How assets are collateralized and recovered is arguably one of the most overlooked factors in private credit investing. Senior-secured loans are typically backed by general corporate assets such as equipment, receivables, or inventory. Lenders with senior-secured status are essentially granted priority in bankruptcy proceedings, entitling them to repayment before junior creditors and regular bondholders. In contrast, asset-based lending (ABL) is secured by identifiable cash flow-generating assets—such as leased aircraft, machinery, or real estate—that is held in a special purpose vehicle, offering more transparency and a clearer path to asset recovery.

Does your private credit portfolio have the right safeguards in place?

Senior-secured credit has played a pivotal role in making direct lending more appealing. In comparison to unsecured financing alternatives, senior-secured credit helps provide an added layer of security in the event of default, acts as a potential inflation hedge due to floating-rate structures, and contributes to portfolio diversification given its low correlation to traditional stocks and bonds. However, senior-secured status doesn’t necessarily offer full protection, prompting investors to look for innovative ways to enhance or complement their private credit allocations. 

Senior-secured positioning doesn’t imply you’re fully protected

On the surface, it may seem like all senior-secured loans are the same, but in practice, the degree of protections they offer vary according to their underlying security structures. For instance, super-senior-secured creditors (i.e., revolving lenders that allow borrowers to withdraw and repay funds on an ad hoc basis) are entitled to collateral before first- and second-lien secured creditors, which rank lower in the repayment hierarchy.  

Senior-secured loans are often pooled together, and because of this, they may lack specificity on exactly which assets back the loans. In the event of bankruptcy, multiple creditors may have an equal claim on the same assets, resulting in a situation called pari passu, which can create legal challenges and delay recoveries. In this case, repayments or pledges on collateral are split on a pro rata basis accounting for the size of each lender’s individual claim.

Another consideration involves the value of collateral. Values can be uncertain and fluctuate over time, often requiring extensive and at times costly appraisals. In bankruptcy, assets may depreciate or be consumed during costly and lengthy proceedings. Courts also have broad discretion to redirect assets to other claimants, potentially reducing recovery for lenders. Because recovery depends on the borrower’s overall financial health and the court process, there’s a chance returns could be diluted.

"Senior-secured loans are often pooled together, and because of this, they may lack specificity on exactly which assets back the loans." 

Unearthing the ABL advantage

Asset-based loans are generally tied to specific collateral that is protected from general creditors and bankruptcy proceedings. Unlike direct lenders, who might be subject to lengthy restructuring processes, ABL lenders can reclaim or take control of their designated assets, such as buildings, machinery, or intellectual property.

As such, ABL lending fundamentally changes the risk equation by focusing on what matters most: the specific assets backing investments. ABL links capital and valuable assets in a way that can be efficiently recovered if need be. In addition, asset values are determined upfront and monitored regularly, ensuring transparency. Lastly, many asset-based lenders limit loan values to a percentage of the asset’s value, creating a margin of safety.

Many ABL structures are bankruptcy remote, isolating collateral from the borrower’s corporate credit risk and creating a clear path to asset recovery without lengthy court proceedings. Assets can be liquidated or transferred to lenders efficiently in case of default, and the self-amortizing nature of many ABL loans helps reduce risks tied to market conditions or borrower insolvency.

In sum

Marrying direct lending with asset-based lending in a private credit portfolio may prove to be advantageous in more ways than one. In the context of bankruptcy, it’s important to acknowledge that both senior-secured positioning (which is used in direct lending allocations) and ABL may offer protection, with the latter seemingly offering a clearer path to asset recovery in the event of default. In comparison to unsecured financing alternatives, senior-secured lending can offer added protection, act as a potential inflation hedge, and enhance portfolio diversification. In comparison, asset-based loans are pledged on specific rather than general collateral, and the value of these assets is straightforward and regularly monitored, offering more transparency during bankruptcy proceedings.   

"ABL lending fundamentally changes the risk equation by focusing on what matters most: the specific assets backing investments."

A high-level assessment of private credit risks

Investors need to be mindful of the general risks associated with investing in private credit as a whole—such as credit, liquidity, and leverage risks. Private credit issuers may experience short-term or permanent financial distress, which may render them incapable of meeting their obligations. In addition, private credit funds are relatively illiquid due in part to their illiquid underlying assets and lock-in periods that limit redemptions in the context of retail funds.

Investments in direct lending are mainly subject to corporate credit risks. This contrasts with ABL, which is predominately exposed to asset-specific risks. Both are exposed to liquidity and leverage risks, although ABL is generally less exposed to leverage due to its emphasis on specific types of collateral, which offers the potential for risk mitigation in certain situations. Before investing, always be sure to evaluate the suitability of the investments under consideration.