The Big Idea

Originator and investor incentives tilt value toward the middle market

Steven Abrahams | March 21, 2025

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The market in private debt covers a lot of territory these days, and the risks across types of debt obviously differ. That is increasingly true in the market for private corporate debt. Broadly syndicated loans and middle market loans have long histories but these days seem to be following distinct paths. The differences seem less about the credit of the borrowers and more about the incentives of the originators and investors. The result is that middle market loans these days may be the better relative value.

The market typically distinguishes broadly syndicated loans from middle market loans roughly based on the revenues of the borrower. Companies with lots of revenue usually need big loans that require syndication among dozens or hundreds of lenders, and companies with less revenue may be able to borrow from a single lender or a small club. Other factors come into play, of course. Broadly syndicated loans often get public ratings while middle market loans might get credit estimates or shadow ratings. The line between broadly syndicated and middle market loans is fuzzy, but many investors paint it with a broad brush in the neighborhood of $75 million to $100 million.

Above and below the line, many companies show comparable credit metrics such as earnings-to-debt ratios, earnings-to-interest-expense, cash or liquidity on the balance sheet and the like. The mix of industries above and below the line also is comparably diverse. But companies below the lines do tend to be smaller, and that often means a more concentrated product line, geography, customer base or the like. Concentration leaves a company more easily subject to some idiosyncratic disruption. All else equal, investors and rating agencies usually see smaller companies as riskier, leaving investors to require more spread and rating agencies to assign lower ratings. And when broadly syndicated and middle market loans get put into CLOs, investors and rating agencies require more subordination for the same rating for deals backed by middle market collateral.

As big direct lending programs have developed among alternative asset managers, some single lenders or small clubs have started making loans in the hundreds-of-millions- or billions-dollar range, leading some to scratch the label of middle market and just call them private loans. Some direct lenders have originated loans of more than $2 billion. That highlights a distinction between broadly syndicated and middle market loans that is getting increasingly important: originator incentives.

The risk profile for originators of broadly syndicated and middle market loans differ. In brief, syndicates retain risk profiles different from the risk they sell, and middle market lenders retain the same or even a more concentrated version of they risk they sell. In other words, middle market originators may be better aligned with their investors.

A few details.

The banks originating broadly syndicated loans usually create a Term Loan A and a Term Loan B. The Term Loan A usually is held by the originating banks, amortized evenly over five to seven years and may have a revolving feature while the Term Loan B usually is a 5- to 7-year bullet maturity with limited call protection. The syndicate usually retains the Term Loan A and sells the Term Loan B to CLOs, loan funds or other investors. As a result, the retained credit risk of the originating syndicate is materially different than the risk of the Term Loan B investors, opening the door to misalignment of incentives.

When a Term Loan B goes into a CLO, the CLO manager also does not have to retain risk. This is based on the 2018 decision of the US Court of Appeals for the District of Columbia that open-market CLOs are not subject to the risk retention requirements of Dodd-Frank.

Middle market or private loans, on the other hand, are rarely sold, eliminating the issue of misalignment between originator and investor. They are financed through CLOs, however, but the 2018 decision did not exempt middle market CLOs from risk retention. A middle market lender usually holds equity risk in a CLO financing, better aligning the originator with debt investors.

In recent years, alignment of incentives has become an important issue in a surprising way when investors in Term Loan B tranches of leverage loans have started squaring off against one another in actions called liability management exercises, or LMEs. LMEs, also called distressed exchanges, help companies and often their private equity sponsors avoid the risk and expense of bankruptcy. They also often create an in-group of investors in the Term Loan B that can exchange their share of the loan for new first-out super-senior debt, leaving the out-group with suddenly subordinated debt trading at a deep discount to par. The process leading to an LME can be opaque. Nevertheless, LMEs and distressed exchanges these days are a record high 73% of all credit events in the Morningstar/LSTA leveraged loan index, at least counting by issuer (Exhibit 1).

Exhibit 1: LMEs and distressed exchanges are now 73% of all BSL credit events

Note: Data shows last 12 months (LTM) number of payment defaults and distressed exchanges as a share of outstanding issuers in the Morningstar LSTA leveraged loan index.
Source: PitchBook | LCD, Santander US Capital Markets

LMEs seem to have made broadly syndicated loans riskier than middle market loans. Credit histories on portfolios of middle market loans are difficult to find, but Ares Capital Corporation (ARRC), the largest US business development corporation, does publish a history of loans in its middle market portfolio that have stopped making payments for 90 days or more, known under US GAAP as non-accruing loans. When Ares non-accrual rates are compared to the credit history of the Morningstar/LSTA leveraged loan index, the differences are striking (Exhibit 2). The Ares credit history roughly tracks the loan index history until the middle of 2023, when it continues to track measures of traditional leveraged loan payment default while the combination of leveraged loan defaults and distressed exchanges rises significantly.

Exhibit 2: Ares MM credit history tracks BSL payment defaults, not LMEs

Note: Morningstar/LSTA data shows last 12 months (LTM) number of payment defaults and distressed exchanges as a share of outstanding issuers in the Morningstar LSTA leveraged loan index.
Source: PitchBook | LCD, Santander US Capital Markets. ARCC data shows non-accrual loans at the end of each period as defined by US GAAP.

Caveats do apply, of course. Morningstar/LSTA reports figures for the last 12 months while Ares reports non-accruals at the end of each period, so different lags in reporting may cause differences in levels. Also, the mix of loans in the index and in the Ares portfolio may vary, creating material differences in credit risk.

Nevertheless, these data are consistent with the possibility that LMEs have made broadly syndicated leveraged loans riskier for now than middle market loans. Add to that the clearer alignment of risk between originator and investors in middle market loans, mainly investors in middle market CLO debt, and the case for relative value goes to middle market lending.

* * *

The view in rates

The market has come out of the March FOMC continuing to price in three cuts this year, one more than the Fed’s new March dots. The market and the FOMC are still in a minor standoff. The Fed clearly hesitates to draw strong conclusions about pending tariffs but anticipates that any price increases and accompanying inflation will be “transitory.”

Other key market levels:

Fed RRP balances closed at $201 billion as of Friday, up $75 billion in the last week. With the Treasury General Account declining by $370 billion since the start of February, reflecting maturity of Treasury bills and the return of cash to money market funds, repo lenders are long on cash with few opportunities in the repo market and are being forced to deploy to the RRP.
Setting on 3-month term SOFR closed Friday at 430 bp, unchanged on the week.
Further out the curve, the 2-year note traded Friday at 3.95%, down 7 bp in the last week. The 10-year note traded at 4.25%, down 6 bp in the last week.
The Treasury yield curve traded Friday with 2s10s at 30 bp, unchanged in the last week. The 5s30s traded Friday at 59 bp, steeper by 6 bp over the same period
Breakeven 10-year inflation traded Friday at 233 bp, up 2 bp in the last 1week. The 10-year real rate finished the week at 192 bp, down 8 bp in the last week.

The view in spreads

Bearish on credit spreads with US trade policy in flux. The Bloomberg US investment grade corporate bond index OAS traded on Friday at 90 bp, tighter by 3 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 138 bp, wider by 1 bp in the last week. Par 30-year MBS TOAS closed Friday at 36 bp, unchanged in the last week.

The view in credit

We are starting to see cracks in credit quality at the weaker end of the distribution. Fundamentals for the average consumer and most corporate credits continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. Consumer debt service coverage is roughly at 2019 levels. However, serious delinquencies in FHA mortgages and in credit cards held by consumers with the lowest credit scores have been accelerating. Consumers in the lowest tier of income look vulnerable. The balance sheets of smaller companies show signs of rising leverage and lower operating margins. Leveraged loans also are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy, back to 2020 post-Covid peaks. If the Fed only eases slowly this year, fewer leveraged companies will be able to outrun interest rates, and signs of stress should increase. LMEs are very opaque transactions, so a material increase could make important parts of the leveraged loan market hard to evaluate.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2025 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.