Dealmakers Go Beyond the Mainstream

Spreads in direct middle market loans compressed during the third quarter and leverage ticked higher as lenders competed for a limited supply of deals. Activity remained sluggish as pipelines continued to slowly rebuild from the dislocations surrounding the tariff announcements.

With leveraged buyouts still relatively constrained, add-on mergers and acquisitions (M&A) has been a more consistent source of demand for private credit lenders, accounting for nearly three-quarters of buyout transactions in the third quarter.¹ In the lower middle market, in particular, we are seeing activity in private equity rollups of basic, cash-flowing businesses with pricing power and inelastic demand—such as HVAC, plumbing, elevator servicing and landscaping. For private equity buyers, these smaller businesses offer an opportunity to professionalize, scale and consolidate within sectors of the US economy that have long remained outside the M&A mainstream.

It’s possible that the Fed’s recent rate cuts—with the potential for additional cuts before year end—may herald a change in M&A sentiment. If so, we believe that activity in the lower middle market is likely to accelerate before demand in the upper end. With relatively simple capital structures and limited leverage, smaller companies tend to be more sensitive to changes in the cost of capital and modest rate cuts can spur a pickup in dealmaking. That said, spread levels are unlikely to improve meaningfully even if volumes increase over the next few quarters, in our view, as it will take time for the market to reestablish supply/demand equilibrium.