Private Credit in the US Middle Market
A look at middle market private credit in the US in the context of current macroeconomic conditions, and potential applications of DeFi
By Justin Skoff, Senior Credit Manager at Warbler Labs
- Businesses in the US Middle Market — defined as companies with annual earnings before interest, taxes, depreciation, and amortization (“EBITDA”) of between $1 million and $100 million — represent an attractive market segment for private credit investment.
- This segment of the market includes a broad range of high growth and recession-resistant companies which are backed by well-capitalized equity investors. Private credit investments in this space carry attractive terms and have performed well historically on a risk-adjusted basis.
- Additionally, the landscape of lenders has been shifting in recent years due to regulatory changes and other market shifts, potentially providing an opportunity for disruption by DeFi.
Composition of the US Middle Market
The US Middle Market includes a wide range of businesses which represent a meaningful cross-section of the economy. Industries and illustrative examples include:
- niche manufacturing (e.g., a manufacturer of specialized aircraft parts),
- value-added distribution (e.g., importer of residential light fixtures),
- business services (e.g., staffing company),
- retail (e.g., franchisor of national fast-casual restaurant),
- consumer services (e.g., car wash operator),
- and healthcare (e.g., servicer of medical diagnostic equipment).
There are over 200,000 Middle Market businesses in the US, which collectively borrow over $1 Trillion in loans and represent approximately one-third of the national private sector economy.
US Middle Market Investment Highlights
Private credit investment in the US Middle Market can provide a safe-haven for investors in uncertain times such as the current economic and political landscape many areas are facing. A large portion of US Middle Market businesses have attractive credit risk profiles and demonstrated strong risk-adjusted returns across many instances and types of economic cycles.
The rate of default has been only 3.0% in the last year, 5.4% since 2018, and 4.0% since 1995. The qualities of Middle Market businesses which drive this success include strong profit margin profiles, high cash flow conversion, recurring customer base, recession-resistant end markets, lack of commodity price exposure, seasoned management, well-capitalized ownership groups, and attractive loan terms and structure.
Companies in the Middle Market also benefit from being large enough to enjoy economies of scale, but small enough to be nimble in strategy and decision-making. As illustrated in Figure 1 above, Middle Market company growth (gold bars) has outpaced the S&P 500 (blue bars) for the eight quarters following the global onset of COVID-19 and its resulting financial turmoil.
The structure of US Middle Market loans is another key driver of attractive risk-adjusted returns. The loans are often reasonably levered (typically the debt is 3.0x to 5.0x EBITDA) and have meaningful equity backing (often 25% to 50+% of total capital structure). This provides a strong “cushion” to declines in enterprise value, and requires company owners to have “skin in the game” that is subordinated to loan repayment.
“When combined with the attractive credit dynamics and low historical rate of default, this pricing provides meaningful risk-adjusted returns.”
A significant portion of the lending market is to private equity firms for leveraged buyouts, an attractive segment due to the private equity funds’ dedicated pools of capital to support their portfolio companies and the funds’ track record of successfully operating businesses. Additionally, key terms of the loan often include credit enhancements such as financial covenants, excess cash flow recapture (i.e., required pay-down of the debt), amortization, restrictions on non-operating payments such as dividends, rigorous financial reporting requirements, and other terms tailored to the borrowers’ specific business risks.
Loan pricing is dependent on size, market dynamics, leverage, and credit quality. As of November 2022, pricing ranged between SOFR + 6% to 12%. (SOFR stands for the Secured Overnight Funding Rate, and as of the time of writing is approximately 3.5%. Source: Sofrrate.com)
When combined with the attractive credit dynamics and low historical rate of default, this pricing provides meaningful risk-adjusted returns. As illustrated in Figure 2 below, the total return of Middle Market loans (green line) has outpaced large public-borrower loans (black line) since 2015.
Potential for Disruption by Defi
Banks have been the historical lenders to the US Middle Market, however, recent changes in regulatory requirements has resulted in banks exiting the market. Most notably, the fallout of the financial crisis resulted in an increase in bank capital requirements for illiquid investments such as Middle Market loans.
Since 1994, banks’ share of Middle Market lending has decreased from 72% to 9% (Source: Alliance Bernstein). To fill this gap, non-bank “alternative lenders” have entered the space. DeFi, via Real World Asset lending protocols like Goldfinch, could provide another alternative source of capital for Middle Market borrowers. DeFi offers many potential benefits versus banks and other existing lenders, including a significantly lower fee structure, direct access between borrowers and lenders, more efficient and flexible payments via on-chain transactions, and increased transparency.
Additionally, borrower access to banks and current alternative lenders is gated by a need for relationships through specific channels such as investment banks and/or private equity owners. DeFi can provide a streamlined portal for borrowers to directly access capital providers without the need for multi-layered, gated channels. Further, the investment diligence, documentation, and funding process can be significantly shortened (typically taking 6+ weeks) and executed at a lower cost due to the utilization of payment rails and smart contract structures.
Goldfinch is a decentralized credit protocol on a mission to connect the world’s capital to the world’s growth, by creating a single global credit marketplace. That means everyone, from startups in Lagos to institutions in New York, can borrow from the same capital markets and that all investors can access those deals directly.
USDC yields come from real-world lending to proven emerging market businesses, and investments are collateralized off-chain by real-world assets, making Goldfinch distinctly different from the highly volatile DeFi lending you may be familiar with.
Learn more at goldfinch.finance, or follow Goldfinch on Twitter at @goldfinch_fi.
This content was published for educational purposes and is not intended as financial advice. For the avoidance of doubt, neither the Goldfinch Foundation nor Warbler Labs, Incorporated (“Warbler”) provide investment, tax, or legal advice. You are solely responsible for determining whether any investment, investment strategy or transaction using the Goldfinch protocol is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance.