CPD: The structural advantage of US middle market private credit

Alternative investment strategies offer unique opportunities generally not available through traditional markets and are increasingly an important component of a balanced portfolio.

Private credit has moved from a niche institutional allocation to a mainstream component of modern portfolio construction. It offers advisers a compelling way to enhance income, diversification and portfolio resilience. As traditional fixed income faces periods of lower real yield and heightened correlation to equities, investors are increasingly looking to alternative sources of return that are underpinned by structural rather than cyclical drivers.

One of the most attractive segments within this expanding universe is US middle market private credit. This segment focuses on lending to mid-sized, often sponsor-backed companies that sit between large-cap borrowers with access to syndicated bond markets and smaller businesses reliant on traditional bank lending. It is precisely this positioning – too complex and bespoke for public markets, yet too large for relationship banking alone – that has enabled private lenders to establish a durable and growing presence.

For financial advisers, US middle market private credit has become particularly relevant as global managers scale access to this segment. It offers client portfolios exposure to floating-rate income streams, senior-secured structures and robust covenant protections. It also provides access to a deep and diversified universe of borrowers in the world’s most developed credit market, one that has an expanding opportunity set for private capital.

Against this backdrop, private credit is increasingly being viewed as a core building block in diversified income strategies.

Understanding the history of private credit

Private credit is an umbrella term used to describe the provision of credit to businesses by lenders other than banks^[1]. These may include direct loans, distressed debt, asset-based loans or specialty finance solutions.

Unfortunately, recent challenges facing a number of SaaS companies have reinforced perceptions of private markets as a breeding ground for inflated valuations and speculative capital. As concerns over AI disruption and the sustainability of software business models have triggered sharp repricings, the narrative has increasingly focused on bubble risk rather than fundamentals. Yet this framing ignores the more disciplined, historically grounded segments of private markets, where rigorous underwriting and strong lender protections remain central to investment outcomes.

Understanding the history of private credit can shed light on how the industry evolved, and why painting all managers with the same brush today clouds the strength of the underlying fundamentals that made the asset class popular with investors.

Commercial bank officers in the 1980s knew that selling leveraged loans to structured vehicles such as collateralised loan obligation (CLOs) was better than holding them. For middle market loans, specialised teams within banks and finance companies better understood smaller to mid-sized company risk profiles.

Consolidation and regulation pushed many banks out of the middle market, a retreat that was structural, not cyclical. Post-GFC regulation reduced bank appetite for leveraged lending, capital requirements made middle market loans less attractive to traditional lenders and relationship banking no longer scaled economically.

Seasoned credit pros raised long-term capital from insurance companies and private equity firms to build the first private credit shops. They hired underwriting and origination teams who had successfully run middle market loan portfolios and built relationships with leading private equity owners.

At first, progress was slow. With non-banks’ commitment sizes limited, some banks remained competitive. But after the GFC, investors noted how well mid-cap loans performed compared to broadly syndicated loans (BSLs) and demand for capital did not disappear with bank exits. Fundraising for new private platforms took off, propelling their hold levels to US$100 million per deal and higher.

Amid the zero-rates of the 2010s, investor appetite for higher yielding instruments soared. Investment banking executives followed this slipstream, forming firms offering bank/bond options to large corporates. Because banks could still distribute this paper, non-banks had to match their aggressive terms: high leverage, tight spreads and weak covenants.

The game changed with the formation of ‘semi-liquid’ vehicles, including Business Development Companies (BDCs) and interval funds.  BDCs are a type of publicly traded or private investment firm created by the government specifically to fund small and mid-sized businesses that typically struggle to get traditional bank loans. Interval funds are regulated, semi-liquid investment vehicles that allow individual and institutional investors to access private debt markets.

These entities provided the first retail access to the asset class. Enormous capital inflows allowed managers to commit over US$1 billion per deal. At this point, non-banks could compete on almost any sized financing. Soon leveraged buyout (LBO) financings had all but disappeared from the bank market.

Key takeaways for advisers

1. The history of private credit is not academic background; it is the foundation for explaining why discipline in this asset class was built into its institutional origins, not retrofitted after problems emerged.
2. The distinction between core middle market managers and large-market peers is one of the most consequential portfolio positioning questions in private credit today; understanding how that distinction developed gives a grounding to guide clients toward it with conviction rather than caution.
3. The post-GFC performance record of mid-cap loans relative to broadly syndicated loans delivered a clear institutional signal about where credit discipline was concentrated – those who can articulate that signal may be better positioned to anchor client conversations in evidence rather than in headlines.
4. Middle market private credit emerged directly from the expertise of seasoned bank credit professionals who left consolidating institutions to build independent lending platforms, bringing institutional underwriting discipline with them. That lineage is one of the most credible narratives for clients sceptical of the asset class.

The relationship advantage of middle market credit

The zero-interest rate period post-GFC allowed private equity firms to buy companies with higher leverage and sell them at higher multiples. For the largest direct lenders, this included mega software businesses with increasingly borrower-friendly financing terms.

The Covid-19 pandemic forced the Fed and Congress to pump almost US$5 trillion into the system. It saved the economy but also ignited inflation and rate hikes. Reality returned in 2022 as the Secured Overnight Financing Rate (SOFR) soared from zero to 5%. Financing costs became headwinds, borrower leverage shrunk, and the upward march of purchase price multiples halted. Public credit markets shut down. Private markets remained open, but with M&A slowing, competition among upper-market lenders surged, resulting in significant portfolio overlap.

The core middle market is relationship driven. Sponsors and lenders are long-term holders, so successful outcomes require alignment of interests. A solid partnership of trust is more valuable than squeezing the last turn of pricing or leverage. Sectors and borrowers must prove resilience through cycles because, unlike large caps, you can’t easily sell an overweight position.

For years lenders demanded an illiquidity premium for mid-caps, anywhere from 100–300 bps. And more protection: maintenance financial covenants, security on all assets and cash flows and lower leverage.

But liquidity risk is different from credit risk. In fact, default and loss rates are historically lower for middle market loans than broadly syndicated loans. In part this is thanks to the cooperation between lenders and borrowers to get through tough times.

This helps point to the fundamentally different origination models, competitive environments, borrower profiles and risk characteristics in mid-caps versus large caps.

Deal sourcing in the core middle market is not dependent on market momentum. Activity is consistent regardless of cycles because experienced managers seek to diversify portfolios across defensive sectors. This helps reduce concentration risk in ways that bank/bond replacement platforms can’t.

The rush of retail money into those platforms worsens this dynamic. The tyranny of dry powder is the relentless quantity-over-quality pressure to put money to work. In contrast, approximately 5% of all middle market companies are owned by PE firms, creating a natural supply/demand balance.

As private credit grows, larger funds gain better origination networks and become first call lenders for sponsors. Even if they wanted to, banks cannot re-enter easily due to regulatory drag. This creates a flywheel in middle market private credit: more capital → better access → better deals → more capital.

Today’s credit concerns stem from several years of higher rates in higher risk portfolios, particularly AI-sensitive sectors. Flashing red lights for Payment in Kind (PIK) loans^[2], non-accruals and default rates are signs of stress. Using Nuveen Churchill’s portfolio performance as an example, it suggests the core middle market remains more resilient given its broader base of less tech-centric service companies.

Key takeaways for advisers

1. The middle market’s relationship-driven structure offers a compelling framework for discussing private credit quality with clients who ask why not all direct lending behaves the same way in a stress environment.
2. Deal overlap among middle market managers, and within the upper market, signals a fundamentally different competitive dynamic, one that supports more differentiated portfolio construction for clients seeking alternatives exposure.
3. Concentration in AI-sensitive and higher-leverage sectors represents a live risk in the current environment, with rising PIK loans, non-accruals, and default rates serving as warning signs to monitor when evaluating manager selection for clients.

Private credit’s origination divide

In private credit, the character of deal sourcing determines the destiny of the portfolio. How new transactions come in the door, and how a manager selects the best ones to close, drives performance.

As outlined previously in this article, private credit grew from the core middle market (CMM) and set the principles that became popular with issuers and investors alike: loans to small-to-medium-sized enterprises (SMEs) in diverse, defensive sectors backed by private equity sponsors with conservative terms and structures.

Select lenders stuck to this strategy even as enormous retail inflows reshaped the large end of the market. Terms in that segment mimic bank loans and bonds – large exposures in momentum-driven sectors, high leverage, low spreads, and, critically, public style liquidity – elements that have contributed to some of the difficulties faced by some sectors of private credit.

Bank loans and bonds are traded on secondary markets. This allows CLO managers to position portfolios to minimise risk. Large private loans don’t trade, so managers, like those in the core middle market, need to get it right going in. Even so, portfolio quality is governed by deal terms, which in large caps are less investor-friendly across the board than with core middle market loans. That’s because if they aren’t borrower-friendly enough, banks can compete!

If smaller loans are less risky, why are liquid loan spreads historically tighter? The answer is that active credit traders, like public equity traders, value liquidity over almost everything. They accept lower yields and weaker structures knowing they can exit quickly if needed. If your goal is to own, not trade, core middle market assets provide stronger returns and protection.

Like ‘Europe’, ‘private credit’ is a label for a collection of distinct entities with their own identities, legal jurisdictions and value propositions. Investors must understand how valuations, structures and fund liquidity differ for each ‘nation’ within the private credit ‘continent’.

Key takeaways for advisers

1. Deal sourcing, not market headlines, determines the quality of a private credit portfolio. How a manager originates and selects loans is generally the most consequential factor in long-term outcomes.
2. Liquidity expectations matter in client conversations about private credit. The underwrite-to-hold model means these are not liquid instruments, and it is critical clients understand that limited redemption capacity is a structural feature, not a defect.
3. Investor education about private credit’s internal diversity is a significant challenge in the asset class; advisers are well positioned to help close that gap in client conversations about appropriate allocation, structure and risk.

Private credit’s liquidity reality

The word ‘private’ in private credit signifies not just non-public, but non-traded. This is important from an investor perspective because it means you cannot readily buy or sell private assets the way you can stocks and bonds. These assets are called alternatives because they – like real estate and infrastructure – complement liquid assets. It is the foundational characteristic of the asset class.

Do homeowners expect daily valuations on their properties? No, because they know real estate value is proven over time.

Yet as some managers focused on the wealth segment, they suggested the line between liquidity for public and private assets was blurring. This accompanied offering investors the ability to redeem their interests beyond the typical 5% per quarter – implying a degree of flexibility the underlying assets cannot support.

Randy Schwimmer, Vice Chairman of Churchill Asset Management, recently highlighted a fundamental principle of private markets: “You cannot create liquidity from an illiquid asset class.” The comment reflects a growing industry focus on ensuring that redemption terms align with the liquidity characteristics of underlying private loans.

Middle market loans do not trade, so are illiquid. It is possible to package loans and sell them to an institutional buyer at or near par – a growing secondary credit market in private loans exists for exactly this purpose. But those transactions involve considerable due diligence on the part of sophisticated buyers with the capacity and understanding to manage the assets effectively.

In private credit, match funding means synching fund liquidity with asset liquidity. A fund can hold illiquid assets. A fund can hold liquid assets. What a fund cannot credibly do is hold illiquid assets and promise liquid benefits to its investors. If tested, this feature becomes a liability.

Institutional investors understood this from the start. Superannuation, pension plans, insurance companies and sovereign wealth funds have long-term liabilities that are well-suited to the illiquid, long-tenor nature of private credit. Their expectations were set correctly at the outset. The mismatch now being observed in retail channels is not a coincidence. It is a reminder that product complexity and investor transparency must move together.

Key takeouts for advisers

1. The illiquidity of private credit is a foundational characteristic of the asset class, not a temporary condition to be engineered away. Establishing this clearly at the point of allocation may shield clients from expectation mismatches now emerging across the wealth channel.
2. Match funding, the principle that fund liquidity must align with asset liquidity, is the standard that should apply when evaluating any private credit vehicle for client portfolios, since products that promise redemption flexibility beyond what underlying assets can support may create structural risk for both redeeming and remaining investors.
3. This inflection point, when investor expectations are colliding with reality across the industry, creates a meaningful opportunity to educate clients proactively and lead with transparency rather than follow with explanations.

As private credit continues to mature as an asset class, investors should look beyond the headlines and focus on the segment that has long formed its foundation: the US middle market. Often described as the OG of private credit, the middle market has demonstrated an ability to deliver resilient, risk-adjusted returns across a range of economic environments.

Its appeal lies in a structural market inefficiency. These companies are too large for traditional bank balance-sheet lending alone, yet too small, bespoke and complex for public debt markets or broadly syndicated loans. This creates a persistent financing gap that private lenders are uniquely positioned to fill.

Importantly, private credit’s growth should not be viewed as a wholesale replacement of traditional lending markets. Rather, it reflects the targeted capture of a segment where banks face structural constraints and borrowers place a premium on certainty, flexibility and long-term lending relationships. For financial advisers seeking diversified sources of income and return, this enduring opportunity set helps explain why US middle market private credit is increasingly earning a place as a core portfolio allocation rather than a peripheral alternative.

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] https://acc.aima.org/about-acc/about-private-credit.html
[2] PIK loans in private markets refers to a financing feature where borrowers defer cash interest or dividends by paying them in additional debt or equity rather than cash.