Upper Middle Market Lending “Resilient” — Evening Brief – 09.05.24
Upper middle market lending has proven “resilient” in the face of persistent macroeconomic volatility, according to new research by global investment behemoth KKR.
The firm reaffirmed its commitment to the sector, which it defines as having an EBITDA of $50 million to $200 million, by outlining its preferences in a note to investors authored by Ian Anderson, a managing director in the firm’s credit business, Rony Ma, a managing director on the credit team, and George Mueller, a partner in KKR’s credit and markets business.
Historically, upper middle market companies have demonstrated robust, consistent financial performance, with lower default rates and appealing opportunities. Additionally, KKR contended that the spread differential between returns in the upper and lower middle market is not as extensive as commonly believed.
“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,” the authors wrote. “Larger companies tend to have more diversified revenue streams, which can sometimes help them weather market volatility and pass through rising costs.”
The company stated that profit margins have remained consistent in its direct lending portfolio, which has an average EBITDA of just over $100 million, despite the pandemic and subsequent period of high inflation.
Default rates on covenants have been higher for smaller companies than for those in the upper middle market, according to KKR. This has led analysts to conclude that there is a correlation between the size of a company and the default rate on covenants.
The firm also cited data indicating a “mere” 24 basis-point average spread gap between companies with EBITDA of $40 million to $100 million and those with EBITDA of less than $40 million.
“We think the higher competition in the lower middle market is a key factor in this tight spread,” Mueller, Ma and Anderson added. “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 [Business Development Companies] and private funds vying for deals.”
“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.”
The credit team concluded that they value the resilience that larger companies appear to have across market cycles, whereas the returns difference for financing smaller companies does not compensate for the increase in potential credit risk.