Middle market direct lending is an increasingly important allocation for UK Local Government Pension Scheme (LGPS) funds, offering resilient income, structural downside protection, and diversification versus public credit. A bespoke approach spanning sponsored and non sponsored lending can enhance outcomes and improve risk adjusted returns, says John McNichols, head of investment product and strategy at PGIM.
The case for a broader opportunity set
The middle‑market direct lending universe is far from homogeneous. Sponsored and non‑sponsored borrowers often have distinct credit profiles, objectives and financing needs. While sponsor‑backed activity has expanded, non‑sponsored companies still represent about 90% of the opportunity set yet remain underserved due to sourcing complexity and relationship‑driven origination.
For long‑term investors such as LGPS funds, this imbalance presents a compelling opportunity. Private credit portfolios that combine sponsored and non‑sponsored exposures benefit from differentiated risk drivers, enhanced yield potential, and improved resilience across economic cycles.
The attributes of non‑sponsored direct lending
Non‑sponsored transactions can offer attractive structures but demand greater underwriting discipline. Without a private equity sponsor, and with some borrowers turning to private markets because banks will not lend, deep bottom‑up analysis and strong lender‑management relationships are critical to access and diligence.
These financings typically support non‑change‑of‑control events such as growth capital or recapitalisations, reducing exposure to the execution risks of leveraged buyouts and acquisitions. They often feature lower leverage, stronger covenants and bespoke documentation, with enhanced information rights and closer engagement with management. Origination capability adds flexibility: capital can be deployed based on relative value and fundamentals rather than volume, supporting disciplined portfolio construction across cycles.
The evolving opportunity set
Markets showed notable momentum in 2025. In the US, private credit has scaled rapidly, with assets under management approaching $2tn. Larger deal sizes and tighter spreads, alongside rising bank interconnectedness, have drawn regulatory scrutiny around opacity and concentration. Recent events also underscored liquidity and sector risks in some vehicles, including drawdowns in software.
Europe and the UK remain smaller, more fragmented and more relationship driven than the US, but structurally resilient. Europe’s private debt market is valued at approximately $600bn, which is roughly a third of the size of the US market. The UK accounted for about 30% of European direct lending deal volume in 2025, skewed to refinancings and bolt‑on M&A amid subdued buyout activity. Sponsored deals dominate the UK market with an estimated 85% market share, though non‑sponsored transactions are gaining market share.
Competitive pressure and excess dry powder have compressed margins in the upper mid‑market, with some erosion of covenant protection at the top end. At the same time, regulation has played a pivotal role, with AIFMD reforms and Bank of England stress tests elevating the importance of transparency and liquidity discipline and advantaging managers with strong local origination and downside control.
Persistent macroeconomic and geopolitical uncertainty is likely to keep borrowers focused on longer dated, flexible funding and diversified capital sources, positioning institutional direct lenders well to meet demand. We expect deployment to continue rising in 2026, supported by a strong sponsored pipeline, sustained interest in non-sponsored lending and a gradually improving backdrop for junior capital.
Why this matters for LGPS portfolios
For LGPS funds, middle‑market direct lending offers several compelling attributes: contractual income, floating‑rate exposure, senior secured positioning, and low correlation to public markets. Moreover, LGPS capital is structurally well‑suited to finance local UK infrastructure projects, where long‑dated, inflation‑linked cashflows align with scheme liabilities, and where pooled scale could unlock materially higher investment into transport, energy, housing and clean‑growth assets across the UK.
As the cycle matures, private credit outcomes will lean more on underwriting quality, covenant protection and manager discipline. The practical takeaway is to prioritise managers with origination control, strong documentation and clear early warning rights rather than scale alone. This selectivity aligns well with the long-term, patient capital profile of LGPS funds helping them deliver sustainable, long-term investment outcomes for members.
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