AI Disruption is Reshaping Software Credit
SaaS valuations are contracting as AI challenges traditional moats, pushing lenders toward credits with strong defensibility and creating opportunities in AI‑insulated sectors.
Capital Solutions Tools are Becoming Essential
Capital solutions and the creative options these funds can provide are becoming more mainstream, providing an increasingly relevant flexible capital as underlying portfolio stress is appearing.
Private Credit is Overtaking Public Markets
Direct lending now leads European buyout financing as significant dry powder facilitates pricing convergence and structural flexibility.
As 2026 unfolds, European credit investors are contending with a market in transition: SaaS valuations under pressure from AI, growing stress within private credit portfolios requiring creative capital tools and a private debt market eclipsing public issuance in sponsor financing. These dynamics are reshaping pricing, structure and sector focus across the continent.
The European software sector, which in the last two years has accounted for 40% of direct lending transactions, is facing a fundamental re-evaluation as advancements from Anthropic and OpenAI disrupt traditional SaaS moats. This "SaaS-pocalypse" narrative has driven a contraction in software multiples, at a minimum causing a pause in activity and, for highly levered private credits with a perceived lack of AI defensibility, pushing loan-to-value ratios beyond levels lenders ever anticipated. But lender sentiment is polarised and while some are fully risk-off, others (unsurprisingly including those with specialist sector teams) see it is an overreaction and remain keen to deploy.
Even for those still keen to transact, ICs need be comfortable with the defensive characteristics of a credit in the face of this market noise. The characteristics gaining support include: (i) proprietary domain data (ii) entrenched vertical integration (iii) regulatory auditability (iv) applications embedded into workflow rules (v) criticality and consequences for inaccuracies and (vi) where management teams are embracing the operationalizing of AI.
The software fallout has triggered contagion into adjacent sectors and other business models, such as professional services, perceived as susceptible to AI risk, are also facing challenges raising capital. This has created a window of opportunity for AI-insulated credits in previously neglected sectors in a market still full of capital. Baird expects this trend to continue in the short-medium term and drive competitive terms for borrowers in these more traditional sectors, despite the recent turmoil.
Underlying portfolio stress is becoming increasingly visible through continued debt fund equitisations. Reported debt-for-equity swaps hit a similar level again in 2025 (32 vs 31 in 2024) with a noticeable increase at the end of the year (14 in the final quarter). This activity remains highly concentrated, with approximately two-thirds of 2025 debt-for-equity swaps involving just ten asset managers.
While headline default rates for 2026 are forecast to rise a little 3.0% to 3.5% (above the long-term European average of 2.0% - 2.5%), these figures largely mask the underlying stress being managed through creative "negotiated pauses" and out-of-court settlements. To preserve cash for operations and avoid enforcement triggers, there is a growing reliance on Payment-in-Kind toggles and innovative junior capital instruments. PIK loan volumes increased 23% 2025 from 2024, with direct lenders deploying more than 10% of their total capital into such structures by the third quarter of 2025. This increase also reflects a rise in PIK-by-amendment (i.e. deferring interest beyond levels permitted in the original documentation), which reached 6% of direct lending investments in Q3 2025 - more than doubling the level seen in 2021.
This environment has fuelled further growth in dedicated Capital Solutions funds, transforming what was once an opportunistic niche for alternative credit managers into a core strategy for private credit. As portfolio challenges emerge, capital solutions have become a mainstream alternative to some of the more niche hedge-fund-type providers of the past.
Baird has recent experience in sourcing flexible capital to alleviate maturity walls, covenant breaches, and unsupportive incumbent lender dynamics.
The landscape for European buy-out debt has reached an inflection point as direct lending officially surpassed institutional syndicated debt as the primary source of M&A financing in 2025. Last year, private market issuance for buy-outs reached EUR 19.1 billion, against the EUR 10.4 billion provided by public markets, illustrating the shift in sponsors’ approach to raising capital. There are several reasons for this.
Dry powder in the private market continues to grow, indeed European-focused private credit fundraising overtook the US for the first time last year ($66bn vs. $52bn in the first 9 months of 2025), helped by a reallocation from some US investors given heightened nervousness on the domestic economy and geopolitical risk. This, combined with the continued slow pace of M&A, has continued to drive credit spreads and fees down in the private market such that the premium vs the public market ended the year at an average of just 77bps, the narrowest level in recent years.
Furthermore, the threshold at which the private market is prepared to provide cov-lite structures continues to fall, removing a further historic advantage of the public market. And if not on day one, the private market is increasingly willing to provide cov-lite triggers once EBITDA hits a minimum level.
With this narrowing in pricing and scope for cov-lite, the premium to avoid the spotlight of the rating agencies and the fall-out from unhelpful discounted trading of underperforming credits is starting to look very good value.
Andrew Lynn
+44-20-7667-8529
anlynn@rwbaird.com
James Jewers
+44-20-7667-8592
jjewers@rwbaird.com
