The Rise of Layered Capital Structures in Middle Market Finance

The binary choice between senior secured bank debt and mezzanine financing is fading from the middle market. In its place, a more deliberate architecture has taken hold: layered capital structures that combine asset-based lending facilities, unitranche term loans, and payment-in-kind components within a single transaction. The scale of the market that makes this architecture possible is substantial. According to the Secured Finance Network’s 2025 Market Sizing Study, secured finance year-end levels totaled approximately $12.1 trillion as of the fourth quarter of 2024, with asset-based lending commitments alone reaching $537 billion at year-end — a figure that has grown every year since 2018.¹ That foundation of ABL capital is the senior-most building block in most layered structures, and its continued expansion has made multi-tranche architecture practically achievable across a wider range of deal sizes than previously possible.

The competitive dynamics within direct lending have accelerated the trend. McKinsey’s Global Private Markets Report, covering 2025 data published in June 2026, documents that direct lending new-issue median spreads compressed to 544 basis points at year-end 2025, down from 716 basis points in March 2023 — a decline of more than 170 basis points in roughly two and a half years.² As pricing on single-tranche unitranche facilities has compressed, sponsors have sought to optimize blended cost of capital by stacking a tight ABL revolver beneath a larger term loan, capturing the benefit of cheaper, collateral-driven advance pricing for the most liquid portion of the borrower’s asset base. The result is a capital structure that is neither purely cash-flow nor purely asset-based, but a deliberate combination of both — and it is increasingly the norm in transactions of meaningful scale.

Lincoln International’s Q4 2025 Private Market Index report, published in February 2026, provides direct evidence of what this competition has produced at the instrument level. New issue unitranche spreads for borrowers generating between $40 million and $100 million in EBITDA settled at SOFR plus 450 basis points in Q4 2025, with original issue discounts tightening to approximately one percent on average — with some transactions carrying no OID at all.³ At the same time, Lincoln observed that lenders extended upward of 0.5x of additional leverage to larger borrowers to win competitive processes, further enabled by record buyout multiples that averaged 13.1x EBITDA in Q4 2025.³ The combination of compressed spreads and stretched leverage is precisely the environment that makes a well-structured ABL first layer valuable: it reduces the average cost of capital in the stack without requiring the term loan lender to price below a defensible return threshold.

How the Layers Work Together

The logic of multi-tranche architecture begins with collateral quality. ABL tranches are structured against liquid, self-liquidating assets — accounts receivable and inventory — where the collateral is physically identifiable, independently appraisable, and convertible to cash in the ordinary course of the borrower’s business cycle. This tangibility allows ABL lenders to advance at rates that reflect collateral value rather than enterprise value: typically up to approximately 85 percent on eligible receivables and in the range of 50 to 65 percent on eligible inventory, according to standard industry practice documented across multiple ABL surveys.¹ Because the asset base supports the credit independently of operating performance, ABL pricing remains tighter than cash-flow facilities.

The unitranche term loan occupies the middle of the stack, secured by substantially all remaining assets of the enterprise and relying on enterprise value as the ultimate backstop for recovery. As the McKinsey 2025 data shows, new-issue yields on direct lending facilities averaged approximately 9.3 percent on an all-in basis in 2025, down from 10.5 percent in 2024, reflecting the combination of lower SOFR and continued spread compression.² A third tranche — PIK-toggle notes, preferred equity, or subordinated mezzanine — is warranted in transactions where the senior secured leverage capacity has been maximized but the sponsor requires additional funding for the equity purchase price. Lincoln International’s Q4 2025 data provides a precise measure of PIK penetration: 11 percent of all loans in its proprietary private market database paid some component of PIK interest in 2025, up from 7 percent in 2021.³

Importantly, Lincoln’s analysis distinguishes between what it terms “structural PIK” and distress-driven PIK. Of the 11 percent of loans with PIK interest, Lincoln determined that 58 percent of those had no PIK component at origination — meaning the PIK election emerged from stress rather than design.³ For layered capital structures, the distinction matters considerably. PIK originated at transaction close as part of a deliberate junior tranche is structurally different from PIK that appears in a distressed amendment, and lenders underwriting the senior portion of a stack need to model both scenarios independently.

The Direct Lending Volume Context

The market in which these structures are proliferating has experienced notable volume and composition shifts. McKinsey’s 2025 private credit analysis, drawing on PitchBook LCD data, reports that leveraged buyout financings in direct lending rose to $81 billion in 2025 from $73 billion in 2024 — the highest level on record.² That growth occurred even as overall direct lending deal count declined by approximately 16 percent year-over-year, and total direct lending volume fell approximately 10 percent.² The divergence between rising LBO financing volume and declining deal count reflects a market where capital is concentrating into larger, more complex transactions — the precise environment where layered capital structures add the most structural value to sponsors managing large equity checks.

Average LBO deal size in direct lending rose by approximately 29 percent in 2025, reaching roughly $380 million compared with about $295 million in 2024.² At that scale, a single-tranche unitranche facility can generate meaningful collateral inefficiency: a borrower with substantial eligible receivables and inventory is leaving lower-cost ABL capacity on the table if the entire facility is structured as a cash-flow term loan. Multi-tranche architecture captures that efficiency. Syndicated ABL volume reinforces the demand signal: the syndicated ABL market totaled $147.3 billion in 2025 — the third-highest annual total ever recorded by LSEG Data and Analytics — with Q4 2025 volume alone reaching $31.1 billion, a 41 percent year-over-year increase.⁴

Recovery Dynamics and Intercreditor Complexity

The structural appeal of layered capital comes with a corresponding requirement for disciplined recovery modeling. First-lien senior secured loans have historically recovered approximately 70 to 80 cents on the dollar on an ultimate recovery basis, with recent expected recoveries drifting toward 60 to 70 percent as modern capital structures have shifted toward loan-heavy configurations with limited junior debt cushion.⁵ Moody’s has estimated expected ultimate recoveries on U.S. first-lien loans at approximately 68 percent, below the long-run historical experience in the high 70s, driven by covenant-lite documentation, liability management exercises, and a greater proportion of asset-light borrowers whose value evaporates in distress more quickly than hard-asset industrials.⁵

The recovery gradient by borrower type is meaningful for ABL underwriters in a layered structure. Hard-asset industrials — manufacturing, infrastructure — have produced typical first-lien recoveries in the 75 to 90 percent range in historical rating-agency studies, because tangible, saleable collateral retains value in liquidation. Software and business services borrowers, by contrast, have produced first-lien recoveries in the 55 to 75 percent range, because value is concentrated in customers and code that can deteriorate rapidly in a stressed sale process.⁵ ABL lenders whose collateral is concentrated in the receivables of an asset-light services borrower should model recovery scenarios that reflect the enterprise value dynamics of that sector, not the long-run average of secured lending broadly.

The intercreditor agreement is the document that governs the relationship between ABL and term loan lenders in a layered stack. These agreements define the lien priority on each collateral category, standstill periods during which junior lenders are contractually prevented from exercising remedies against the senior collateral, payment waterfall mechanics, and enforcement rights in each lender’s respective collateral pool. KBRA’s Q3 2025 Middle Market Borrower Surveillance Compendium, published in November 2025 and covering 2,287 unique middle market sponsored borrowers, documented that downgrades had outpaced upgrades for seven consecutive quarters through Q3 2025, and that the share of borrowers receiving the lowest assessment scores reached a record high over the trailing twelve months.⁶ That environment — stressed borrowers, active amendment negotiations, and increasing lender-on-lender conflict — is precisely the scenario in which poorly drafted intercreditor provisions create the most damage.

Covenant Evolution and Structural Discipline

McKinsey’s 2025 data also captures a significant structural shift in loan documentation: covenant-lite transactions rose to 21 percent of direct lending deals in 2025, up from 4 percent in 2023 — a near-fivefold increase in two years.² That expansion of covenant-lite penetration within direct lending has implications for how senior ABL lenders in a layered structure receive early warning of credit deterioration. In a fully covenanted unitranche, the ABL lender receives leverage-test failures and EBITDA shortfalls as notification triggers well before a payment default occurs. In a covenant-lite unitranche, those signals are absent — leaving the ABL lender to rely on its own borrowing base monitoring and field examinations as the primary early warning mechanism.

This dynamic reinforces the importance of maintaining conservative borrowing base mechanics regardless of the structural position of other capital in the stack. ABL advance rates function as a credit quality filter that operates independently of what the term loan lender has underwritten. Advance rates at the upper end of market ranges are defensible when eligibility criteria are tight — excluding diluted, disputed, aged, and cross-aged receivables — and when field examination frequency is calibrated to the borrower’s risk profile. When eligibility criteria expand to capture borderline receivables in a competitive origination process, the advance rate becomes a less reliable indicator of actual collateral value. The deteriorating recovery trends that Moody’s has documented for first-lien loans generally should be read as a caution against assuming that structural seniority alone provides an adequate cushion.

Implications Across the Ecosystem

For private equity sponsors, the practical implication of the multi-tranche environment documented in the data above is that the ability to structure a transaction — not merely the cost of capital on any single instrument — has become a meaningful driver of deal economics. Lincoln International’s Q4 2025 data shows leverage on new buyout transactions averaging 5.2x EBITDA across the direct lending market, approximating levels last seen at the 2021-2022 market peak.³ A layered structure that pairs an ABL revolver against the working-capital assets with a unitranche term loan against enterprise value allows sponsors to access that leverage while keeping a portion of the capital at tight, asset-based pricing — improving the blended cost of capital without requiring any single lender to stretch its risk parameters beyond what is appropriate for its collateral position.

For ABL lenders, the multi-tranche environment presents both a market opportunity and an underwriting discipline challenge. The SFNet 2025 data shows ABL commitments growing consistently year over year since 2018, with $537 billion in commitments at year-end 2024.¹ That growth has coincided with a broadening of the transactions in which ABL participates — including leveraged buyouts, recapitalizations, and restructurings that would previously have been financed through cash-flow structures alone. Maintaining advance rate discipline, tight eligibility criteria, and robust field examination programs is the mechanism through which ABL lenders preserve the collateral-driven risk profile that justifies their senior position in a layered stack. The junior debt behind an ABL tranche provides a loss buffer only to the extent that enterprise value at enforcement exceeds the ABL claim — a condition that cannot be assumed in a distressed scenario, particularly given the recovery trends documented in recent Moody’s and rating-agency research.

For unitranche and term loan lenders, the existence of an ABL revolver above their position in the capital stack creates a competing claim on the borrower’s most liquid assets in a workout. Recovery modeling must account for the scenario in which the ABL lender has swept receivables and inventory proceeds before the term loan enforcement process concludes. Second-lien recovery rates historically run 30 to 45 cents on the dollar, with wide dispersion depending on enterprise value at enforcement — a range that should anchor expectations for any lender effectively occupying a second-priority position against the borrower’s core working-capital assets.⁵

Conclusion

The multi-tranche middle market capital structure is not a departure from the foundational principles of secured finance. It is an application of them. ABL has always been predicated on the idea that the best credit is one where the lender controls access to the most liquid and independently verifiable assets. Unitranche direct lending has always been predicated on the idea that concentrated, flexible capital — delivered by a single provider with broad documentation rights — commands a premium over syndicated alternatives. PIK and junior debt have always existed to fill the gap between what senior lenders will advance and what sponsors need to close transactions at prevailing multiples.

What is new is the systematic combination of all three within a single, well-documented structure, at a scale now documented by the SFNet at approximately $12.1 trillion in total secured finance and $537 billion in ABL commitments alone. The professionals who understand each tranche’s collateral logic, pricing discipline, and intercreditor position — and who can document and manage those relationships clearly when a borrower comes under stress — will define the competitive landscape of middle market finance through the remainder of this decade. Those who treat structural seniority as a substitute for collateral analysis, or who extend advance rates without rigorously applying eligibility criteria, will discover that the layered stack is only as strong as its weakest underwriting decision.

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Footnotes

1. SFNet Data Committee, “Secured Finance at Scale: Why the SFNet 2025 Market Sizing Study Matters More Than Ever,” *The Secured Lender*, February 9, 2026 (total secured finance year-end levels approximately $12.1 trillion as of Q4 2024; ABL commitments reached $537 billion at year-end 2024; ABL commitments have grown every year since 2018; typical ABL advance rates up to 85% on eligible receivables, 50–65% on eligible inventory per standard ABL practice).
2. Hyder Kazimi, John Spivey, and Warren Teichner, “Private credit in 2025: A maturing industry navigates change,” McKinsey Global Private Markets Report 2026, June 9, 2026 (new-issue median spreads 544 bps at year-end 2025, down from 716 bps in March 2023; all-in new-issue yields approximately 9.3% in 2025 vs. 10.5% in 2024; LBO financings rose to $81 billion in 2025, highest on record; average LBO deal size rose approximately 29% to approximately $380 million; covenant-lite transactions rose to 21% of direct lending deals in 2025 from 4% in 2023; direct lending volume fell approximately 10% and deal count approximately 16% year-over-year).
3. Lincoln International, “The Lincoln Private Market Index Ends the Year with its Slowest Quarter of Growth in 2025,” February 11, 2026 (average buyout multiple 13.1x EBITDA in Q4 2025; leverage levels 5.2x; new issue unitranche spreads S+4.50% for borrowers with $40M–$100M EBITDA; OIDs approximately 1% on average, with some deals carrying no OID; lenders stretched leverage upward of 0.5x for larger borrowers; 11% of loans paid PIK interest in 2025 vs. 7% in 2021; of loans with PIK interest, 58% had no PIK at origination).
4. Eileen Wubbe, “2025 Ends on a High Note for Syndicated ABL: Strong Finish Despite Uneven Trends,” *The Secured Lender*, Secured Finance Network, February 4, 2026 (syndicated ABL volume $147.3 billion in 2025, third-highest on record per LSEG Data and Analytics; Q4 2025 volume $31.1 billion, 41% year-over-year increase).
5. “Loan Recovery Rates: Historical Data by Lien, Collateral & Rating (1987–2026),” CollateralizedLoanObligations.com, last reviewed June 12, 2026 (first-lien senior secured loans: long-run ultimate recovery approximately 70–80%; recent expected recoveries 60–70%; Moody’s estimated expected ultimate recoveries on U.S. first-lien loans at approximately 68%; hard-asset industrials typical first-lien recovery 75–90%; software/business services 55–75%; second-lien loans: 30–45%; AAA CLO stress scenarios assume 45–60%).

6. KBRA, “Private Credit: Q3 2025 Middle Market Borrower Surveillance Compendium: Defaults Will Rise,” November 25, 2025 (2,287 unique global middle market sponsored borrowers assessed over LTM ended September 30, 2025; downgrades outpaced upgrades for seven consecutive quarters; record count of obligors assessed at ccc- in the LTM period; KBRA Middle Market Default Monitor at 3.5% by count and 2.1% of more than $1 trillion in assessed notional