Market & Topical Perspectives

Reflections: Let the Circle Be Unbroken

Reflections: Let the Circle Be Unbroken

Though middle market direct lending volumes have firmed relative to a moribund 2022–23, Federal Reserve easing has yet to unleash the massive wave of mergers and acquisitions (M&A) activity needed to truly open the floodgates. But as First Eagle Alternative Credit’s Michelle Handy and Larry Klaff—chief investment officer of Direct Lending and head of Asset-Based Loans, respectively—explain, private lenders able to offer borrowers a range of financing options that includes both traditional cash-flow loans and asset-based lending (ABL) facilities may have the potential to generate potential attractive risk-adjusted returns for investors across the credit cycle.

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 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%—provides 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

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. 
  

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 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 the 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 loans 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 cash flow 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 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 allows 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 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 an 12.5% 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

Source: EvaluServe; data as of December 31, 2023.
 

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 risk-averse 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 structured 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 while driving attractive risk-adjusted returns for their investors.

1. Source: Morningstar; data as of October 31, 2024.
2. Source: Investment Company Institute; data as of November 4, 2024.
3. Source: Securities Industry and Financial Markets Association; data as of December 2, 2024.
4. Source: Board of Governors of the Federal Reserve System, US Bureau of Economic Analysis, National Association of State Budget Officers; data as of November 30, 2024.
5. Source: Moody’s Investors Service; data as of November 15, 2024.
6. Source: FactSet; data as of December 31, 2024.
7. Source: Federal Reserve; data as of December 18, 2024.
9. Source: Freddie Mac; data as of May 15, 2024.
10. Source: US Census Bureau, US Department of Housing and Urban Development, National Association of Realtors; data as of November 26, 2024.
11. Source: Moody’s Investors Service; data as of December 31, 2022.
12. Source: Securities Industry and Financial Markets Association; data as of December 2, 2024.

The opinions expressed are not necessarily those of the firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.

Past performance is not indicative of future results.

Risk Disclosures 

All investments involve the risk of loss of principal.

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Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Alternative Investment Risks 
Alternative investments can be speculative and are not suitable for all investors. Investing in alternative investments is only intended for experienced and sophisticated investors who are willing and able to bear the high economic risks associated with such an investment. Investors should carefully review and consider potential risks before investing. Certain of these risks include: 

• Loss of all or a substantial portion of the investment; 
• Lack of liquidity in that there may be no secondary market or interest in the strategy and none is expected to develop; 
• Volatility of returns;
• Interest rate risk;
• Restrictions on transferring interests in a private investment strategy; 
• Potential lack of diversification and resulting higher risk due to concentration within one or more sectors, industries, countries or regions; 
• Absence of information regarding valuations and pricing; 
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• Carried interest, which may cause the strategy to make more speculative, higher-risk investments than would be the case in absence of such arrangements; and 
• Below investment grade loans, which may default and adversely affect returns. 

Indexes are unmanaged and one cannot invest directly in an index.
Bloomberg Municipal Bond Index (Gross/Total) measures the performance of the US municipal tax-exempt investment grade bond market. A total-return index tracks price changes and reinvestment of distribution income.
Bloomberg US Aggregate Bond Index (Gross/Total) measures the performance of the investment grade, US dollar-denominated, fixed-rate taxable bond market in the US, including Treasuries, government-related and corporate securities, fixed-rate agency MBS (agency fixed-rate and hybrid ARM passthroughs), ABS and CMBS. A total-return index tracks price changes and reinvestment of distribution income.
Bloomberg US Corporate Bond Index (Gross/Total) measures the performance of investment grade, fixed-rate, taxable corporate bond market. It includes US dollar denominated securities publicly issued by US and non-US industrial, utility and financial issuers. A total-return index tracks price changes and reinvestment of distribution income.
Bloomberg US Corporate High Yield Bond Index (Gross/Total) measures the US dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. A total-return index tracks price changes and reinvestment of distribution income.
Cliffwater Direct Lending Index is an asset-weighted index of US middle market direct loans.
Consumer price index (CPI) (Price) measures inflation as experienced by consumers in their day-to-day living expenses by capturing the average change over time in the prices paid for a representative basket of consumer goods and services. A price-return index only measures price changes. 
Fannie Mae Home Purchase Sentiment Index (HPSI) (Gross/Total) distills consumer responses to Fannie Mae’s monthly National Housing Survey into a single indicator designed to provide signals on future housing outcomes. A total-return index tracks price changes and reinvestment of distribution income.
ICE BofA AA-BBB US Fixed Rate Automobile ABS Index (Gross/Total) measures the performance of asset-backed securities collateralized by automobile loans with a middle rating in a range of AA/Aa to BBB/Baa as measured Moody’s, Fitch and S&P. A total-return index tracks price changes and reinvestment of distribution income.
ICE BofA AA-BBB US Floating Rate Credit Card ABS Index (Gross/Total) measures the performance of asset-backed securities collateralized by credit card loans with a middle rating in a range of AA/Aa to BBB/Baa as measured Moody’s, Fitch and S&P. A total-return index tracks price changes and reinvestment of distribution income.
ICE BofA AA-BBB US Floating Rate Student Loan ABS Index (Gross/Total) measures the performance of asset-backed securities collateralized by student loans with a middle rating in a range of AA/Aa to BBB/Baa as measured Moody’s, Fitch and S&P. A total-return index tracks price changes and reinvestment of distribution income.
ICE BofA Current 10-Year US Treasury Index measures the performance of US Treasury securities with a remaining maturity exceeding seven years and less than or equal to 10 years. A total-return index tracks price changes and reinvestment of distribution income.
Morningstar LSTA US Leveraged Loan Index (Gross/Total) is a market value-weighted index that measures the performance of the US leveraged loan market. A total-return index tracks price changes and reinvestment of distribution income.
MSCI China Index (Net) measures the performance of large and midcap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings. A net-return index tracks price changes and reinvestment of distribution income net of withholding taxes.
MSCI World Index (Net) measures the performance of large and midcap equities across developed markets. A net-return index tracks price changes and reinvestment of distribution income net of withholding taxes.
Palmer Square CLO AAA Index (Gross/Total) is a subindex of the Palmer Square CLO Debt Index that tracks only CLOs originally rated AAA. A total-return index tracks price changes and reinvestment of distribution income.
Palmer Square CLO BBB Index (Gross/Total) is a subindex of the Palmer Square CLO Debt Index that tracks only CLOs originally rated BBB. A total-return index tracks price changes and reinvestment of distribution income.
Russell 2000® Index (Gross/Total) measures the performance of the small cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. A total-return index tracks price changes and reinvestment of distribution income.
S&P 500 Index (Gross/Total) measures the performance of 500 of the top companies in the leading industries of the US economy and is widely recognized as a proxy for the US market as a whole. A total-return index tracks price changes and reinvestment of distribution income.
S&P Municipal Bond High Yield Index (Gross/Total) measures the performance of bonds in the S&P Municipal Bond Index that are not rated or whose ratings are below investment grade. A total-return index tracks price changes and reinvestment of distribution income.
S&P Municipal Yield Index (Gross/Total) measures the performance of high yield and investment grade municipal bonds. A total-return index tracks price changes and reinvestment of distribution income.

Definitions

A 10-year Treasury note is a debt obligation of the US government with a maturity of 10 years upon issuance.
AA credit rating—as used by S&P Global Ratings and Fitch Ratings—is an investment grade rating on a bond considered to have a very strong capacity to meet its financial commitments. The equivalent rating from Moody’s Investors Service is Aa.
AAA credit rating—as used by S&P Global Ratings and Fitch Ratings—is an investment grade rating on a bond considered to have an extremely strong capacity to meet its financial commitments. The equivalent rating from Moody’s Investors Service is Aaa.
Asset-based lending (ABL) is corporate borrowing supported by specific assets of the borrower rather than its cash flows.
BBB credit rating—as used by S&P Global Ratings and Fitch Ratings—is an investment grade rating on a bond considered to have adequate capacity to meet its financial commitments but that is more susceptible to adverse business, financial and economic conditions. The equivalent rating from Moody’s Investors Service is Baa.
Beta is a measure of an investment’s price volatility relative to that of the overall market.
A bull market is generally defined as a period during which a securities market index rises by 20% or more.
A business development company is a closed-end investment vehicle that invests in early stage and/or distressed small and medium- sized companies.
Collateralized loan obligations (CLO) are financial instruments collateralized by a pool of corporate loans.
Collective investment funds (CIFs), also known as collective investment trusts (CITs), are bank-administered trusts that hold commingled assets.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other bonds. Ratings are measured on a scale that generally ranges from AAA/Aaa (highest) to D/RD (lowest); ratings are subject to change without notice. Not rated (NR) indicates that the debtor was not rated and should not be interpreted as indicating low quality.
Credit-risk transfer (CRT) securities are synthetic securitizations that reference the credit risk of a designated group of mortgage loans guaranteed by Fannie Mae or Freddie Mac.
Currency debasement refers to the reduction of a currency’s purchasing power.
Direct lending refers to a loan agreement between a borrower and single lender or small group of lenders. Direct lending can also be referred to as “private credit” or “private lending.”
Exchange-traded funds (ETFs) are listed investment vehicles that seek to provide exposure to a benchmark, index or actively managed strategy.
Federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis.
General obligation bonds are municipal securities in which payments are backed by the full faith and credit of the issuer and by extension its ability to tax its residents.
A Goldilocks economic scenario refers to a level of growth that is neither strong enough to promote inflation pressures nor weak enough to suggest recession may be near.
Government-sponsored enterprises (GSEs) were established and chartered by the US federal government for public policy purposes. They are private companies, and their securities are not backed by the full faith and credit of the federal government.
High yield municipal bonds are debt securities issued by states, cities, counties and other public entities that offer a higher rate of interest due to their perceived higher risk of default.
An interval fund is a pooled investment vehicle that offers investors periodic liquidity at an interval specified in its prospectus.
Moody’s Investors Service is a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other bonds. Ratings are measured on a scale that generally ranges from Aaa (highest) to RD (lowest); ratings are subject to change without notice.
Mortgage-backed securities (MBS) are debt securities whose payments of principal and interest are backed by the cash flow generated by pools of mortgage loans.
Net orderly liquidation value (NOLV) is the estimated proceeds from selling a borrower’s collateral assets in an orderly manner, including a reasonable amount of time to find a buyer, after all costs related to the sale.
Not rated (NR) indicates that the debtor was not rated and should not be interpreted as indicating low quality.
A private fund is a pooled investment vehicle that is not required to be registered or regulated as an investment company under the Investment Company Act of 1940, as amended.
Revenue bonds are municipal securities whose payments are backed not by a government’s taxing power but by revenues from a specific project or source, such as highway tolls or lease fees.
Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
A separately managed account (SMA) is a portfolio of securities that is managed by a professional investment firm.
A soft landing refers to a gradual economic slowdown that comes to an end without triggering a recession.
Sovereign debt refers to debt obligations issued by a country’s government as a means to borrow capital.
S&P Global Ratings is a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments, or other bonds. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice.
A tranche is a portion of a security issue with its own unique risk/reward characteristics and credit rating.
Undertakings for Collective Investment in Transferable Securities (UCITs) are pooled investment vehicles registered in countries in the European Union.
Volatility represents the degree to which an investment’s price has deviated from its average over time.
A yield curve is a graphical representation of interest rates on debt of equal credit quality across a range of maturities.

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Important Information for Residents of the Kingdom of Saudi Arabia
The information contained herein is provided for informational purposes only and should not be considered a solicitation or offering of investment services, nor a solicitation to sell or buy any shares of any securities (nor shall any such securities be offered or sold to any person) in any jurisdiction where such solicitation or offering would be unlawful under the applicable laws of such jurisdiction. Unless otherwise indicated, no regulator or government authority has reviewed this material or the merits of the products and services referenced herein, including the Saudi Arabian Capital Market Authority. This material and the information contained herein has been made available in accordance with the restrictions and/or limitations implemented by any applicable laws and regulations. This material is directed at and intended for institutional investors (as such term is defined under the laws of the Kingdom of Saudi Arabia). This material is provided on a confidential basis for informational purposes only and may not be reproduced in any form. Before acting on any information in this material, prospective investors should inform themselves of and observe all applicable laws, rules and regulations of any relevant jurisdictions and obtain independent advice if required. This material should not be relied upon as investment advice and is not a recommendation to adopt any investment strategy. This material is for the use of the named addressee only and should not be given, forwarded or shown to any other person (other than employees, agents or consultants in connection with the addressee’s consideration thereof).

Important Information for Residents of Taiwan 
First Eagle Investment Management, LLC is not licensed to engage in an investment management or investment advisory business in Taiwan and the services described herein are not permitted to be provided in Taiwan. However, such services may be provided outside Taiwan to Taiwan resident clients.

Important Information for Residents of United Arab Emirates (Abu Dhabi) 
The offering of the products and/or services described herein have not been approved or licensed by the UAE Central Bank, the UAE Securities and Commodities Authority (SCA), the Dubai Financial Services Authority (DFSA) or any other relevant licensing authorities in the UAE, and accordingly does not constitute a public offer in the UAE in accordance with the commercial companies law, Federal Law No. 2 of 2015 (as amended), SCA Board of Directors’ Decision No. (13/Chairman) of 2021 on the Regulations Manual of the Financial Activities and Status Regularization Mechanisms or otherwise. Accordingly, this material is not offered to the public in the UAE (including the Dubai International Financial Centre (DIFC)). This material is strictly private and confidential and is being issued to a limited number of institutional and individual clients: a) who meet the criteria of a Professional Investor as defined in SCA Board of Directors’ Decision No. (13/ Chairman) of 2021 on the Regulations Manual of the Financial Activities and Status Regularization Mechanisms or who otherwise qualify as sophisticated clients; b) upon their request and confirmation that they understand that the products and/or services described in this material have not been approved or licensed by or registered with the UAE Central Bank, the SCA, DFSA or any other relevant licensing authorities or governmental agencies in the UAE; and c) must not be provided to any person other than the original recipient and may not be reproduced or used for any other purpose.

Important Information for Residents of United Kingdom This material is issued by First Eagle Investment Management, LLC and is lawfully distributed in the United Kingdom by First Eagle Investment Management, Ltd. First Eagle Investment Management, Ltd is authorised and regulated by the Financial Conduct Authority (FRN: 798029) in the United Kingdom. This material is directed only at persons in the United Kingdom who qualify as “professional investors.” This material is not directed at any persons in the United Kingdom who would qualify as “retail investors” within the meaning of the UK Alternative Investment Fund Managers Regulations 2013 (S.I. 2013/1773) or the EU Packaged Retail and Insurance-based Investment Products Regulation (No 1286/2014), the UK PRIIPs Regulation, and such persons may not act or rely on the information in this material. 

First Eagle Investments is the brand name for First Eagle Investment Management, LLC and its subsidiary investment advisers. First Eagle Alternative Credit and Napier Park are brand names for the two subsidiary investment advisers engaged in the alternative credit business.

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