• Though the volume of large M&A transactions has remained muted, lower middle market companies—particularly those businesses with private equity sponsors—may represent a sweet spot for nonbank lenders. 
   
• ABL facilities have long served as an all-weather financing option for asset-rich but cash-constrained companies whose access to traditional capital market channels is often limited.
   
• Given the low correlation between direct lending and ABL returns, lenders with the experience and flexibility to opportunistically toggle between the two may be positioned to potentially provide investors with complementary sources of return across credit cycles.
   
• The ability to provide borrowers with flexible lending solutions while maintaining disciplined underwriting standards underpins consistent access to deal flow and may help drive attractive risk-adjusted returns for investors.

Shifting market dynamics in recent years highlight the importance of flexibility in a nonbank capital provider. Not only are nimble lenders able to deliver creative financing solutions to borrowers across liquidity environments, they also may be well positioned to provide investors with differentiated and complementary sources of return by leveraging the countercyclical interplay between directly originated loans and asset-based loans.

Even as competitive pressures have eroded negotiating power on larger cash flow-based loans, lower middle market borrowers continue to represent a sweet spot for lenders, in our view, particularly if they have a private equity sponsor. Meanwhile, asset-based loans—which are secured by specific collateral of the borrower—remain what we consider an all-weather source of competitively priced funding for asset-rich but cash-constrained companies. Private lenders able to offer exposure to multiple financing solutions may help drive attractive risk-adjusted returns for investors.

The Lower Middle Market Direct Lending Trifecta: Yield, Leverage and Structure

Unrated and without a secondary market, middle market loans offer investors complexity and illiquidity premia alongside credit premia, risks that can potentially be mitigated through vigorous underwriting and structuring. Typically positioned at the top of the borrower’s capital structure, these senior-secured loans provide lenders first recourse on the borrower’s assets in case of default/restructuring, and a conservative loan-to-value ratio—often 30–50%—seeking to provide a substantial equity cushion. Strong documentation and traditional financial covenants are standard, and a floating interest rate minimizes duration risk. Additionally, directly originated senior-secured loans historically have exhibited low to negative correlations with traditional fixed income and only moderate correlation to equities, as shown in Exhibit 1, offering potential portfolio diversification benefits.

Exhibit 1. Private Credit Can Provide Attractive Risk/Reward Characteristics and Potential Diversification Benefits   
Annualized Total Return per Unit of Risk, January 2005 through March 2024

Correlation, January 2005 through March 2024

Note: US Direct Lending = Cliffwater Direct Lending Index; US Leveraged Loans = Morningstar LSTA US Leverage Loan Index; US Treasuries = ICE BofA Current 10-Year US Treasury Index; US Aggregate Bonds = Bloomberg US Aggregate Bond Index; US Municipal Bonds = Bloomberg Municipal Bond Index; US IG Corporate Bonds = Bloomberg US Corporate Bond Index; US HY Corporate Bonds = Bloomberg US Corporate HY Bond Index; US Large Cap Equities = S&P 500 Index.
Source: Bloomberg, Cliffwater, Morningstar; data as of March 31, 2024. Index definitions are on final page.

While competitive pressures in recent years have eroded lenders’ negotiating power on larger loans, we believe lending to the lower middle market—companies with annual EBITDA (earnings before interest, taxes, depreciation and amortization) of $5–$50 million—may represent a sweet spot, particularly those businesses with private equity sponsors. Direct lending in the lower middle market can provide private lenders and their investors the potential for an attractive combination of yield, leverage and structure, while smaller deal sizes facilitate diversification across borrowers and industries. In addition, such loans tend to facilitate greater access to management teams, allowing for more comprehensive due diligence by lenders as well as closer collaboration that can help contain default exposure and maximize recoveries during challenging times.

Asset-Based Lending: Differentiated Return Profiles Secured by Pledged Collateral

Asset-based lending (ABL) facilities have long represented a differentiated, if somewhat unheralded, source of return in a private debt portfolio and a strong complement to traditional loans, given the low 0.25 correlation between the two.¹ Borrower demand for financing via ABL has grown in recent years as retrenchment in bank lending and reduced investor appetite for certain types of credit assets have predominated, thanks to tightening liquidity conditions and asset impairments that accompanied the onset of the Fed’s rate-hike cycle in early 2022.

The traditional middle market loans referenced in the previous section typically are underwritten based on an assessment of the borrower’s cash flows and governed by a range of maintenance covenants tied to those cash flows; asset-based loans, in contrast, are secured by specific assets of the borrower and feature provisions designed to maintain collateral coverage and loan-to-value ratios. Providers of ABL facilities seek to generate attractive returns while taking advantage of market dislocations and transitions within companies or industries.

As a result, collateral is the primary focus of lenders’ initial ABL underwriting and ongoing oversight. Valuing collateral on the basis of net orderly liquidation value (NOLV) rather than current fair-market value can provide lenders an element of risk mitigation, as can a focus on collateral assets expected to retain value across a range of economic conditions. Loan term sheets outline frequent and detailed monitoring requirements for collateral, along with a variety of triggers intended to mitigate downside impact and keep the loan within formula. While liquidating collateral assets is an option for a nonperforming loan, it typically is a last recourse; backed explicitly by assets that are expected to retain value and bolstered by tightly structured loan terms that preserve the lender’s interests, ABL facilities historically have had low loss-given-default rates.

Borrowers in the ABL space often are companies that have high working-capital needs and substantial assets but sometimes inconsistent or seasonal cash flows, such as retailers that maintain large inventories or industrials renting high-capex equipment. With limited access to more traditional capital market channels as a result, these borrowers often turn to ABL for competitively priced funding for a variety of purposes, from expanding their senior debt capacity, to monetizing assets while retaining control of them, to serving as a source of acquisition capital for a private equity sponsor.

Nimble Providers Can Potentially Benefit from the Countercyclical Interplay between Direct Loans and ABL

Given the low correlation between direct lending and ABL, comprehensive lenders able to offer borrowers both cash flow-based loans and ABL facilities may be well positioned to provide their investors with differentiated, complementary sources of return throughout credit cycles.²

M&A activity—the primary driver of lending volume across the middle market—slowed considerably in conjunction with the start of the Federal Reserve’s rate-hike cycle in early 2022, as shown in Exhibit 2. With the central bank now having turned to rate cuts as it continues to negotiate a soft landing for the economy, and interest rates having receded in response, a rebound in M&A activity could be a potential tailwind for direct lending demand in 2025, particularly as private equity sponsors eventually unleash $2.7 trillion in dry powder.³ Though improved from the low levels of 2022–23, the rebound in M&A activity was somewhat muted in 2024, and refinancings have underpinned demand for lower middle market direct loans.

Exhibit 2. Decreased Private Equity Deal Flow Has Weighed on Direct Lending Volumes   
US Private Equity Middle Market Deal Activity, 2014 through September 2024

Source: Pitchbook | LCD; data as of September 30, 2024.

Although the need for ABL facilities is persistent, demand strength historically has been countercyclical to direct lending; borrower interest in ABL tends to increase when rates rise and cash flow-based loans become less affordable or accessible. While stricter requirements for cash-flow loans are the norm during periods of economic uncertainty or tightening credit—as tougher credit standards challenge coverage ratios and other credit metrics—the backstop of collateral may allow ABL providers to take advantage of attractive risk-adjusted opportunities, a dynamic that was particularly evident in the aftermath of 2023’s regional bank failures.

While the direct lending market awaits a resurgence in M&A activity to fuel a significant pickup in demand, ABL facilities serve as what we consider an all-weather alternative financing option for asset-rich but cash-constrained companies. As shown in Exhibit 3, ABL activity has picked up in recent years as higher rates have weighed on direct lending origination, and demand for these facilities is projected to grow at a 12.6% compounded annual rate between 2023 and 2028.

Exhibit 3. Demand for ABL Is Expected to Increase Through the Decade   
Projected Size of Global Asset-Based Lending Market in Billions of US Dollars, 2023 through 2028

EvaluServe; data as of December 31, 2024.

In our view, the playing field for experienced, disciplined ABL providers is wide open. Regional and midsized banks—traditional providers of ABL facilities to middle market borrowers—remain highly selective and riskaverse following the regional bank failures of 2023, and in many cases are more focused on their liquidity profiles and capital reserves than on writing new business. Meanwhile, $2.2 trillion of commercial real estate loans, anticipated to come due by 2027, could create an additional source of demand for financing options.⁴

Underwriting and All-Weather Relationships Underpin Success in Private Credit

A successful, full-cycle lender must be creative and flexible—toggling between cash-flow loans and ABL as risk-adjusted opportunity dictates. Committed capital, with the promise of certainty to close, is a prerequisite. Beyond that, true success in the lower middle direct lending and ABL markets ultimately comes down to quality underwriting, loan structuring, portfolio composition and relationships.

In direct lending, creditworthiness can reliably be found in borrowers with stable historical earnings, strong cash flows and, ideally, private equity sponsorship, often in growth industries with resilient businesses and deep management insights into broader industry trends. A first-lien position in the borrower’s capital structure—complemented with financial covenants—provides potential mitigation of idiosyncratic risk.

ABL facilities usually focus first and primarily on the collateral available to secure the loan, with all other considerations flowing from there. While the highly structured nature of ABL is a key element of risk management, it is also a double-edged sword; while disciplined underwriting, proper controls and diligent monitoring can mitigate potential loss, the complexity of these tasks can expose inexperienced lenders to considerable risk.

In the final analysis, lending—whether through traditional cash flow loans or ABL facilities—is a collaborative activity, and the “all-weather” relationships that prove most durable are those that enable borrowers to thrive and grow their companies when conventional sources of capital may be scarce. A lender able to provide flexible financing solutions across credit cycles—without compromising their underwriting standards—may solidify relationships with borrowers and support consistent access to deal flow in pursuit of attractive risk-adjusted returns for their investors.