Private Credit Defines its Place in the Middle Market

As the middle market has grown in both size and stature, many observers have astutely highlighted the challenge in trying to define the middle market as the private credit universe continues to expand. The propensity of mega-financings over the past two years, rather than instilling more ambiguity, is conversely forcing many managers to confront this question head on. This is bringing newfound clarity and focus around where, exactly, the borders reside that will define the middle market today and in the future.

Those longer in the tooth will recall that the private equity industry went through this same maturation.

There was, of course, the junk bond era, when the fledgling buyout industry became a fleeting beneficiary of the bubble in high yield bonds in the late-1980s. This proved to be somewhat ephemeral as the industry, in subsequent years, settled into more of a cottage industry in which activity in the 1990s gravitated back to the smaller, less efficient investments. It wasn’t until the 2004-2007 timeframe that record fund sizes translated into the mega deals that—once they became more ubiquitous and unexceptional—forced managers to choose their swim lanes and be deliberate about where they wanted to focus their attention and resources.

It’s against a very similar backdrop, as the private debt industry matures and continues to scale, that managers are being asked to be explicit in terms of what they mean when they describe themselves as a middle-market firm.

As the private debt industry matures and continues to scale, managers are being asked to be explicit in terms of what they mean when they describe themselves as a middle-market firm.

Private Credit’s Rapid Maturation 

Make no mistake: the “megatranche” financings that have become common in private debt today are a positive development. In fact, these deals reflect several trends that collectively speak to a broader shift as private credit continues to pick up market share from banks and other sources of financing.

For one, capital is now available in the private credit arena to support most deals, big and small. Across all private credit strategies, the total assets under management are approaching $1.7 trillion, according to Preqin. Within private credit, direct lending strategies account for approximately $800 million of AUM, a nearly fourfold increase from the start of 2018.

Private credit lenders also provide flexibility to borrowers and can craft bespoke financing arrangements that solve for very specific borrower needs. Observers saw this firsthand, for instance, when rates jumped and sponsors turned to mezzanine debt as a solution to fund portfolio company expansion without having to reprice existing credit facilities. The flexibility of private debt lenders helped ensure the economics worked and ultimately allowed private equity firms to continue investing in their portfolio companies at a time when the cost of capital had become otherwise prohibitive.

Today, private lending is comprised of a range of alternatives, from senior debt and unitranche facilities to ABL and junior debt, and everything in between. And one manager can often provide a gamut of credit alternatives, including first lien, stretch senior, unitranche, second lien and subordinated debt as well as equity co-investments—effectively deploying a supermarket approach to financing.

Related content: Navigating the Competitive Private Credit Market

But it’s the depth and breadth of the market today that signals a more permanent change. Blackstone’s and Magnetar’s recent $7.5 billion debt financing facility for CoreWeave, one of the largest private financings in history, provides a great example of how much the industry has matured.

Fifteen years ago, $7.5 billion would’ve accounted for more than half of the total annual volume of direct lending facilities arranged throughout all of 2008. Moreover, technology and software companies, prior to 2012, were generally hard-pressed to find any financing outside of venture debt. And AI infrastructure—at the center of CoreWeave’s value proposition—was still the stuff of science fiction. This arrangement, with six other lenders participating, underscores the growth and maturation of the private credit landscape.

But it still begs the question of where the middle market resides as the private debt universe continues to expand.

The Audax Perspective

To be sure, there is no right or wrong definition. But depending on how managers answer the question, it can provide clarity around everything from pricing and documentation (for borrowers) to yields and diversification (for investors). Recall, too, that investors in the early-2000s sought similar clarity when the largest private equity GPs used club deals to go after ever-larger targets, creating concentration risks LPs would rather avoid.

At Audax Private Debt, we define the middle market as comprising companies with EBITDA of between $15 million and $75 million. We prefer this segment because it remains inefficient and free of competition from the broadly syndicated markets that would otherwise eat away at the illiquidity premium that makes private debt so attractive.

These attributes provide a level of consistency unique to the middle market, at least as we define it.

Consider, for instance, how terms have shifted over the past year amid an inflationary, elevated-rate environment that has seen deal flow move in fits and starts. In the area where we operate, the shifts are barely perceptible. Pricing has come down by about 50-to-100 basis points to S+ 500-550 bps, while total leverage has moved up by barely half a turn to approximately 4.5x to 5.5x EBITDA. But call protections remain standard at two years, and equity capitalizations of over 50% have held steady. Moreover, loan documentation—consisting of maintenance covenants, caps on EBITDA adjustments, and limitations on restricted payments and debt incurrence—are still considered “market” and provide a valued alignment of interests between lenders and borrowers.

As private credit moves upstream, larger deals are going to be impacted by competitive dynamics. Borrowers can turn to broadly syndicated loans, public debt or large commercial banks, for instance. Anecdotally, that has led to wider swings in pricing and total leverage over the past year, as well as looser terms, such as incremental debt allowances or other cov-lite features that seem to vacillate in and out of favor as the market dictates.

Another related benefit is that the market where we operate is driven as much by relationships as anything else. It may sound trite or trivial, but that has always been a core tenet in private debt, where sponsor reputations and track records help inform underwriting, while firsthand experience and rapport can open doors for sponsors even in challenging environments. Across our history, we’ve worked with more than 280 different private equity firms, a large proportion of whom we count as repeat clients.

Related content: A Decade on, Private Credit Matures and Evolves

To be sure, each lender is going to have a different view on what they consider to be the middle market. And those that gravitate to one end or another will benefit from developing a niche and specialization that serves borrowers in the specific segments they serve. The growth of the market, however, will force participants to understand what that looks like and how it takes form.

Audax, itself, was launched 25 years ago as the private capital industry came of age. And as the asset class, in those early years, ascended from its cottage industry beginnings to become a force across asset management and the economy at large, Audax found its niche by keeping its focus trained on the segment where it always operated. We see the same opportunity surfacing today, which is why we believe the expansion and growth of private debt will bring clarity around where, exactly, the middle resides for us.

Steve Ruby is the Co-Head of Originated Debt at Audax Private Debt, overseeing the firm’s unitranche and junior debt investment teams. Prior to joining Audax in 2003, he held positions at Greenwich Street Capital Partners and DLJ Investment Partners, which became Credit Suisse Private Equity’s dedicated mezzanine fund.

Rahman Vahabzadeh is the Co-Head of Originated Debt at Audax Private Debt, overseeing the firm’s unitranche and junior debt investment teams. Rahman has over 28 years of experience in private credit. Prior to joining Audax in 2001, he held positions at TCW/Crescent Mezzanine, LLC., Merrill Lynch & Co., and Salomon Brothers Inc.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.