The Lower Middle Market Advantage

As private credit grew in popularity and capital poured in, lenders increasingly focused their dry powder on the larger end of the middle market. Not only has this trend hastened the deterioration of many structural protections in core and upper middle market deals, it has also resulted in increased overlap among lenders in these spaces—and made investors’ access to diversification more challenging.¹

As shown in the chart below, the percentage of portfolio overlap among core and upper middle market deals has been on the rise over the past three-plus years, suggesting portfolio exposures are more concentrated than they may appear on the surface. Overlap among lower middle market deals, in contrast, has remained limited.

We think there are a few reasons for this. The higher volume of transactions in the lower middle market—the number of loans to these borrowers annually is about seven times that made in the upper and core middle markets combined—provides lenders with ample opportunity to source deals, and the smaller average size of these loans often enables them to be funded by a single lender.² Beyond greater diversification, the relatively muted competition in the lower middle market that has resulted from the upmarket migration of lenders has supported the preservation of robust covenants, conservative leverage and lender control that originally drew investors to the asset class.

The lower middle market—comprising approximately 180,000 companies with earnings before interest, taxes, depreciation and amortization between $5 and $25 million—offers exposure to the “backbone of the American economy”.³ Even with less competition than larger segments of the market, however, lending to these smaller companies still carry risks such as greater sensitivity to economic conditions, management risks and less diversified operations. In our view, these risks highlight why we believe high quality sponsored deals are essential and the importance of a dedicated sourcing network, as well as disciplined underwriting, term structuring and credit documentation.