CPD: US middle market private credit – the investment case

Exposure to the private credit sector can provide benefits to your clients’ portfolios.

In today’s rapidly shifting investment landscape, traditional sources of fixed income are struggling to meet the yield and diversification needs of investors. They are also becoming more closely correlated with equities. With public markets becoming increasingly volatile and interest rates elevated yet unpredictable, many advisers are turning to alternative strategies that can offer enhanced returns, downside protection and low correlation with traditional fixed income investments.

Interest in alternative asset classes is intensifying as advisers look to improve the return profiles of client portfolios in an increasingly challenging environment. The universe of non-publicly traded debt and equity comprises a wide array of sectors with unique structures and risk-return profiles.

One asset class that has gained significant traction over the past decade is private credit. Much has been written lately about the huge increase in the number of private credit funds available to Australian investors.

Private credit refers to non-bank, non-traded debt financing, typically by institutional investors, private debt funds or alternative lenders. Unlike public bonds or syndicated loans, private credit transactions are negotiated directly between lenders and borrowers, often tailored to meet the specific capital needs of the borrower. The private credit sector has steadily increased in popularity since the Global Financial Crisis (GFC), filling the lending gap left by banks constrained by a tighter regulatory environment.

As with all asset classes, there are diversification opportunities within the private credit sector and it is important that advisers, and their clients, understand the private credit exposure each sector – and each fund – offers.

Within the expanding private credit sector, the US middle market stands out as a particularly compelling segment. Comprised of businesses typically earning US$10 million to US$100 million in EBITDA, the US middle market sector offers a unique combination of structural advantages, attractive yields and reduced correlation to public assets.

For clients seeking stable, income-generating assets with strong risk-adjusted returns, as well as low correlation with traditional asset classes, US middle market private credit represents a growing and underappreciated opportunity. An allocation to US middle market private credit can be added to a diversified portfolio as a complement to other private market loan segments.

US middle market private credit

The number of publicly listed US companies has plummeted by more than half since peaking at more than 8,000 in the mid-1990s. The rise of private equity allows companies to remain private longer, giving them time to establish themselves without market scrutiny and the rigour of regular reporting.

Within the broader market private credit market, US middle market private credit specifically targets companies that fall between large corporates and small businesses in terms of size and financial profile. It’s a growing segment; the GDP generated by the sector places it in the top five worldwide (figure one). The demand for private capital solutions in the US middle market meaningfully outpaces supply, resulting in a compelling opportunity for private capital investment.

Middle market companies are generally defined as having annual revenues between US$50 million and US$1 billion, or EBITDA ranging from US$10 million to US$100 million^[1]. These companies are often high-growth businesses that generate significant cash flow and are commonly backed by private equity sponsors. However, they may lack access to the public capital markets or prefer the speed, flexibility and certainty that private credit solutions can offer compared to traditional bank loans or public debt issuance.

The types of loans in this segment typically include senior secured debt, unitranche loans (a blend of senior and subordinated debt), second lien loans and mezzanine financing. These instruments are commonly floating-rate, short to medium-term in maturity, and structured with covenants and collateral protections that give lenders significant control and oversight.

One of the defining features of middle market private credit is that loans are typically privately negotiated. Consequently, lenders can generally negotiate terms that provide meaningful downside protection. Such terms may include financial maintenance covenants, board observation rights and tighter reporting requirements. A hands-on approach allows for more active risk management and greater alignment between lender and borrower.

As a result, middle market private credit offers an attractive blend of yield, structure and control, which are attractive attributes in today’s volatile environment.

Market size and growth drivers

The US private credit market has grown dramatically over the past decade. Industry-led research^[2] indicates that the global private credit market passed the US$3 trillion milestone in late-2024.  Within that, US middle market private credit represents a significant and expanding subset (figure two), driven by both structural shifts in lending and increased investor demand for yield and diversification.

One of the key catalysts for this growth has been the retreat of traditional banks from middle market lending. In the wake of the GFC and the tighter regulatory environment that resulted from the implementation of Basel III regulations, commercial banks faced stricter capital requirements and risk-weighted asset constraints. This regulatory shift made it less attractive and, in some cases unfeasible, for banks to continue to provide capital to middle market borrowers. This created a significant funding gap.

Private credit funds, often backed by institutional capital, stepped in to fill this void. They offer a more agile and tailored approach to underwriting and can move quickly on deals, providing certainty of execution—an increasingly valuable trait in complex transactions such as buyouts, growth financings, and recapitalisations.

Another major driver for the growth in US middle market private credit is the expansion of private equity activity. Private equity firms rely heavily on debt financing to support leveraged buyouts (LBOs) and growth investments. As middle market private equity deals have proliferated, so has the demand for flexible, non-bank lending solutions.

However, private equity fundraising has meaningfully outpaced middle market private debt fundraising, creating a significant “dry powder gap” and sustainable demand ahead (figure three). Private credit managers with strong private equity sponsor relationships are well-positioned to capitalise on this sustained trend.

Strong tailwinds for growth in the middle market are evident. The ongoing turmoil in the banking sector and dislocation in the public credit markets is likely to see direct lending continue taking share across the middle market (figure four).

These growth drivers demonstrate that the growth of middle market private credit is not a temporary phenomenon. Instead, it’s the result of a long-term structural evolution in capital markets.

The investment case

Middle market private credit offers several benefits for those clients who seek stable, risk-adjusted returns and portfolio diversification. As public financial markets become more volatile and fixed income yields fluctuate with the macroeconomic uncertainty unleashed by Trump 2.0, this asset class can be viewed as a strategic solution for income generation and capital preservation. Several factors support the investment case, including:

1. Market assessment

• Significant white space for private equity and debt investment, with over 200,000 private businesses^[3] and less than 10,000<^[4] with private equity sponsor backing
• Highly diverse and fragmented, with a multitude of opportunities to grow organically and through acquisitions

2. Sourcing

• Large target universe of companies
• Fragmented nature of intermediaries, funds and financing sources places a premium on relationship development; those managers with the best relationships will be well placed to source the greatest opportunities
• Quality managers with a strong sourcing network can uncover deals unavailable to the broader market

3. Capital structure

• Lower total leverage multiples than buyouts of large corporates^[5], potentially resulting in meaningful sponsor equity commitment and attractive prospects for equity co-investment
• A focus on senior secured positions; middle market lenders often negotiate these positions to give them first claim on assets in the event of default
• Loans are typically collateralised, which means the borrower has pledged assets as security for the loan. If the borrower fails to repay, the lender can seize the asset/s to recover the money owed

4. Value creation

• Consistent opportunities to improve business models and professionalise operations
• Middle market sponsors have multiple ways to create and drive substantially higher growth rates

5. Monetisation

• Investors receive an illiquidity premium that compensates for the lack of daily liquidity
• Middle market companies can be attractive acquisition candidates to strategic buyers and a maturing private equity ecosystem
• Little to no reliance on volatile exit channels such as IPOs
• Importantly, US middle market private credit delivers returns that often exceed those of traditional fixed income, such as high-yield bonds or syndicated loans.

Middle market lending allows managers to directly negotiate terms and often underwrite deals off-market, resulting in bespoke structures with favourable pricing and covenants. The existence of financial covenants and reporting requirements that allow lenders to monitor borrower performance closely; this structuring offers more control and early warning mechanisms than public credit markets generally provide.

Importantly, returns from US middle market private credit have exhibited relatively low volatility across credit cycles and have demonstrated low correlation with traditional public equities and fixed income, making it a powerful contributor to diversification in a balanced portfolio. Because these loans are not traded on public markets, they are less susceptible to mark-to-market volatility driven by sentiment or macro shocks.

A note on risk and other considerations

While US middle market private credit offers many advantages, like all investments, it is not without some risk. It is important that you and your clients understand these risk factors.

1. Liquidity risk

Private credit investments are typically held in closed-end structures with multi-year lock-up periods. However, investing via a unitised structure – such as a managed fund – generally provides regular access to invested capital (for example, on a monthly basis).

2. Credit risk and default potential

Despite lender protections, middle market borrowers are inherently riskier than large-cap public companies. They may have more concentrated revenue streams, less diversified operations and limited access to capital markets. During economic downturns, defaults may rise, particularly among businesses in cyclical industries. Consequently, it is important to select an experienced investment manager with strong underwriting, sector expertise and a focus on companies with positive attributes – such as quality management teams and competitively positioned companies with strong financial histories – to mitigate these risks.

3. Transparency and valuation challenges

Unlike public markets, private credit lacks real-time pricing. Valuations are typically mark-to-model and may lag actual changes in borrower performance or market conditions. This opacity can sometimes mask emerging risks or overstate asset values during periods of stress. Investors must rely on the investment manager to undertake rigorous due diligence and carefully manage ongoing governance.

Performance in private credit is highly dependent on manager quality. Top quartile managers may deliver consistently strong returns with low losses, while bottom-quartile managers can face elevated defaults, poor performance and weaker deal sourcing. The dispersion of outcomes underscores the importance manager selection.

As banks retreat from the middle market and private equity continues to drive demand for non-bank financing, the sector’s growth trajectory looks set to continue. US middle market private credit has emerged as a powerful complement to traditional fixed income and other private credit sectors and offers compelling risk-adjusted returns and a proven track record through credit cycles.

In an era of volatile public markets and uncertain interest rate trajectories, private credit’s floating-rate and senior-secured loans provide both inflation resilience and mitigation of downside risks. By including US middle market private credit in a diversified portfolio, investors can unlock a sustainable income stream and fortify their holdings against future market turbulence.

The information included in this article is provided for informational purposes only. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. PAN-Tribal Asset Management Pty Ltd, its related bodies and its associates do not give any warranty nor make any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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Notes:
[1] S&P LCD
[2] Alternative Credit Council, Financing the Economy 2024, November 2024
[3] National Center for the Middle Market’s Year-End 2022 Middle Market Indicator report
[4] PitchBook; as of Q2 2023
[5] Refinitiv LPC