Mountain Capital.⁶ One large PC lender noted that while SOFR spreads are tighter than they were 12 months ago, they have remained relatively stable despite the lack of significant M&A volume.

Middle Market Borrowers Remain Strong

Middle market private companies have continued to perform well with year-over-year (YOY) revenue growth of 4% and earnings growth of 3.3% as of Q3 2025, the 12th quarter in a row of solid profit performance, according to a study by Golub Capital.⁷ This suggests U.S. companies continued to successfully navigate a challenging and uncertain environment in Q3 and profit margins were generally stable. Notably, profit margins even modestly expanded in some sectors (i.e., Healthcare and Technology). Moreover, the strong profit performance suggests such companies continued to exercise pricing power and maintain cost discipline—boosting cash flow even before the effects of the Fed’s rate cut in September and the future cuts expected by the market.

Refinancing Wave

Until “new money” M&A loan volume in the middle market returns to normal levels, PC lenders have turned to less preferred types of transactions to deploy capital, namely refinancings. Benefiting from the lowest spreads since the 2008 financial crisis, borrowers of all sizes have been seizing the opportunity to reduce loan rates and extend maturities on their credit facilities. Depending on credit profile, most lenders have been able to reduce loan rates by 1%-3% and take the opportunity to improve lending terms (covenants, delayed draw term loan re-loads, etc.).

Window is Open for Dividend Recaps (…for now)

For much of the past two years, sponsors have increasingly turned to loan-funded dividends as a means to return capital to their LPs given the difficulties of exiting portfolio investments through the traditional sale and initial public offering (IPO) routes. After minimal activity in 2022 and 2023, dividend recaps are back on the scene. These deals are typically reserved for companies with strong credit fundamentals and are often paired with an accretive use of proceeds (M&A or growth initiatives). Most lenders (especially banks) have a natural bias against dividend recaps but will generally consider such deals for existing borrowers and/or new clients showing particularly strong financial performance. When M&A platform acquisition activity eventually returns at scale, lender appetite for dividend recaps will inevitably decline to moderate levels.

Key Credit Metrics

Cashflow-based lenders focus on a variety of key measures and ratios when determining debt capacity, including debt/EBITDA, loan-to-value, and interest coverages, among others. Given today’s still elevated levels of nominal interest rates, debt capacity has been held in check by relatively thin coverage ratios (interest- and fixed charge-coverage). With interest rates on the downward trend, debt capacity levels are expected to inch upwards in coming quarters and benefit the middle market leveraged finance environment.

Stable Default Rates

Lower interest rates, accommodative lenders, and equity support from PE sponsors have positively impacted loan default rates. The Proskauer Private Credit Default Index for senior and unitranche loans in Q3 was 1.84%, a level consistent with the prior quarter figure (1.76%), according to a Proskauer press release.⁸ The index suggests that U.S. companies remain strong and resilient despite the impact of tariff policies and macroeconomic uncertainties. Moreover, it indicates that sponsors, borrowers, and lenders are proactively finding ways to avoid true defaults by addressing potential credit issues before they become acute. For those borrowers facing stress/distress, lenders have been quick to provide support through amendments that allow covenant relief, maturity extensions, and liberal use of Pay-In-Kind (PIK) interest. PIK interest essentially allows borrowers to pay its interest with more debt. Loans with a PIK component accounted for an average of 16% (~$20 billion) of total investments across the cohort of top 15 BDCs as of June 2025, according to PitchBook LCD. Credits shifting to non-accrual status are concentrated amongst those facing weaker consumer demand and tariff exposure.

Of note, the default rate for PC was lower than levels experienced in the Broadly Syndicated Loan (BSL) market largely due to the structural differences of PC: more rigorous underwriting, constant monitoring, greater access to information/management, a small group of lenders, and financial maintenance covenants.

What We Hear From Lenders

Recent surveys of middle market lenders echo the concerns that we continue to hear from PC lenders: (i) difficulty in sourcing new loan opportunities; (ii) prevalence of loose loan terms; and (iii) the potential for heightened stress/default risk, according to PitchBook LCD.⁹ Capstone has also noted, in some cases, that large lenders have moved down market to meet new-loan origination goals amid lackluster deal volumes in the upper market and, in the process, brought large-cap deal terms (i.e., borrower-friendly) with them—a benefit to smaller middle market borrowers.

Market Wrap Up

Q3 press releases from the top dozen BDCs share several themes: deal activity in all segments (mega, mid, and small) has begun to accelerate, competition among lenders remains aggressive (especially for top-tier borrowers), deal mix and building pipelines have improved, and more opportunities are being reviewed in committee. Overall, optimism of a more normal M&A market points to a strong H2 2026 and an even better 2027.

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