The relationship advantage of middle market credit

The financial professional take on “The Lead Left” newsletter series, authored by Randy Schwimmer, Vice Chairman and Chief Investment Strategist at Churchill Asset Management, is dedicated to help financial professionals stay informed about developments, and movements in private capital investing.

Bottom-line for financial professionals upfront

1. The middle market's relationship-driven structure offers a compelling framework for discussing private credit quality with clients who ask why not all direct lending behaves the same way in a stress environment.
2. Deal overlap among middle market managers, and within the upper market, signals a fundamentally different competitive dynamic, one that supports more differentiated portfolio construction for clients seeking alternatives exposure.
3. Concentration in AI-sensitive and higher-leverage sectors represents a live risk in the current environment, with rising PIK loans, non-accruals, and default rates serving as warning signs to monitor when evaluating manager selection for clients.

As we highlighted in Private credit at an inflection point, the zero-rate period post-GFC allowed private equity firms to buy companies with higher leverage and sell them at higher multiples. For the largest direct lenders, this included mega software businesses with increasingly borrower-friendly financing terms.

Reality returned in 2022 as SOFR soared from zero to 5%. Financing costs became headwinds, borrower leverage shrunk, and the upward march of purchase price multiples halted. Public credit markets shut down. Private markets remained open, but with M&A slowing, competition among upper-market lenders surged, resulting in significant portfolio overlap.

The core middle market is relationship driven. Sponsors and lenders are long-term holders, so successful outcomes require alignment of interests. A solid partnership of trust is more valuable than squeezing the last turn of pricing or leverage. Sectors and borrowers must prove resilience through cycles because, unlike large caps, you can't easily sell an "overweight" position.

For years lenders demanded an illiquidity premium for mid-caps, anywhere from 100–300 bps. And more protection: maintenance financial covenants, security on all assets and cash flows, and lower leverage. But liquidity risk is different from credit risk. In fact, default and loss rates are historically lower for middle market loans than broadly syndicated loans. In part this is thanks to the cooperation between lenders and borrowers to get through tough times.

These relationships also limit deal overlap among middle market managers to nearly half of the upper market. Being an LP in 350 top-tier PE GPs reduces our own portfolio overlap to less than 10%; less than the lower MM. This helps point to the fundamentally different origination models, competitive environments, borrower profiles, and risk characteristics in mid-caps versus large caps.

Deal sourcing in the core MM is not dependent on market momentum. Activity is consistent regardless of cycles because experienced managers seek to diversify portfolios across defensive sectors. This helps reduce concentration risk in ways that bank/bond replacement platforms can't.

The rush of retail money into those platforms worsens this dynamic. The tyranny of dry powder is the relentless quantity-over-quality pressure to put money to work. In contrast, approximately 5% of all middle market companies are owned by PE firms, creating a natural supply/demand balance.

Today's credit concerns stem from four years of higher rates in higher risk portfolios, particularly AI-sensitive sectors. Flashing red lights for PIK loans, non-accruals, and default rates are signs of stress. Our own portfolio performance suggests the core middle market remains more resilient given its broader base of less tech-centric service companies.

In our next installment, we explore how financing terms for borrowers, in both middle and large cap markets, translate to terms for investors.