Importance of Lower Middle Market and Middle Market in an Investing Portfolio

Middle market companies are generally passed over by traditional investors despite the recent expansion of the asset class. There are about 350,000 private middle market companies in the United States, collectively employing nearly 32 million people. While these companies have been served predominantly by commercial banks and traditional lenders, interest in the middle market has drastically increased in recent years.

Returns on the middle market tend to outperform other types of similar investments:

 

Importance of Lower Middle Market

Middle market loans can also offer investors a trifecta of benefits of credit investing including:

  • A yield premium over traditional syndicated loans
  • Lower leverage and higher coverage ratios
  • More conservative deal terms and traditional covenants

According to Thomson Reuters, there is an expected $800 billion in new loan demand in this segment over the next few years, and about $583 billion in middle market debt that will need to be refinanced by 2020. These circumstances should provide a steady flow of attractive investment opportunities in this space.

Since the credit crisis in 2007, drastic changes in regulation have led to larger, traditional lending institutions facing increased capital requirements and greater red tape. Large banks are constrained by regulations such as Basel III and the Dodd-Frank Act. This provides a favorable competitive environment for non-traditional lenders in the middle market space.

  • Basel III: Updated requirements force larger banks to reserve more equity capital in leveraged loans
  • Dodd-Frank: Risk retention requires that the sponsor hold 5% of the face value of the securitization on their balance sheet — favors middle market alternative lenders
  • Volcker Rule: Prevents banks from owning or sponsoring alternative investment firms

With these new opportunities in the middle market space come some corresponding risks:

Credit Risk:  Both default and credit deterioration risk
Mitigant: Thorough due diligence and experienced team

Structuring Risk: Poor loan documentation/structure
Mitigant: Thorough due diligence, conservative covenants and experienced team

Spread Volatility Risk: Reduction in price of the loan
Mitigant: Middle market conditions reduce this risk since these loans are generally not actively traded. Even those that are traded show lower risk than larger counterparts

Illiquidity Risk: Inability to sell the loan
Mitigant: N/A currently, however as middle market marketplace lending grows, plans are to develop secondary marketplaces

Interest Rate Risk: Reduction in price due to increase in interest rates
Mitigant: Middle market loans generally have floating interest rates

The CrowdOut platform provides mitigants for these risks and many others. The CrowdOut blog will continue to illuminate pros and cons of various yield investment types and explain how the CrowdOut platform fits into this landscape.