MIDDLE MARKET SHINES IN PRIVATE CREDITMIDDLEMARKETSHINESINPRIVATECREDIT

Despite less-than-ideal macroeconomic conditions and lower overall financing activity recently, resilient private credit lenders have taken market share from banks. As we enter a more stable economic environment underpinned by prospects of lower interest rates, conditions are improving as borrowers feel more confident pursuing private credit financing and private lenders appear more willing to deploy capital.

M&A ACTIVITY REAWAKENING

Private credit volume is highly dependent on merger-and-acquisition (M&A) activity and leveraged buyouts (“LBOs”) led by private equity sponsors. Higher interest rates and economic uncertainty amidst recession fears have stifled M&A activity recently and stymied originations growth. While headwinds remain for dealmakers, activity has started to recover from lows extending into Q4 last year. We expect a resumption of M&A activity and capital investment across markets as the backdrop continues to stabilize and sponsors seek high-quality private credit managers hungry to deploy capital after a period of stymied originations growth. Further, with more positive outlooks, banks are reclaiming syndicated loan activity they had relinquished to private lenders after the regional bank fallout in 2023. These dynamics are creating increased competition and tightening loan spreads for private lenders focused on the upper ends of the market. We believe this shift in competitive behavior and appetite for these loans will result in lower yields for investors in the larger segments of the market.

DISTINCT MIDDLE MARKET ADVANTAGES

With heightened competition and potentially deteriorating quality in the up-market and large market segments, we believe the core middle market continues to offer better relative value and return potential. It remains a largely underserved segment where borrowers are accustomed to stricter underwriting standards, including lower entry leverage and tighter covenants. As a result, opportunities for private credit deals in the core middle market are poised to improve both in terms of deal flow and underwriting quality. Middle market companies, even with strong financial performance, have more limited access to financing, which offers middle market investors several key benefits:

• Expanded opportunity set: Of the roughly 200,000 U.S. middle market companies in the U.S., 90% are considered lower/core middle market while the rest are considered large/upper middle market (with $100+ million in annual revenue).¹
• Stronger yields: While large companies tend to have broad financing options, core middle market companies tend to have more limited access to financing and will increasingly rely on direct lenders due to bank dislocation and regulation. Therefore, middle market yields tend to be higher than larger segments and more resilient during periods of rapid spread tightening.
• Better underwriting standards: Higher lender competition in the up-market and large market segments often leads to less-restrictive underwriting standards and higher leverage. Meanwhile, middle market lenders typically demand stricter underwriting terms, tighter covenants, and lower leverage to provide better downside protection for themselves. Further, with smaller transaction sizes, middle market lenders are able to take sole/majority positions, which reduces lender-on-lender violence recently observed in the up-market.