The Hidden Risk in ‘Senior Secured’ Loans

When evaluating a loan investment, investors should focus on three questions:

• What is the yield?
• How likely is the borrower to default?
• What will be the recovery rate if the borrower does default?

In an Oct. 8, 2026, article, “Why Are Recoveries Down?,” Shiloh Bates, partner and chief investment officer at Flat Rock Global, provides a timely reminder of why that question matters. He explains how changes in capital structures and lending agreements have weakened the protection historically associated with first-lien leveraged loans: While the label has remained the same, the protection behind it has not.

The key distinction is between priority and protection. Being first in line to collect is valuable—but how valuable depends on what remains to be collected.

The Recovery Assumptions Have Changed

Bates recalls that when he began working for collateralized loan obligation managers in 2000, an expected recovery of about 80 cents on the dollar was a reasonable starting point. At that recovery level, interest collected before default could sometimes offset the eventual principal loss, leaving investors whole. Recent figures are much less reassuring. Bates reports that first-lien loan recoveries averaged 61% over the past 25 years. He also cites a J.P. Morgan average recovery figure of just 33% as of July 31, 2026.

Independent evidence supports the broader concern. Fitch Ratings found that first-lien recoveries for companies with at least $100 million of first-lien term-loan and bond debt that emerged from bankruptcy in 2025 averaged 43%, weighted by debt principal. That was the lowest level in its 2016–25 dataset and well below the period’s 62% average.

While Fitch’s 43% and the 33% cited by Bates should not be treated as directly comparable (Fitch specifies a bankruptcy-emergence sample covering both first-lien loans and bonds), they both point to the danger of relying on older recovery assumptions.

How Successful Lending Markets Can Weaken Lender Protection

Bates traces the deterioration partly to the success of the leveraged loan market itself. Strong historical performance and the search for yield attracted capital. He reports that the US leveraged loan market expanded to approximately $1.5 trillion by the end of 2025 from about $500 billion in 2010.

More capital competing to lend gave borrowers greater negotiating power. According to Bates, that competition contributed to two developments: capital structures that leave senior lenders with less protection beneath them and loan agreements that give lenders fewer opportunities to intervene before a borrower’s condition deteriorates.

This is an important investment lesson. An asset class’ historical success can attract enough money to change the conditions that helped produce that success. Investors cannot safely assume that the protections available to earlier lenders remain available to today’s lenders.

A Thinner Cushion Beneath the Loan

A first-lien lender has a senior claim on pledged collateral. But seniority alone does not determine recovery. The amount of debt relative to the value supporting it matters, as does the presence—or absence—of junior claims that absorb losses first.

Bates argues that many contemporary capital structures rely on loans without the junior debt that previously provided an additional cushion beneath senior lenders. S&P Global has similarly identified shrinking subordinated debt cushions, increased leverage, and covenant-lite lending as contributors to declining first-lien term-loan recoveries.

Weaker Covenants Can Delay Intervention

The second change involves covenants—the contractual provisions that protect lenders.

Bates reports that more than 90% of the broadly syndicated loan market is now covenant-lite, compared with roughly 20% in 2007.

“Covenant-lite” does not mean that a loan has no covenants. The important distinction is that these loans generally lack regular financial maintenance tests, such as a requirement to remain below a specified leverage ratio. They may still contain restrictions triggered when the borrower takes certain actions, such as incurring additional debt.

A maintenance covenant can give lenders a seat at the negotiating table while the borrower still has liquidity and meaningful business value. Without that trigger, lenders may have less leverage until the financial deterioration is much more advanced. That is one of the mechanisms Bates identifies behind weaker recoveries.

First in Line Can Become a Moving Target

Loan documentation also governs whether borrowers can add debt, transfer assets beyond existing lenders’ collateral package, or undertake restructurings that treat different creditor groups differently.

Bates highlights liability management exercises: transactions that restructure a borrower’s obligations outside a conventional bankruptcy process. Depending on the documents and transaction, some lenders can receive stronger claims while others are left with weaker protection.

Fitch has documented how substantial those differences can be. In a 2023 analysis, it described one restructuring in which participating lenders were expected to recover 74%–76%, while nonparticipating lenders were expected to recover less than 3%. The concern is, therefore, not the restructuring itself. It is the possibility that weak documents allow value and priority to shift away from particular lenders.

Why Recovery Assumptions Matter to Expected Returns

A useful starting approximation is:

Default probability times (1 minus recovery rate) equals expected credit loss

Consider a hypothetical portfolio with a 3% annual default rate:

A higher yield may compensate for that deterioration. Or it may not. The relevant question is not whether the quoted income looks attractive, but whether the spread adequately compensates investors for both the probability of default and the likely severity of loss.

Caveats

Bates’ paper focuses on the broadly syndicated loan market. The BSL market consists primarily of large, floating-rate loans to sizable companies with below-investment-grade credit ratings. Typically arranged by banks and distributed among institutional investors, these loans are generally “senior secured”—backed by company assets and ranking ahead of unsecured debt for repayment.

Unlike broadly syndicated loans, which generally finance larger companies, the privately negotiated loans held by many business development companies and direct-lending interval funds (such as Cliffwater Corporate Lending Fund Class I Shares CCLFX, in which I invest) primarily serve middle-market businesses. These loans carry higher spreads (which compensate for credit and liquidity risks) and often have stronger contractual protections, including financial maintenance covenants: periodic tests of leverage or interest coverage that give lenders an opportunity to intervene before a missed payment.

In addition, negotiating with a single lender (versus a syndicate of banks) can make workouts more manageable than coordinating a large syndicate and reduce the risk of “lender-on-lender violence,” in which some creditors improve their position at others’ expense. Thus, one should not automatically extrapolate Bates’ findings in the BSL market to middle-market private credit loans.

That said, the comparison is not one-sided. Many private loans, particularly unitranche loans, are also single-tranche structures with no junior debt beneath them, and covenant protection varies by deal and lender. As with BSL loans, the key question is how much equity sits beneath the loan, which depends on loan/value and underwriting discipline rather than the “private credit” label.

Data from the Cliffwater Direct Lending Index, which tracks the loan portfolios of BDCs, offers some evidence that recoveries on middle-market direct loans have not deteriorated in the same way. Because business development companies do not report actual recoveries on impaired loans, the index calculates an implied recovery rate: the aggregate fair value of loans on nonaccrual divided by their cost. By that measure, first-lien implied recoveries averaged 48.8% in 2025, in line with the trailing 10-year average of 48.6%. Second-lien implied recoveries averaged 37.5% versus a 10-year average of 32.3%. For all nonaccrual loans combined, implied recovery was 52.8% in the first quarter of 2026 and 48.7% in the second quarter, within the range of recent years.

These figures are marks on loans still on nonaccrual, not final realized outcomes, and the index’s definition differs from the figures cited by Bates and Fitch, so they should not be compared directly with them. They do suggest that recoveries on middle-market direct loans have stayed near their long-term norm.

Investor Takeaways

Manager selection matters a great deal, and due diligence should start with the credit culture. Falling recoveries make it especially important to look beyond a fund’s yield and the “senior secured” label. Investors should evaluate how the manager underwrites borrowers, scrutinizes loan documents, and assesses recovery prospects—not just the probability of default. A strong credit culture means maintaining lending standards when competition intensifies, giving the investment team the authority to reject weak deals and rewarding disciplined risk-taking rather than simply growing assets. Ask for examples of loans the manager declined, how realized recoveries compared with underwriting assumptions, and what changed after losses. The key is not just whether a manager can identify attractive loans but also whether the organization consistently prioritizes protecting investor capital.

The Bottom Line

Flat Rock’s article highlights a problem with relying on investment labels: The name can stay the same while the underlying economics change. First-lien loans can retain their contractual seniority even as thinner cushions and weaker documents reduce the value of that seniority. Middle-market borrowers do not have the same negotiating power that the larger companies borrowing in the BSL market have, which often translates into stronger creditor protection, although terms vary by deal and manager.