The “true” middle market offers best opportunities, says Barings
The traditional middle market offers the most compelling direct lending opportunities, as fierce competition in the upper middle segment is leading to lower returns and unfavourable loan terms on larger deals, according to Barings.
In an analysis, Stuart Mathieson, head of Europe and APAC private credit and capital solutions, and Tyler Gately, head of North America private credit, highlighted that direct lending deals are getting bigger as managers look to deploy capital more quickly.
“Deploying tens of billions of dollars into deals in increments of around $100m (£78.6m)–$200m is not only inefficient, but also difficult to execute in a timely manner,” the authors said. “As a result, many managers have chosen to move up-market, ramping large funds by making bigger investments in upper (upper) middle market companies ($100m+ in EBITDA), rather than patiently deploying capital into more traditional middle market opportunities.”
Read more: JPMorgan sees growth opportunity in private credit
This can lead to issues for investors from a return, documentation and structuring standpoint, they said.
In the upper middle segment, direct lending managers are competing against the broadly syndicated loan market, which can result in lenders consenting to less favourable terms in order to secure a deal.
In certain deals, spreads have narrowed as well, the Barings article said, meaning that the illiquidity premium has begun to fade.
“Even without the yield premium that would typically offset the illiquidity risk associated with these assets, investors in some instances are still paying the premium fees characteristic of private markets,” the authors said.
Read more: Barings re-hires private credit veteran Shettle
“Ultimately, this misalignment can lead to scenarios in which investors are exposed to the risks associated with illiquid assets but positioned for lower total returns.”
Additionally, financial maintenance covenants and other structural protections have become more diluted in the upper part of the middle market, which can raise the risk of losses for investors, Barings said.
“Amid the growing prevalence of asset collection and upper (upper) middle market deals, there is a strong case to be made for ‘asset selection’ and remaining disciplined in the traditional or true middle market,” the article said.
“While this segment of the market has stayed largely out of the limelight, it continues to offer strong potential for attractive risk-adjusted returns over time, particularly in the more conservative parts of the capital structure, namely first lien senior debt.”
Read more: Ares: Private credit market will double within five years
