Private credit lenders have moved decisively towards the senior end of the capital structure. Research from the Bank for International Settlements found that, among the technology borrowers in its direct-lending sample, the proportion of loans with first-lien status increased from 77.6% pre-2020 to 92.2% post-2020.
That shift should improve recovery prospects, but it has occurred alongside less reassuring developments. Among profitable technology borrowers, median debt relative to EBITDA tripled, while the proportion of borrowers reporting negative EBITDA almost doubled from 23% to 46%. Lending spreads also became less differentiated, suggesting that pricing may not always reflect the growing variation in borrower quality.
For investors financing private equity-backed companies, this creates an important distinction. Seniority can improve a lender’s position relative to other creditors, but it cannot ensure that sufficient value will remain when that priority needs to be exercised.
Why has first-lien lending become more attractive?
Moving higher in the capital structure is a logical response to greater economic uncertainty, weaker borrower fundamentals and elevated financing costs. If a company defaults, first-lien creditors ordinarily have the earliest contractual claim over the assets included within their security package.
Private credit can also give lenders negotiated covenants, access to management and greater influence over a restructuring than may be available through widely syndicated debt. Because the loans are generally held rather than actively traded, lenders may have more flexibility to amend terms when a viable business encounters temporary difficulty.
The protection nevertheless depends on what is supporting the loan. The BIS research focuses heavily on technology businesses, where value may be concentrated in recurring revenue, intellectual property and customer relationships rather than property, machinery or other assets that can be separated and sold. These businesses can command considerable valuations while operating successfully, but their assets may be harder to value and realise during an insolvency.
What changes when private equity is involved?
Private equity introduces two additional variables: the price paid for the company and the amount of debt used to finance the acquisition.
The Financial Stability Board estimates that private-credit borrowers typically carry debt of five to six times EBITDA, compared with approximately four times for leveraged-loan borrowers. It also warns that leverage may be closer to seven times when optimistic adjustments to EBITDA are excluded. These adjustments frequently incorporate expected cost savings or acquisition benefits that may not materialise as planned.
A senior lender may have the first claim on enterprise value, but that offers limited comfort if the company cannot produce the cash flow needed to service its borrowings. Seniority determines the order in which creditors are paid. It does not determine how much value will be available.
Consider a company valued at £100 when a £70 first-lien loan is made. If operating performance deteriorates and the business can subsequently be sold for only £55, the lender’s first-ranking position does not prevent a loss. Even before restructuring costs and other priority claims, the available value would cover less than 79% of the original loan.
The sponsor’s equity provides a buffer, but its size at acquisition does not necessarily represent the protection available several years later. Underperformance, further borrowing and a lower exit valuation can reduce the value beneath the debt. Payment-in-kind interest may help a borrower conserve cash temporarily, but it also increases the outstanding claim that must eventually be repaid or refinanced.
What does first-lien status actually cover?
The description of a loan does not capture every feature that could affect recovery.
Several creditors may share security over the same assets, while revolving credit facilities, hedging arrangements, restructuring finance and certain statutory claims can influence how value is distributed. The outcome will depend on the loan documents, intercreditor arrangements and applicable insolvency law.
Investors therefore need to examine the security package and contractual ranking rather than relying on the label “senior secured”. Relevant questions include whether additional borrowing is permitted, how much secured-debt capacity remains and whether other creditors could acquire equal or superior claims over important assets.
This matters particularly when a company requires further capital. Existing lenders may agree to provide additional funding, but the terms can alter the relative position of different creditor groups. A lender’s influence during those negotiations may be valuable, although it does not remove the economic problem that made the new financing necessary.
Can greater seniority conceal shared risks?
Moving towards first-lien lending can make individual loans appear more defensive while leaving investors exposed to many of the same underlying assumptions.
If several funds finance similar PE-backed businesses using comparable expectations for recurring revenue, profit growth and future exit valuations, seniority does not remove that common exposure. It changes the order of potential losses rather than the conditions that could cause them.
Competition can also affect the price of protection. The BIS found that lending spreads became less dispersed even as borrower fundamentals diverged. If lenders secure senior positions by accepting lower returns or greater contractual flexibility, improved ranking may be partly offset by a smaller margin for error.
What should investors test?
The relevant question is not simply where a loan ranks when it is issued, but what that ranking could be worth under stress.
That requires examining cash generation without aggressive adjustments, the value and transferability of collateral, the borrower’s capacity to add debt, covenant headroom and the claims of other creditors. Investors should also consider whether repayment depends on operating cash flow or on a future refinancing, sale or public listing.
First-lien status remains valuable. It can improve recovery prospects and give lenders greater influence when a borrower encounters difficulty. However, it is one element of protection rather than a substitute for assessing leverage, documentation and enterprise value.
Seniority determines who reaches the remaining value first. The quality of the underwriting determines how much value is likely to remain.