The allure of smaller scale?
Not all private credit funds are created equal. The asset class encompasses diverse sub-strategies, each with distinct dynamics.
The upper segment of middle-market lending has evolved into a distinct asset class dominated by a growing number of private credit managers, primarily focusing on underwriting substantially sized loans (ranging from USD 500 million to USD 2+ billion) to large enterprises generally owned by prominent private equity sponsors. As referenced earlier, the majority of fundraising within this segment has accounted for a significant portion of the recent capital raised in private credit. Preqin data supports this, showing that private debt investors are allocating capital to a small number of larger funds.4
While attention has predominantly focused on upper-middle-market direct lending, lesser-known sub-strategies and segments warrant consideration as a supply and demand mismatch persists in these parts of the market. Other strategies include: the non-sponsor-backed lending; asset-backed lending (which may involve financial assets and/or hard assets as collateral); mezzanine lending special situations or hybrid opportunities and distressed investing).
Historically, lending to the non-sponsor backed market was conducted by regional and mid-size banks; however their capacity to serve these segments has diminished due to regulatory constraints and internal strains. As the latest Senior Loan Officer Opinion Survey on Bank Lending Practices highlighted, “regarding loans to businesses, survey respondents, on balance, reported tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the fourth quarter.”5
Notably, sourcing opportunities in the non-sponsor backed part of the market poses challenges due to the large number of potential borrowers who own and operate middle-market businesses that do not have “capital markets” desks. This ecosystem typically generates deal flow characterized by smaller, relatively complicated loans (USD 25 million to USD 250 million) to help them find (and negotiate with) lenders. This requires disciplined underwriting and structuring tailored to the specific company or assets being financed. This presents a significant opportunity as small to mid-sized US companies significantly outnumber their large sponsor-owned counterparts, creating persistent need despite limited non-bank/private credit lender supply.
Implications for investors
While data on this portion of the market is relatively scant, data is starting to show that the combination of these factors – i.e., non-sponsor/smaller sponsor loans – allows for higher pricing, lower leverage and more lender-friendly covenants.6
It is therefore possible for investors to diversify their private credit portfolios by incorporating such exposure; returns are typically uncorrelated with other credit holdings and exhibit diminished sensitivity to interest rate fluctuations.
However, few private credit managers can deliver this as doing so generally requires access to proprietary and well-established sourcing networks capable of facilitating steady deal inquiries across diverse borrower profiles, loan structures, and collateral types – an example of where being affiliated with a global bank and wealth manager can be a notable advantage. The handful of managers that can offer this may be able to exploit the scarcity premium on offer by providing tailored borrowing solutions in markets with limited lending competition.
