The business of private credit: What makes the core middle market resilient across cycles

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. The core middle market, comprising companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) of $25 million to $75 million, is drawing renewed attention from private equity buyers and direct lenders as elevated leverage and weaker structures create concern in large-cap portfolios.
2. Portfolio construction discipline, built around sector diversification, commitment size limits, and a preference for services over manufacturing, has defined the managers who navigated prior downturns most successfully.
3. Sector selection principles, favoring commercial over consumer demand and low-obsolescence businesses over cyclically exposed ones, offer advisors a framework for evaluating which private credit managers are positioned to hold up across market cycles.

As financial professionals guide high-net-worth clients toward private credit allocations, the core middle market offers a case study in why portfolio construction discipline matters as much as deal sourcing.

Why the middle market deserves a closer look

In a world where every conversation seems to revolve around AI, mega-software mergers and acquisitions, and data center infrastructure, it is easy to overlook the arena that creates significant private sector employment and revenue growth. But as investors grapple with AI transition risks, elevated leverage, and weaker structures in large-cap portfolios, the core middle market is getting second and third looks.

“Old economy” sectors and the rise of HALO businesses

Pest control companies, veterinary clinics, and HVAC services aren’t featured on many prime-time business TV programs or conference agendas. But “old economy” sectors are commanding more attention from private equity buyers and their direct lending partners who specialize in core middle market companies. Purchase price multiples for these HALOs (heavy asset, low obsolescence) businesses, with cash flows in the $25 million to $75 million range, have risen to double-digit EBITDA multiples, improving the cash equity share of buyouts and holding down leverage multiples.

How portfolio construction lessons from the Great Recession shaped today's leading managers

Today's industry composition of portfolios for the leading core middle market direct lenders did not materialize overnight. Those few private credit managers who lived successfully through the Great Recession learned some important lessons in those tough times.

First, diversify. Keep watch on outsized sector concentrations. No matter how much you may love dental practices, don't build your entire portfolio with them.

Diversify by commitment size, particularly in the early stages of building a fund or portfolio. Nothing should be more than 2% of the total assets under management (AUM). That way an unexpected problem with a large exposure doesn't hurt your returns. Remember, credit investment success means getting your interest and principal back. Don't reach for the moon when all you have is a stepladder.

Second, cyclical companies are what they say they are; in a recession, these businesses will be the first to feel the pain and sometimes the last to recover. In other words, if you plant nothing but crocuses in your garden, your landscaping will be pretty bare most of the growing season.

Why commercial exposure, services, and sector selectivity matter

Emphasize commercial over consumer. Demand trends for the former are easier to predict than for the latter. We thought consumer brand names would carry the day during the Global Financial Crisis (GFC), as they did in prior downturns, but it turned out value brands won out. With so many buying options available, the velocity of changing consumer tastes has never been more challenging to predict.

Finally, services over manufacturing. Specialized manufacturers can be excellent middle market businesses, but rising labor expenses and tariffs have made the input cost story more challenging. Not to say service companies don't employ human capital. But the skilled ones have higher free cash flow margins that allow for more leverage and investment growth.

What we will examine in future posts

Private credit investors may see what's in manager portfolios, but not always the history and knowledge behind the scenes. In upcoming posts, we will look at the history of business selection in the middle market. How the macro environment shapes sector allocation, how private equity expertise influences those decisions, and how experienced managers build all-weather portfolios designed to diversify and help manage risk for their investors.