The business of private credit: Where core and upper middle market discipline diverges

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. Sector discipline in the core middle market differs meaningfully from the upper middle market, where portfolios more closely mirror the momentum-driven concentrations of the broadly syndicated loan market.
2. Concentration risk in the upper middle market has widened over the past five years, and non-accruals have climbed alongside the sectors that drove recent performance.
3. Portfolio construction that pairs public equities and fixed income with a private capital allocation may balance momentum exposure with the stabilizing characteristics of private credit, subject to illiquidity and suitability considerations.

For financial professionals guiding high-net-worth clients through private credit allocation decisions, the distinction between core middle market and upper middle market lending has direct implications for portfolio concentration, cyclicality, and long-term risk management.

How manager structure reflects where a lender competes

We've spent the last few weeks covering the businesses of the core middle market (CMM). Does that same discipline hold when you move up market?

The way managers organize their underwriting and portfolio management teams is a byproduct of sector focus. Deal selection in the broadly syndicated loan (BSL) market runs through sector specialists, analysts responsible for specific coverage areas. The core middle market leans towards generalists evaluating businesses on their own merits. The upper middle market (UMM) uses a generalist model with some industries (for example, healthcare) deserving more attention.

Why the upper middle market inherits BSL momentum traits

Given how the UMM competes with the BSL market, it can reflect the same momentum-driven traits. The hottest sectors and themes tend to make up a larger share of the portfolio. Whether that is energy, retail, or transportation when the economy is running hot, or AI and technology in the post-COVID, low-interest rate world.

What core middle market underwriting actually looks like

In the CMM, the borrower comes first. You underwrite a pest control company, an HVAC business, or a wastewater management contractor because of what it does and who it serves. Middle market businesses are too niche and specialized to fit neatly in industry categories. Think Standard Industrial Classification (SIC) codes.

Concentration risk has widened in the upper middle market

As we noted in our (Smaller) Size Matters piece, concentration runs meaningfully higher in the UMM than the CMM, and that gap has only widened. Over the last five years, UMM overlap has climbed sharply, a function of just how competitive and crowded that end of the market has become.

Everyone looks good when the cycle cooperates. But when it turns, or a hot sector starts showing cracks, that concentration compounds fast. Non-accruals in software have been climbing right along with the momentum that drove them.

The CMM approach favors LALO businesses across cycles

Core MM lenders typically don't chase sectors. They favor "LALO" (light-asset, low obsolescence) businesses that have demonstrated steady, non-dramatic growth. Owners and management teams improve revenue and cash flows through customer relationships, disciplined M&A, and operational execution rather than sector tailwinds. Performance can often outpace their larger (or non-sponsored) peers, though outcomes vary by manager and cycle.

And because sector exposure is a secondary sourcing filter, CMM portfolios are spread across industries that aren't synched to the same economic cycles.

Portfolio construction: momentum and brakes

Momentum can be your friend, but sometimes not so much. We think public equities and fixed income are complements to a private capital allocation because investors can access different return drivers across the portfolio. Momentum as the accelerator and privates as the brakes can help support a disciplined investing journey, provided the investor can accommodate the illiquidity and long horizon that private credit requires.