Private Markets

Private Debt: The Core Middle Market

The middle markets in the U.S. and Europe are sometimes overlooked in the context of the broader economy, but they are important segments where we see compelling opportunities in private debt.

Key takeaways

  • 01

    Continuing to scale

    In both the U.S. and Europe, middle market companies represent roughly one third of the workforce and GDP, and these companies continue to scale meaningfully.

  • 02

    Funding gap

    Tighter bank lending standards and a structural shift in public debt markets toward larger deals have created a funding shortfall for many middle market firms.

  • 03

    Significant opportunity

    We see investments with non-sponsored companies – business that don’t have backing from private equity – as a significant opportunity in the core middle market.

Middle market companies in the U.S. are those with annual revenues between US$10 million and US$1 billion. Definitions vary throughout Europe – in the U.K. and Germany, they are defined as those with annual revenues between €20 million and €1 billion, while in Italy the range is typically from €5 million to €250 million1.

There are roughly 200,000 such businesses in the EU and an equal number in the U.S. They are responsible for roughly one-third of U.S. employment and GDP. And they drive a similar percentage of Europe’s economic activity1.

The middle market has seen double-digit annual growth in both revenue and employment in 2022 and 20231. Despite its collective size and economic might, the middle market today lacks the capital and financing options it once had.

A need for capital

The past 20 years have seen traditional banks pull back from financing middle market companies. This has opened the door for private lenders to increasingly become the main - and sometimes only - option for middle market borrowers.

Chart of premium spreads

Source: Cliffwater; 2023 Q3 Report on U.S. Direct Lending.

Core opportunities

Amid a favorable environment for private lenders across the middle market, we see particularly compelling opportunities in the core segment, which we define as companies with an annual EBITDA between €10 million and €50 million in Europe, and US$25 million and US$75 million in the U.S. Deals in this space are usually underwritten by either a single lender or a club of no more than five institutional investors.

The loans require more extensive due diligence, and this can make sourcing deals more challenging at scale. Smaller companies can also bring higher business and operational risks.

Chart of more covenants

Source: Moody’s Investors Services, September 30, 2023.

In addition, we see significant upside in the core middle market compared with the upper middle market, where there are more lenders competing for deals. Reduced competition in the core middle market offers wider spreads to lenders, providing greater agency over pricing and better opportunities for outperformance.

Investor protections are one major reason we like the core segment. Smaller borrowers are typically more amenable to providing lenders with covenants and other protections.

Challenges and opportunities

The market for middle market loans is spread out geographically and across industries. Sourcing the right opportunities can be challenging, given the breadth of companies and the limited information available to lenders. Venture capital and private equity firms can be a reliable pipeline for private lenders, and these relationships are essential in this space. Loans to companies backed by these investors are referred to as sponsored financings, with the sponsor often playing a big role in soliciting and negotiating the loan.

Non-sponsored loans are those made to companies that lack the backing of a venture-capital or private-equity investor. Rather, the lender works directly with the company, often without a bank or other intermediary.

Lending to non-sponsored companies typically requires an experienced lender with the resources and expertise to complete a more hands-on due diligence and credit analysis.

It’s important for lenders to access different sourcing channels in response to market events, so if sponsor-backed M&A activity slows down, investors can still access non-sponsored deployment opportunities without sacrificing on key terms.

The importance of middle market companies to the global economy makes it essential for them to access capital when they need it. And we believe that this segment offers unique opportunities to the lenders who provide the requisite capital to these companies as they continue to expand their operations.

Chart of going private

Source: Pitchbook LCD, Nov. 30, 2023. Chart is composite of data for LBO and non-LBO deals. Private credit count based on transactions covered by LCD News.

James Keenan
Chief Investment Officer and Global Head of Private Debt
Stephan Caron
Head of European Private Debt
Phil Tseng
Co-Head of U.S. Private Capital
Raj Vig
Co-Head of U.S. Private Capital

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