Between 2015 and 2021, the U.S. leveraged loan market grew 75%, ballooning from roughly $800 billion to $1.4 trillion.
Private equity deal volume in the middle market topped 10,000 transactions during the COVID-era peak of 2020–2022, nearly 75% of all PE deals. Lenders competed aggressively to deploy capital. Coverage ratios compressed. Covenant-lite became the norm. The businesses didn't get better. The credit terms got worse.
At Axar, we've watched this pattern before: significant growth, reversal of the factors underpinning that growth, erosion of credit quality, and increased defaults. It's a familiar cycle in credit markets. And we believe we're still in the early innings of the current one.
The expansion was fueled by generationally low interest rates, an extended economic expansion, and insatiable demand from private equity for leveraged buyouts. CLOs, flush with capital from the same tailwinds, competed with each other to deploy greater sums to a universe of companies that remained roughly flat over the same period.
The result was predictable: lenders eagerly provided more debt to sponsor-backed companies, increasing leverage on increasingly generous terms. Purchase multiples averaged roughly 12x from 2020–2022, compared to about 8x in 2007, a 33% increase. These companies were never underwritten to service persistent interest costs not seen since the early 2000s.
Lenders took comfort in record equity valuations, strong free cash flow, sponsor "relationships," and a benign macro picture. Then the tide shifted.
Starting in late 2022, the Federal Reserve tightened policy aggressively. Roughly 90% of the leveraged loan market is floating rate, and SOFR moved from near zero at the end of 2021 to approximately 4.3% by mid-2025. That translates to a roughly 75% increase in total borrowing costs for companies that were already stretched.
Many market participants expected this to be transitory, much like the inflation that caused it. It wasn't. The Fed has maintained its "elevated for longer" posture as sticky inflation persists, and executive branch tariff policy variability has further complicated an already difficult operating environment.
This isn't a crash. It's a grind. And grinds, in our experience, produce a deeper and more persistent opportunity set than sudden shocks.
The data tells a clear story. From January 2022 to June 2025, $427 billion in loans held by CLOs were downgraded, compared to just $265 billion upgraded. That's a 1.7-to-1 downgrade-to-upgrade ratio. This isn't a short-term blip: downgrades have outpaced upgrades in 36 of the last 37 months.
The drivers, according to Moody's, are weaker operating performance, reduced interest coverage, high leverage, and margin pressure from inflation and supply chain dislocations. Middle market companies, particularly those backed by private equity and purchased at peak multiples using peak COVID-era EBITDA with peak leverage at historically low rates, were never built to handle persistent interest costs at these levels.
The default rate, typically a lagging indicator, has responded. Today's dual-track default rate, which includes traditional "hard" defaults plus Liability Management Exercises, has reached nearly 8%, up from roughly 1% at year-end 2021. For perspective, peak default rates during the 2009 Global Financial Crisis reached 10%, and that was during a post-Lehman, 100-year economic shock. We're approaching similar levels during a period of near record equity markets, low unemployment, and relatively strong GDP growth.
A key factor driving the growth in defaults has been the rise of LMEs. These are voluntary defaults, initiated by financial sponsors responding to an inability to exit portfolio companies, an inability to refinance, or outright balance sheet stress.
From a borrower's perspective, an LME is a temporary lifeline: raise additional debt, usually super-senior, for fresh liquidity to kick the can and hope for recovery. But in nearly every LME we've studied, the fundamental issue of a bad balance sheet remains unresolved. LMEs delay restructurings. They rarely prevent them.
For Axar, that's the opportunity. Post-LME securities typically feature improved documentation and discounted entry points as incumbent CLO holders seek to exit. Roughly 60% of recent LME activity falls within the sub-$1 billion debt outstanding segment, our sweet spot. We're actively tracking numerous pre-LME situations that we'd be excited to invest in, depending on how negotiations evolve.
What makes today's opportunity distinct isn't just that credit standards deteriorated and then tightened. It's that the tightening is concentrated in middle-market structures where institutional capital operates inefficiently.
Large distressed funds have grown too big for this market. The average distressed debt fund raised in YTD 2025 is dramatically larger than those raised just two years ago. A $50 million position in a $300 million capital structure requires the same legal diligence, monitoring, and committee time as a $200 million position in a $2 billion structure. The economics don't work for firms deploying hundreds of millions per opportunity.
CLOs are structurally forced to sell. CLOs own over 75% of the leveraged loan market. When credit quality deteriorates and OC tests breach, CLO managers shift from optimizing equity returns to restoring compliance, typically by selling lower-rated credits. As of August 2025, CCC exposure in post-reinvestment period CLOs rose to 10.3%, up from 6.4% in January 2022, and junior OC test failures spiked from 5.1% to 30.7%. These managers aren't choosing to sell. They have to.
Former competitors have left the field. The number of distressed debt funds raised with strategies similar to ours has collapsed. From 2015 to 2021, an average of 12 comparable funds were raised annually. That dropped to seven between 2022 and 2024, with only one raised through June 2025. Many of our former competitors diversified into direct lending, capital solutions, and asset-backed finance, chasing scale over complexity.
These aren't temporary constraints. They're likely permanent features of how large institutional capital operates. The wider this moat becomes, the more persistent the opportunity.
We believe our approach is well-suited for this current environment. We go deep, not wide. We focus on a concentrated set of complex middle-market situations, building positions gradually over 18–24 months and increasing exposure as our conviction strengthens. We envision the exit at entry. We recruit transformational CEOs. We sit on boards. We don't buy and hope. We buy and build.
With a middle market universe of 100,000+ companies and over 15,000 sponsor-backed companies held for five years or longer, we see a deep and actionable pipeline. And with competition at its weakest in recent memory, we believe this environment will persist for several years.
Sub-investment-grade debt has grown at a roughly 6.4% CAGR over the last 20+ years. The opportunity set isn't shrinking. It's expanding. And the number of investors equipped to capture it is contracting.
This is the first in a series of perspectives drawn from our Credit Unbound research. In the full four-part series, we examine why competition has retreated from middle-market distressed debt, how structural factors in the leveraged loan market cause risk to be consistently mispriced, and why we believe Axar's process, expertise, and mandate are positioned to take advantage.
For allocators evaluating exposure to middle-market credit, distinguishing temporary dislocations from structural shifts matters. We believe this is structural.
Axar Capital Management LP is a $3.3 billion opportunistic investment manager focused on U.S. middle market companies with $200 million to $800 million in debt outstanding. Founded in 2015 and 100% employee-owned, Axar specializes in complex situations where traditional institutional capital operates inefficiently. The firm is headquartered at 402 W 13th Street, New York, NY.
Disclaimer: Axar Capital Management LP ("Axar") has prepared this content for informational purposes only. This content is not intended to constitute legal, tax, financial, or investment advice. While all information contained herein is believed to be accurate, no guarantee, representation or warranty is made as to its accuracy, completeness or fairness. Certain information reflects the current opinions of Axar which may prove to be incorrect and are subject to change. Past performance is not indicative of future results. Investing involves a material risk of loss. Certain statements herein reflect forward-looking views, which are inherently uncertain and subject to change. Actual results may differ materially.