The business of private credit: What middle market lenders learned about building lasting portfolios

The financial professional take on “The Lead” newsletter series is dedicated to help financial professionals stay informed about developments, and movements in private capital investing.

Bottom-line upfront

1. Middle market private credit's resilience stems from decades of hard-won underwriting discipline, refined through cycles from the savings and loan crisis of the late 1980s through COVID-19-era supply-chain disruptions and recent rate and tariff shocks.
2. Service-oriented businesses and specialized manufacturers with low capital expenditure requirements and predictable free cash flows represent, in our view, the core of a well-constructed middle market private credit portfolio which we believe are built to perform across market conditions.
3. The "just finish the race" standard in middle market direct lending, where lenders hold loans to maturity rather than trading positions, favors borrowers with durable business models over those with momentum-driven growth stories.

The analysis below explains why experienced middle market lenders build portfolios designed to endure, and how that discipline translates into a private credit allocation that can anchor a client's long-term wealth strategy.

How middle market private credit builds resilience across economic cycles

The roots of middle market direct lending came from traditional commercial bank lending in the 1970s and 1980s. Designed to serve regional companies that lacked the size and scale to access the broadly syndicated loan or high yield markets, this arena was driven by relationships. Founder- and private equity-owned borrowers clubbed together like-minded lenders they trusted to provide their significant capital needs.

These lenders often shared a similar approach to evaluating risk, informed by decades of experience with their clients. This began to change, however, as leveraged buyouts in the late 1980s and early 1990s pushed leverage higher. Non-bank lenders such as finance companies carved out specialty areas in healthcare, technology, consumer goods, and light manufacturing. They also worked closely with sponsors on niche middle market sectors, such as car washes, ripe for consolidation.

The global financial crisis as a turning point for underwriting discipline

Then came the global financial crisis (GFC). The worst downturn since the Great Depression swept away long-held assumptions about portfolio construction. Consumer brands lost value. Cyclical businesses were not rescued by lower leverage. And product purchases dependent on financing collapsed.

The few credit managers who survived the GFC learned from their mistakes. Industry screens for the all-cycle playbook required constant vigilance and updates. The 2015 oil crisis, COVID-19-induced inflation and supply-chain shocks, rate hikes and tariffs all tested underwriting models.

How industry focus differs across middle market segments

Our recent post "The relationship advantage of middle market credit" highlighted how core middle market and larger issuers differ in industry focus. The bank and bond replacement market includes more momentum sectors where funds trade in and out of positions. Buy-and-hold lenders target companies with strong, predictable free cash flows in sectors offering natural buffers against headline risks. This favors service-oriented businesses and specialized manufacturers.

The LALO framework: light-asset, low-obsolescence businesses

Wall Street identifies HALO (heavy-asset, low-obsolescence) as favored industries. The middle market operates at the ground level, with a comparable framework we describe as LALO: light-asset, low-obsolescence businesses. With low capital expenditure requirements, these companies can grow even when the broader economy does not. Private credit investments carry meaningful liquidity constraints; investors should expect limited ability to access capital during the investment period, which may span multiple years.

Portfolio construction for long-duration private credit

Portfolio construction for private credit in its most resilient form is found in the middle market. If you hold loans for the long run, the businesses they finance must perform in any market. As one of our good friends likes to say, in private credit your horse does not have to win, place, or show. It just has to finish the race.