The recent growth of the private credit market has only accelerated against a backdrop of credit tightening from traditional lenders. Maggie Arvedlund, CEO and managing director of private credit investment firm Turning Rock Partners, explores the ascent of non-sponsor backed private credit lending and opportunities for such lenders in the lower middle market.

The “higher-for-longer” interest rate scenario is persisting in the U.S. as monetary policy remains restrictive. In addition, Congress continues to spend and authorize additional domestic infrastructure, foreign military spending and other geopolitical aid packages, while global strife continues in Ukraine and the Middle East. Amidst these factors, the global economy is expected to decelerate this year, growing at just a 3.1% rate, lagging behind the two-decade average of 3.8% from 2000 to 2019. As wars rage on and growth slows across the world, markets remain sensitive, making it a challenging time to allocate capital.

However, effective yields in the loan market are at 15-year highs as spreads over nominal base rates have widened out and investor demand has picked up. Given elevated base rates, uncertain growth expectations and volatile
equity markets, fixed income and credit strategies can play a vital role in portfolios to provide ballast and income production. There is clearly an advantage on a risk-adjusted yield basis for credit investors in the U.S., but these same investors must also consider the systemic driver which is supporting overall demand — the secular retrenchment of bank lending and recent regional banking market dislocation.

BANK TIGHTENING CONTINUES

The dramatic rise in interest rates back in 2022 (the longest and fastest seen since the 1980s) caused significant deterioration in banking conditions. Elevated borrowing costs put pressure on deposit bases at regional banks which were already credit constrained in an attempt to keep Tier 1 capital on balance sheets and maintain reserves for problem loans. Bank earnings, lending rates, funding costs and overall fair value of assets have moved dramatically since. As a result, for the last six consecutive quarters, banks have tightened commercial and industrial loan standards, according to a Federal Reserve survey of senior loan officers.

The pullback in bank lending has widened out the demand for alternative or “non-bank” lenders to fill that gap. As the Federal Reserve tightened last year to combat inflation, the sudden rise in interest rates created distress in many regional and mid-sized banks, with depositors fleeing to higher-yielding products and banks needing additional reserves to support existing commercial loan books, limiting their ability to lend.

Not only has there been a secular decline in bank lending — the U.S. banking market experienced substantial volatility in 2023, with the total amount of assets involved in bank failures exceeding even those of the Global Financial Crisis.

The turmoil in the banking sector is negatively impacting lower middle-market companies (defined herein as having under $1 billion in enterprise value) that are too small to tap public credit markets for financing. These companies in the U.S. are frequent customers of smaller and regional banks and rely on these counterparties for working capital, revolving credit capacity, inventory financing, equipment purchases, real estate loans and other needs.

The middle market is a deep, broad and growing segment of the U.S. economy. There are more than 200,000 middle-market companies in the U.S., employing more than 48 million people. Of that segment, roughly 28,000 have revenues of $50 million to $250 million. At an assumption of $20 million to $50 million in capital need per company, the market demand over the next three years could easily exceed $3 trillion.

In an environment of economic uncertainty, lower middle-market private credit, particularly non-sponsor lending, presents a compelling investment opportunity. This market offers investors elevated returns, low volatility, diversification benefits and access to a dynamic segment of the economy. With its unique characteristics and untapped potential, the lower middle-market private credit sector stands poised to deliver compelling returns for discerning investors seeking all-weather absolute returns in a challenging economic landscape.

QUANTIFYING THE OPPORTUNITY

A sensitivity analysis reveals that even a 5% reduction in loan assets from small U.S. banks (a primary source of financing for lower middle-market businesses) would exceed the current dry powder available in U.S. direct lending private credit. Given the heightened volatility and disruption in smaller and regional banks, the pullback could be much greater than 5% in some instances, with the effect potentially cascading.

While public debt markets undoubtedly play a role in diversified portfolios, private credit can offer investors many unique benefits, such as higher loss-adjusted yields, lower volatility and diversification through less correlation to public markets and other alternative assets. Private markets also can offer investors significant returns in excess of public market equivalents.

Looking at loss rates compared to the high yield market, which has a historical default rate of 3.6%, and recovery rates averaging 45%, private credit has shown significantly lower default rates near 2% and recovery rates averaging 60% to 70%. This suggests potentially lower losses and higher recoveries compared to traditional high yield investments. Private credit also can offer significant reductions in volatility, compared to the public markets, while maintaining higher yields.

THE RISE OF NON-SPONSOR LENDING

Traditionally, private credit was dominated by sponsor-backed lending, focusing on dividend recapitalizations or traditional leveraged buyouts. This market tends to be more competitive, with 44% of all private credit assets under management in direct lending strategies. The non-sponsor lending market has emerged as a dynamic and attractive alternative. Non-sponsor lenders provide capital directly to companies, bypassing sponsors and supporting founder or family-owned/led businesses seeking capital.

Beneficial characteristics of non-sponsor lending can include:
• Less competition: Since there are fewer participants in the non-sponsor lending space compared to the sponsor-backed market (based on amount of dry powder available), there is less competition, potentially leading to more attractive deal terms.
• Unique deal flows: Founder-led businesses can offer strong fundamentals and compelling growth trajectories, and they may be tapping institutional capital for the first time.
• Favorable alignment of interests: Non-sponsor lending can create direct relationships with borrowers who typically have substantial equity and cash at risk.

GROWTH OF PRIVATE CREDIT AND THE UNTAPPED POTENTIAL IN THE LOWER MIDDLE MARKET

There has been substantial growth in private credit as an asset class recently. However, while private credit has experienced significant growth, capital allocation has disproportionately favored larger deals and fund sizes. The average syndicated private credit deal is $300 million in size, offered and priced by intermediaries, and has 12 participants.

In a stark contrast to just a few years ago, when deals rarely surpassed $2 billion, private lenders offered a colossal $5.3 billion loan package in Q3/23, highlighting the industry shift toward larger and larger financings. Furthermore, the market is becoming increasingly concentrated among the largest players, with funds spending more than $10 billion, accounting for nearly 60% of investments in the sector. The upward trajectory in deal size and fund size has opened up a less competitive segment for non-sponsor backed credit firms that pursue smaller, less intermediated private credit financings of founder led/owned companies.

PROCEED WITH CAUTION

Despite the current opportunities for the non-sponsored private credit market, lenders in the space should proceed cautiously with an expectation of credit quality deterioration. Amidst such challenges ahead, proceeding through your company’s target markets can be beneficial. At Turning Rock Partners, we expect increased opportunities from commercial real estate and fixed asset owners in need of solutions. We also project an increased need for equipment-backed financing, working capital, floor plans and other acquisition-based commercial loans. Finally, corporate M&A activity in the U.S. is likely to rebound later this year after lagging for the last several quarters, and we expect the U.S. interest rate policy is likely to become less restrictive in the second half of 2024 as inflation eases and employment stabilizes. •

Maggie Arvedlund is CEO and managing partner of private credit investment firm Turning Rock Partners, responsible for strategic direction and overall decision making for the business. Prior to founding Turning Rock Partners, Arvedlund was a managing director at Fortress Investment Group. The Turning Rock Partners organization is based in New York, NY.