Upper Middle Market Lending: Four Reasons We Focus on Larger Companies

There’s an ongoing debate about size in direct lending circles. Namely, is it better to focus on lending to smaller companies or larger ones?

Sometimes we hear investors say it is possible to achieve more attractive returns and better risk profiles by lending to lower middle market (<$50 million EBITDA) companies. Meanwhile, this argument goes, the upper middle market ($50-$200 million EBITDA) has become commoditized, lacks investor protections, and is in direct competition with a resurging broadly syndicated loan market.

We think there are several misconceptions embedded in this view. We focus on lending in the upper middle market because:

1. Upper middle market companies have historically had strong, stable financial performance.
2. This performance pattern has historically resulted in lower default rates for the upper middle market.
3. The spread difference between returns in the upper and lower middle market is not as wide as many believe.
4. History suggests that attractive opportunities are available in the upper middle market even with broadly syndicated markets functioning at full tilt.

We’ll explore these in more detail below.

Reason 1: Upper middle market companies have historically had strong, stable financial performance…

Upper middle market companies have been more resilient in the recent market cycle than smaller companies, which have been hit harder by inflationary pressures and rising costs. Larger companies tend to have more diversified revenue streams, which can sometimes help them weather market volatility and pass through rising costs. Over the last two years, larger companies have experienced stronger EBITDA growth than smaller companies (Exhibit 1).

EXHIBIT 1
Private Credit YoY LTM EBITDA Growth Magnitude by Size

In our own direct lending portfolio, which has an average EBITDA north of $100 million, we have seen stable profit margins even during the COVID-19 pandemic years and inflationary aftermath (Exhibit 2).

EXHIBIT 2
KKR US Private Corporate Credit Borrower Performance Trends

Reason 2: This performance pattern has historically resulted in lower default rates for the upper middle market.

Broad private credit market data suggests that stronger, more stable financial performance seems to translate into average default rates that are 60 basis points lower for companies in the upper middle market compared to the lower middle market (Exhibit 3).

EXHIBIT 3
Average LTM Private Credit Market Default Rates by EBITDA Size

One reason people often believe that lending in the lower middle market comes with greater protections is that loans to smaller companies are more likely to come with covenants. However, we think it’s also important to note that smaller companies had higher default rates on covenants than companies in the upper middle market (Exhibit 4). The effect we have seen is consistent: there is a correlation between size of company and covenant default rate.   It’s also important to remember that covenants do exist in the upper middle market as well. Across our own portfolio, we seek covenant structural protections in large and small companies alike.  

EXHIBIT 4: Covenant default rates continue to be inversely related to size; the percent of companies with <$10m EBITDA defaulting on one or more covenants remained highest in Q1 2024

Private Credit Covenant Default Rate by Size

Reason 3: The spread between returns in the upper and lower middle market is not as high as many believe.

We believe that if investors are lending to smaller companies, which tend to have more volatile performance and higher covenant default rates, they should receive a high degree of compensation for the incremental risk. However, Exhibit 5 shows that since 2018 there has been a mere 24 basis-point (bp) average spread differential between companies with EBITDA between $40 million and $100 million and those with EBITDA less than $40 million.

EXHIBIT 5 
US Re-Underwriting Unitranche Spreads

We think the higher competition in the lower middle market is a key factor in this tight spread. Lenders who focus on companies with less than $50 million in EBITDA make up 90% of the direct lending market, with hundreds of community and regional banks, BDCs and private funds vying with one another for deals. The smaller amounts of capital involved create lower barriers to entry, but lenders typically have more limited balance sheets and a narrower scope of capabilities. We have also heard anecdotally that the speed of deployment in the lower middle market can be a challenge for investors waiting for their capital to get put to work.

Reason 4: History suggests that opportunities are available in the upper middle market even with broadly syndicated markets functioning at full tilt.

As a result of the near-shutdown in syndicated markets in 2022 and 2023, very large companies ($200 million-plus EBITDA) that would otherwise have borrowed in syndicated loan markets sought out private lenders. We do believe that the convenience and speed of execution with private lenders will likely make private credit a more viable option for some of these borrowers going forward. However, we have also always believed that syndicated and private markets must and should coexist. In our own portfolio, we fully expect the size of the average deal to average $100 million to $150 million over time as things normalize.

We sometimes hear that broadly syndicated markets and upper middle market lending ($50-$200 million EBITDA) are similar and compete with each other. However, we also see important distinctions. Only a handful of private lenders have the size and scale to play in the upper middle market, which naturally limits competition. The financing in this category tends to be highly structured with strong protections relative to the broadly syndicated loan market. At EBITDA above $200 million, the main players are CLO funds, bulge bracket banks, loan mutual funds, and insurance companies, and the financing structure is more commoditized. Historically, we have also found that relative to broadly syndicated loans, private loans in this part of the market still preserve their illiquidity premium in spreads. 

Finally, the notion that reactivating syndicated markets spells the end for private direct lending doesn’t line up with history or the market ecosystem. Looking back to 2019, syndicated markets were operating in full swing and very active. We still sourced attractive opportunities to lend to companies with EBITDA between $50 million and $100 million and would expect the same going forward.

Conclusion

We value the resilience that larger companies seem to have throughout market cycles and believe that the returns differential for financing smaller companies does not make up for the step up in potential credit risk. As we build our own portfolio, we continue to evaluate companies across the spectrum, focusing on borrowers from $50 million to more than $200 million in EBITDA. We think that viewing a broad spectrum of the upper middle market enables us to select investments with the most attractive risk-adjusted returns.