What Is Direct Lending? Middle Market Credit, Unitranche Loans, and the BDC Structure
The previous post in this series looked at leveraged loans as CLO collateral, and most of that discussion concerned the broadly syndicated market, where a bank arranges a loan and sells it down to dozens or hundreds of institutional holders. Direct lending is the other channel. A non-bank lender, usually an asset manager running a dedicated credit fund, negotiates the loan with the borrower, funds it from its own vehicle, and holds it to maturity. There is no syndicate, and in most cases there is no secondary market.
That last point is why direct lending matters to this series. The loans are the collateral behind middle market CLOs and a growing share of private credit CLOs, they fill the portfolios of business development companies that report fair value to the SEC every quarter, and they sit on the balance sheets of insurers and pension funds that need a defensible mark for an instrument that has never traded. This post covers what direct lending is, how the loans are structured, how they reach investors, and why pricing them is a distinct problem from pricing the syndicated loans covered earlier.
Direct lending, defined
Direct lending is the origination of loans to companies by lenders other than banks, where the lender negotiates directly with the borrower and retains the loan rather than distributing it. The lender is typically a private credit fund, a business development company, an insurance company's credit platform, or a separately managed account run by an asset manager. The borrower is usually a private company, and very often one owned by a private equity sponsor.
The asset class grew out of a gap. After the 2008 crisis, regulatory capital rules and leveraged lending guidance made it more expensive for banks to hold loans to smaller and more highly leveraged companies. Private equity sponsors still needed acquisition financing for those companies, and a set of non-bank lenders stepped in to provide it. The term "direct lending" describes the origination model. The terms "private credit" and "private debt" describe the broader category of privately negotiated credit, of which direct lending is the largest component.
How direct lending differs from syndicated lending
The economic instrument is often similar: a floating rate, senior secured term loan to a leveraged company, priced at a spread over a benchmark rate such as SOFR. The differences lie in how the loan is created, documented, and held.
In a syndicated deal, the arranging bank underwrites the loan and then markets it to investors, and the terms are shaped by what the market will clear. Documentation tends toward standard forms because the loan needs to be tradable, and covenant protections have loosened over the years as investor demand allowed. Once the loan closes, it trades among CLOs, loan funds, and other holders, and dealer quotes provide observable prices.
In a direct lending deal, one lender or a small club of lenders negotiates the terms with the borrower and its sponsor. The lender can demand financial maintenance covenants that syndicated loans often lack, can build in tighter restrictions on incurring additional debt, and usually secures call protection that compensates it if the borrower refinances early. In exchange, the borrower gets speed, certainty of execution, and a relationship with a lender that will pick up the phone when something goes wrong. The spread is generally wider than a comparable syndicated loan, reflecting the smaller borrower, the illiquidity, and the negotiating work involved.
The loan then stays with the lender. Some direct lending loans do change hands, through participations, secondary sales between funds, or when a lender needs liquidity, but these are occasional events rather than a market. For pricing purposes, the syndicated loan has a stream of quotes and trades. The direct loan has an origination price, a set of loan terms, and the borrower's financial reporting.
The middle market borrower
Direct lending began in the middle market and still concentrates there, although the largest platforms now compete for borrowers that would once have gone to the syndicated market. "Middle market" has no single definition. Lenders and industry groups draw the lines differently, often by revenue or by earnings before interest, taxes, depreciation, and amortization. A common framing splits the segment into the lower middle market, with EBITDA in the low tens of millions and below, the core middle market above that, and the upper middle market, where companies are large enough to access syndicated financing but sometimes choose direct lending anyway. Readers evaluating a specific fund should check how that manager defines the segment, since the definition drives everything from borrower concentration to expected loss.
Middle market lending is heavily sponsor-driven. The typical borrower is a company acquired by a private equity fund, and the loan finances the acquisition, a dividend recapitalization, or a follow-on acquisition. The sponsor's equity sits beneath the loan, the sponsor negotiates on the borrower's behalf, and the sponsor is usually the first source of additional capital if the company runs into trouble. Direct lenders often describe their underwriting as a view on the sponsor as much as on the company.
Middle market loans share the structural features of larger leveraged loans, with floating rates, first lien security over substantially all assets, and amortization schedules that are light in the early years. They differ in size, in the smaller number of lenders involved, and in the depth of information the lender receives. A direct lender typically has access to monthly financials, board materials, and management, none of which is available to a passive holder of a syndicated loan.
Deal structure: senior secured, unitranche, and the rest of the stack
Most direct lending is senior secured lending. The lender holds a first priority lien on the borrower's assets and sits at the top of the capital structure, ahead of any subordinated debt and well ahead of the sponsor's equity. Senior secured loans are the core of nearly every direct lending fund and nearly every middle market CLO.
Below the first lien, a traditional leveraged buyout structure might include a second lien loan, secured by the same collateral but subordinated in recovery, and beneath that a layer of mezzanine debt, which is typically unsecured, carries a higher coupon, and often includes a payment-in-kind feature or warrants. Mezzanine debt was a large part of middle market finance before the crisis and remains an asset class in its own right, though its share of new sponsor deals has shrunk as the unitranche structure absorbed the role it played.
Unitranche is the structure most closely identified with direct lending. A unitranche loan combines what would have been a senior loan and a subordinated loan into a single facility with a single blended interest rate and one set of loan documents facing the borrower. From the borrower's perspective, there is one lender group, one covenant package, and one rate. From the lenders' perspective, the economics are often split behind the scenes through an agreement among lenders, which divides the facility into a "first out" piece that gets repaid first and a "last out" piece that absorbs losses first and earns a higher share of the coupon. The borrower does not sign the agreement among lenders and may not see it.
Unitranche debt appealed to sponsors because it simplified the process: one negotiation, faster closing, and no intercreditor fight between senior and mezzanine lenders if the company struggled. It appealed to direct lenders because it let a single platform provide the whole debt package and earn the blended spread. Unitranche financing now accounts for a large share of sponsored middle market lending, and the last out positions within it are among the harder instruments in the space to value, since their risk profile depends on a private side agreement rather than on the loan document itself.
Direct lending vs private credit
The two terms are frequently used interchangeably, and in practice direct lending is what most people mean by private credit. The distinction is one of scope. Private credit covers the full range of privately negotiated debt: direct corporate lending, but also asset-based finance backed by receivables or equipment, real estate debt, infrastructure debt, specialty finance such as litigation funding or royalty streams, distressed and special situations lending, and venture debt. Direct lending is the corporate cash flow lending slice of that universe, and it is the slice that feeds middle market CLOs and dominates BDC portfolios. When this series refers to private credit in the CLO context, it means direct lending unless stated otherwise.
BDCs: how direct lending reaches investors
Direct lending funds have traditionally been private partnerships open to institutions and qualified purchasers. The business development company is the structure that brought the asset class to a much wider set of investors, and it is also the structure that makes direct lending valuation visible in public filings.
A BDC is a closed-end investment company created under a 1980 amendment to the Investment Company Act of 1940, designed to channel capital to small and mid-sized U.S. businesses. To qualify, a BDC must invest at least 70 percent of its assets in eligible portfolio companies, which in practice means private or thinly traded domestic operating companies, and it must offer managerial assistance to them. Most BDCs elect to be taxed as regulated investment companies, which requires distributing at least 90 percent of taxable income to shareholders each year and results in the high distribution yields the vehicles are known for. BDC leverage is capped by an asset coverage test. The original limit allowed roughly one dollar of debt for each dollar of equity; legislation passed in 2018 allowed BDCs to seek approval to double that, and most large BDCs have done so.
The traditional BDC is publicly listed. Its shares trade on an exchange and, like other closed-end funds, can trade at a premium or discount to net asset value. Listed BDC shares are liquid even though the loans inside them are not, and the market price of the shares is one of the few daily signals the direct lending market produces, imperfect as it is.
The structures that have grown fastest are the non-traded BDC and the private BDC. A non-traded BDC is registered with the SEC and sells shares continuously, typically through wealth management channels, at a price set to the fund's current NAV rather than by an exchange. Investors exit through periodic repurchase offers, commonly quarterly and commonly limited to a small percentage of outstanding shares, so liquidity is real but constrained. A private BDC files with the SEC and follows the same regulatory framework but sells shares only in private placements, usually to institutions and high net worth investors, and often with a defined term and a planned liquidity event. Both structures let a manager raise permanent or semi-permanent capital for direct lending at scale, and both have become a principal route for insurers, family offices, and advisory platforms into the asset class.
What unites all three BDC types is the reporting obligation. A BDC must file quarterly and annual reports with the SEC, and those reports include a schedule of investments in which every loan is carried at fair value. Under the fair value hierarchy in ASC 820, an asset priced from quoted prices in active markets is Level 1, an asset priced from observable inputs such as dealer quotes for similar instruments is Level 2, and an asset priced from unobservable inputs is Level 3. Direct lending loans are Level 3 assets almost without exception. Every BDC schedule of investments is therefore a public record of how a manager valued loans that have never traded, and every non-traded BDC that sells shares at NAV is asking new investors to pay a price built from those Level 3 marks.
Why direct lending is hard to price
For the syndicated loans covered earlier in this series, the pricing question is how to weigh dealer quotes and trades. For direct lending, there are usually no quotes and no trades, so the question is how to construct a price from the loan's terms and the borrower's condition.
The standard approach is a discounted cash flow. The evaluator projects the loan's contractual cash flows, including the floating coupon reset to the forward curve and any payment-in-kind accruals, and discounts them at a rate that reflects what a similar loan to a similar borrower would command today. That discount rate is where the difficulty concentrates. It depends on where comparable credit is being originated, on how the borrower's leverage and coverage have moved since closing, on the loan's position in the capital structure, and on whether covenants have been tripped or amended. Two evaluators with the same loan document and the same financials can reach different marks by making different judgments about the comparable set.
Several features of direct lending make the problem harder than it looks. Unitranche loans require the evaluator to know or infer the first out and last out split to value either piece correctly. Amendments and waivers are common in a lender-borrower relationship and change the economics of a loan without producing a new instrument identifier. Payment-in-kind interest inflates the principal balance while signalling that the borrower could not pay cash, so the evaluator has to decide how much of the accrued balance is recoverable. And because the lender frequently is the valuer, or hires the valuer, the marks carry a credibility question that a traded market resolves on its own.
The users of these prices span the buy side and the service providers around it. BDC boards and their valuation committees sign off on quarterly marks. Fund administrators strike NAVs for non-traded and private vehicles. Insurance companies hold direct loans in general accounts and need marks that satisfy statutory reporting. Custodians and auditors need an independent view to test against the manager's own. Each of them needs a price that can be explained, and in most cases they need it from a source that did not originate the loan.
How SQX approaches private credit pricing
SQX prices private credit instruments on the same principle that runs through its structured finance work: an evaluated price should be traceable to its inputs, and a client should be able to see how the price was reached. For private credit, SQX's published methodology builds the discount rate from an issuer-level credit curve, positioning each instrument by its spread relative to that curve rather than by interpolating between unrelated benchmarks or bootstrapping a curve from sparse data points. The approach is described in detail on the SQX private credit page, and clients receive the supporting inputs and intermediate values alongside each price rather than a number on its own.
Where a direct lending loan sits inside a CLO, the two methodologies meet. The loan needs a defensible mark as collateral, and the CLO tranches need an evaluated price that reflects the collateral pool, the structure's waterfall, and the deal's covenant tests. SQX's CLO and CDO pricing, described on its CLO and CDO page, follows the same transparency standard, so that a client holding both the underlying loans and the securitized tranches sees a consistent view of the credit from both sides.
This is the part of the market where independent pricing carries the most weight. A mark on a syndicated loan can be checked against a screen. A mark on a direct loan is checked against another judgment, and the value of that second judgment depends on whether the reasoning behind it is available for inspection.
Middle market CLOs and private credit CLOs
Direct lending connects back to the series through securitization. A middle market CLO is a CLO whose collateral consists of directly originated loans to middle market companies, in most cases sourced from the CLO manager's own lending platform. Where a broadly syndicated CLO buys loans in the open market from many arrangers, a middle market CLO is largely a financing vehicle for the manager's existing book.
The structural consequences follow from the collateral. Middle market CLO portfolios hold fewer, larger positions than syndicated CLOs, so single obligor concentration is higher. Many of the loans carry no public rating; the rating agencies assess them through private ratings or credit estimates provided to the CLO. Because the collateral is less diversified and less liquid, the rating agencies require more subordination beneath each tranche, and the equity holder, usually the manager itself, retains a larger share of the structure. Reinvestment periods are often shorter, and the manager's ability to source replacement collateral depends on its own origination pipeline rather than on the secondary market.
Private credit CLO is the broader label increasingly applied to these deals, reflecting collateral that has moved beyond the traditional middle market into larger sponsored loans that a decade ago would have been syndicated. Whatever the label, the tranches face the pricing problem described above in compound form: an evaluated price for the tranche depends on marks for collateral that has never traded, produced by a manager with an interest in the result. That compounding problem, and how identification and evaluated pricing work across the structured credit stack, is the subject of the next post in this series.
To learn more about CLOs,
follow SQX
on LinkedIn and subscribe to our
LinkedIn
newsletter to stay ahead of the curve.
Latest News
