KKR hails “resilient” upper middle market lending
KKR has hailed the resilience of upper middle market lending, despite ongoing macro-economic instability.
The investment manager focuses on lending only to upper middle market companies, which it defines as having an EBITDA of $50m (£37.85m) to $200m.
In a note to investors written by George Mueller, a partner in KKR’s credit and markets business, Rony Ma, a managing director on the credit team, and Ian Anderson, a managing director in the firm’s credit business, KKR confirmed its commitment to the sector by detailing the reasons it favours the upper end of the direct lending market.
The authors said that upper middle market companies have historically had strong, stable financial performance, with lower defaults and attractive opportunities.
Read more: KKR eyes private credit to finance FGS Global acquisition
Furthermore, KKR argued that the spread difference between returns in the upper and lower middle market is not as wide as many believe.
“Upper middle market companies have been more resilient in the recent market cycle than smaller companies, which have been hit harder by inflationary pressures and rising costs,” wrote Mueller, Ma and Anderson.
“Larger companies tend to have more diversified revenue streams, which can sometimes help them weather market volatility and pass through rising costs.”
The company added that in its own direct lending portfolio – which has an average EBITDA of just over $100m – profit margins have remained stable even during the pandemic and the period of high inflation that followed.
KKR noted that smaller companies have had higher default rates on covenants than companies in the upper middle market, leading analysts to conclude that there is a correlation between size of company and covenant default rate.
The firm also pointed to data which showed that there has been a “mere” 24 basis-point average spread differential between companies with EBITDA between $40m and $100m and those with EBITDA of less than $40m.
“We think the higher competition in the lower middle market is a key factor in this tight spread,” Mueller, Ma and Anderson added.
Read more: KKR’s AUM hits $600bn in Q2 as fee-related earnings reach record high
“Lenders who focus on companies with less than $50m in EBITDA make up 90 per cent of the direct lending market, with hundreds of community and regional banks, BDCs and private funds vying with one another for deals.
“The smaller amounts of capital involved create lower barriers to entry, but lenders typically have more limited balance sheets and a narrower scope of capabilities.
“We have also heard anecdotally that the speed of deployment in the lower middle market can be a challenge for investors waiting for their capital to get put to work.”
The credit specialists concluded that they value the resilience that larger companies seem to have throughout market cycles, while the returns differential for financing smaller companies does not make up for the step up in potential credit risk.
“As we build our own portfolio, we continue to evaluate companies across the spectrum, focusing on borrowers from $50m to more than $200m in EBITDA,” added Mueller, Ma and Anderson.
“We think that viewing a broad spectrum of the upper middle market enables us to select investments with the most attractive risk-adjusted returns.”
Read more: Why private credit investors hold all the cards right now
