Middle Market Debt Weekly: Optimism Rises as Credit Stress and Liquidity Risks Surface

The week ending January 11, 2026, presented a striking paradox for middle market participants: while dealmaking sentiment reached a six-year high, the credit landscape was marked by intensifying legal challenges at prominent industry players, surging BDC redemption pressures, and persistent inflation data that dampened hopes for near-term monetary relief. The juxtaposition underscores the bifurcated nature of today’s middle market—where quality assets command premium attention even as systemic risks accumulate beneath the surface.

As the middle market digests the implications of the Federal Reserve’s anticipated pause, the fallout from the First Brands Group bankruptcy accelerated with the appointment of an independent examiner to probe fraud allegations, while Blue Owl Capital faced class action lawsuits and dramatically increased redemption limits at one of its BDCs. These developments unfolded against a backdrop of looming political uncertainty, with the temporary government funding measure approaching its January 30 expiration.^¹

First Brands Group Saga Deepens with Examiner Appointment and Sale Process

The restructuring of automotive parts distributor First Brands Group took a critical turn this week. On January 9, U.S. Bankruptcy Judge Christopher Lopez approved the appointment of Martin De Luca, a partner at Boies Schiller Flexner, to lead an investigation of the multibillion-dollar fraud claims that have dominated the company’s reorganization effort.^² The U.S. Trustee received more than 70 applications for the examiner position, ultimately selecting De Luca to produce a report on allegations of mismanagement and fraud with a $7 million budget.

The Rochester Hills-based company had launched a formal process on January 8 to market and sell its business as it seeks to emerge from its Chapter 11 bankruptcy.^³ The aftermarket automotive parts company is looking to sell its business either as a whole or in parts. Brands in the company’s portfolio include FRAM, Raybestos, TRICO, Autolite, and Reese, which manufacture auto parts including brakes, filters, plugs, wipers, pumps, and lighting.

The liquidity situation has become critical. Attorney Sunny Singh warned Judge Lopez during a January 8 hearing that First Brands has approximately $190 million in cash remaining—funds that will only sustain operations through the end of January without an immediate financing injection.^⁴ The company had borrowed $1.1 billion to begin its bankruptcy and disclosed liabilities exceeding $10 billion when it filed for Chapter 11 protection in late September 2025.

For middle market asset-based lenders, the First Brands situation carries particular significance. The expedited sale process will provide a crucial real-time valuation benchmark for automotive inventory and receivables in a distressed context. The fraud allegations—which reportedly involved manipulated invoices and factoring irregularities—have prompted scrutiny of bankruptcy-remote structures commonly used in ABL transactions.^⁵ The case serves as a reminder that collateral verification cannot be delegated entirely to borrower-provided reporting, particularly in sponsor-backed situations where aggressive growth targets can create pressure on financial reporting.

Blue Owl Capital Faces Class Actions Amid Sector-Wide BDC Redemption Pressures

The scrutiny on private credit liquidity provisions intensified this week as multiple law firms announced securities fraud class action lawsuits against Blue Owl Capital Inc. The complaints allege that the alternative asset manager made false statements or concealed material information regarding pressure on its asset base from BDC redemptions and subsequent liquidity issues.^⁶ The class period covers February 6, 2025 through November 16, 2025, with a lead plaintiff deadline of February 2, 2026.

In a related development, Blue Owl dramatically increased redemption capacity at one of its private credit funds after being hit with a deluge of requests. The firm is allowing investors in Blue Owl Technology Income Corp. to withdraw as much as 17% of the non-traded BDC’s net assets, worth approximately $685 million—well in excess of the 5% quarterly limit previously in place.^⁷

The redemption pressures extend across the largest BDC platforms. According to Robert A. Stanger & Co., among NAV BDCs with assets exceeding $1 billion, combined redemptions surged approximately 200% quarter over quarter, jumping from $981 million in Q3 to more than $2.9 billion in Q4 2025.^⁸ From Ares Management to Blackstone, the biggest lenders were hit with spikes in withdrawal requests from their large non-traded business development companies.^⁹

“It is all about interest rates,” noted Kevin Gannon, Chairman and CEO of Stanger. “NAV BDCs are income-driven products that are heavily weighted to floating-rate debt investments, and during Q4 the average distribution rate fell below 10% for the first time since September 2023.” Despite the pickup in redemptions, Stanger projects total BDC capital formation to exceed $60 billion in 2025, including more than $40 billion from registered offerings, suggesting that demand remains resilient even as existing investors reassess allocations.

Inflation Data and Fed Policy Outlook Shape Rate Expectations

Market attention turned to the upcoming December CPI report scheduled for release on January 13, with forecasts indicating inflation ticking higher, driven mainly by rising goods prices. Economists project the core consumer price index to rise 2.7% in December from a year earlier, just above the 2.6% annual advance in November.^¹⁰ The November reading had shown headline inflation at 2.7% year-over-year, though data distortions from the October government shutdown have complicated interpretation.^¹¹

Federal Reserve officials remain divided on 2026 monetary policy. While the Fed cut rates by 75 basis points in late 2025, bringing the fed funds rate to a range of 3.50%-3.75%, expectations for further easing have moderated significantly.^¹² Bond futures markets see roughly 16% odds of a cut at the January 27-28 FOMC meeting, with the consensus anticipating only one or two additional cuts for the full year. Fed Governor Stephen Miran has advocated for more aggressive easing of 100+ basis points, while regional Fed presidents have favored holding steady until more data emerges.^¹³

For middle market borrowers, the extended timeline for rate relief compounds ongoing cash flow pressures. Floating-rate borrowers carrying debt at SOFR plus 525-588 basis points face the prospect of elevated financing costs persisting well into mid-2026. The combination of sticky inflation above the Fed’s 2% target and a labor market that has cooled but not deteriorated sharply creates an environment where neither aggressive easing nor tightening appears imminent.

Private Equity Sentiment Reaches Six-Year High as Deal Confidence Surges

Sentiment regarding middle market M&A for 2026 reached a six-year high according to Citizens’ 15th annual M&A Outlook released this week. The survey found that 58% of corporate and private equity leaders characterize the current deal environment as strong, reflecting a clearer economic picture after a year of uncertainty.^¹⁴

Private equity confidence showed a dramatic recovery over the course of 2025. Just 48% of PE leaders felt confident in M&A decision making in the first quarter of 2025; by the fourth quarter, that number had soared to 86%. Looking ahead, 90% of PE firms anticipate that deal flow will remain steady or increase in 2026, driven by improving economic conditions and attractive valuations across sectors.^¹⁵

“Private equity firms have been sitting on dry powder for years, and 2026 may finally deliver the conditions they’ve been waiting for,” said Jason Wallace, head of M&A at Citizens. “As confidence builds and valuations stabilize, sponsors are poised to unlock a backlog of deals.” The survey also found that 79% of companies identify as potential sellers, up from 73% last year, while 61% see themselves as buyers.

The potential middle-market swing factor for 2026 is the role of private equity buyouts and exits, according to PwC analysis.^¹⁶ PE firms now hold more dry powder and older portfolio companies than during prior large-deal cycles, which could drive additional volume if financing conditions remain favorable. Competition for quality middle-market assets is likely to intensify as larger funds turn to the middle market to find opportunities, forcing smaller funds to focus on specific sectors or subsectors to remain competitive.

Asset-Based Lending Markets Position for 2026 Growth

The asset-based lending sector enters 2026 with strong momentum from 2025 activity and continued institutional interest. According to year-end analysis from Addleshaw Goddard, manufacturing transactions were particularly strong in 2025, with significant deal activity in industrials and advanced manufacturing.^¹⁷ Economic and political volatility throughout 2025 made headroom and availability a priority for corporates, who increasingly sought to bolster their working capital solutions.

Private credit’s focus on the ABL market intensified in 2025, with new fund-backed asset-based lenders launching and recruiting established ABL professionals. These new entrants are expected to become increasingly competitive in winning new ABL business throughout 2026. In a competitive market for ABL funders, corporates benefited in 2025 from lower pricing, larger single-hold levels, and structural extras such as accordions.

Deal sizes increased due to the flexibility around products on offer, though transaction timelines lengthened as cyber risk analysis and market volatility created a “watch and wait” culture around financial reporting. Realistic transaction timetables will need to be properly considered by stakeholders at the outset to help drive efficient processes and manage transaction costs in 2026.

The First Brands case has also drawn attention to bankruptcy-remote structures commonly used in ABL transactions. Covington & Burling analysis notes that the case illustrates that “bankruptcy remote” does not mean “bankruptcy proof,” as secured lenders to special purpose vehicles have filed motions challenging the validity of bankruptcy filings made in alleged contravention of governance provisions.^¹⁸ Market participants should monitor how the court evaluates the timing and substance of independent manager appointments and the degree of operational integration between bankruptcy-remote entities and the broader enterprise.

Government Funding Deadline Approaches as Congress Races to Avoid Shutdown

Federal lawmakers face another funding deadline just two months after the record-setting 43-day shutdown that ended in November. Congress has until January 30 to fund major parts of the government, with nine of twelve appropriations bills still pending.^¹⁹ The House passed a bipartisan package of three spending bills on January 8 by an overwhelming 397-28 vote, funding agencies including the departments of Commerce, Energy, Interior, and Justice through September.^²⁰

Combined with the first full-year spending package signed into law in November, Congress has now enacted half of the twelve annual appropriations bills. However, remaining agencies—including the Department of Homeland Security, State Department, and financial services agencies—are still operating under a continuing resolution set to expire January 30. RSM’s Chief Economist estimates the fall shutdown will have provided a drag of close to 1.5% on overall economic activity during Q4 2025.^²¹

For asset-based lenders with exposure to government contractors, the approaching deadline warrants enhanced monitoring. Accounts receivable aging may extend if government payment processing slows during any potential funding gaps, and borrowers may draw more heavily on revolving facilities to manage working capital gaps. Defense sector and healthcare borrowers with significant government revenue concentration merit particular attention.

Items to Consider

Monitor the January 30 Funding Deadline: While bipartisan progress on appropriations bills has been encouraging, several major agencies remain unfunded for the full fiscal year. Middle market lenders with exposure to government contractors should verify liquidity buffers and assess potential receivables aging impacts.

Re-Underwrite Automotive Collateral: The First Brands sale process, moving at an accelerated pace due to liquidity constraints, will provide real-time valuation benchmarks for automotive aftermarket inventory and receivables. These marks could inform advance rate discussions across similar exposures.

Assess BDC and Semi-Liquid Fund Exposure: The surge in BDC redemptions—up 200% quarter-over-quarter among the largest platforms—highlights liquidity matching risks in semi-liquid credit structures. Allocators should scrutinize redemption gate provisions and consider the implications of falling distribution rates as interest rates stabilize.

Prepare for Extended Rate Elevation: With the Fed expected to hold rates steady at its January meeting and only one or two cuts projected for 2026, borrowers waiting for meaningful rate relief may face an extended timeline. Interest rate hedging strategies should be revisited to lock in certainty rather than relying on aggressive easing assumptions.

Capitalize on PE Exit Urgency: Private equity’s renewed confidence and pressure to return capital to LPs creates opportunities for lenders positioned to support transactions. With 90% of PE firms anticipating steady or increased deal flow, the financing market should see increased activity from sponsors pursuing exits and add-on acquisitions.

Evaluate Bankruptcy-Remote Structures: The First Brands litigation over special purpose vehicle governance provisions offers important lessons for ABL transactions utilizing bankruptcy-remote structures. Lenders should evaluate whether governance provisions and independent manager arrangements remain robust under stress scenarios.

Conclusion

The week ending January 11, 2026, crystallized the competing forces shaping middle market finance: record optimism about dealmaking activity coexisting with cautionary developments in credit quality, liquidity management, and the limitations of financial engineering. The First Brands examination and Blue Owl litigation represent warnings that will resonate across the lending community, while the surge in BDC redemptions highlights how quickly sentiment can shift when yields compress.

For asset-based lenders, the current environment reinforces the value proposition of collateral-backed structures while also demonstrating that even ABL facilities are not immune to fraud risk and structural challenges. The private equity community’s bullish outlook suggests transaction activity will accelerate through 2026, creating opportunities for lenders positioned to move quickly on quality credits. The challenge lies in maintaining underwriting discipline amid competitive pressure while identifying genuine quality assets from those whose apparent strength masks underlying vulnerabilities.

Success in this environment requires defensive positioning, creative financing solutions, and operational excellence to navigate complexity while maintaining credit discipline. The ability to adapt quickly to changing conditions—whether geopolitical developments, Fed policy shifts, or individual credit deterioration—will separate successful participants from those caught unprepared as the middle market navigates an extended period of uncertainty.

Footnotes