Aug 2023

Middle Market Resilience Comes into View - 2023 Midyear Outlook

By Sean O'Keefe & Noiel Brill, Managing Directors

Much has been made about the decline of U.S. listed companies. McKinsey documented that in the two decades since 2000, the number of public companies had fallen by more than a quarter. At the same time, the average market capitalization of public companies eclipsed $10 billion in 2020. If these trends create an impression that the middle market is disappearing, advisers can rest assured that is far from the case.

In fact, across the private capital universe, the middle market in 2023 is demonstrating why this segment is such a dynamic and foundational component of the U.S. economy -- even if it has become increasingly difficult for RIAs to access through public markets alone.

The Wall Street Journal documented that while PE-backed deal volume slumped by more than 50% in the first half of the year based on the value of new LBOs, the number of transactions represents one of the most active years on record since Refinitiv began tracking LBO data.

The takeaway is that the resilience of the middle market – and the opportunity set within it – often becomes more pronounced during periods of uncertainty. And within private credit, senior-debt and first-lien strategies are positioned to benefit across both near and long-term investment horizons.

Middle Market Tailwinds
To be sure, lenders are very much attuned to the inflationary pressures, interest-rate uncertainty, geopolitical unrest, and recessionary risks that have slowed deal activity in other areas.

Despite these threats, the middle market has held steady. We see this in cash-flow credit metrics, which at the end of Q1, showed an average interest coverage ratio of more than 2x, underscoring the ability of middle market borrowers to pay down their debt. And beyond the relative health of borrowers, other tailwinds are taking form.

Illiquidity Premiums
We are seeing first-lien loans generate all-in yields of between 11.0% and 12.5% in the current environment, which compare favorably to both investment-grade securities and high-yield credits. The floating-rate characteristics of first-lien private debt also amplify returns currently, while providing an interest rate hedge in a higher-for-longer scenario.

Lower Leverage + Improved Terms
Beyond sustained dealflow, average purchase-price multiples are anecdotally holding firm at approximately 12x EBITDA, reinforcing the resiliency of the middle market. But only the most attractive companies are clearing the market, while leverage multiples have come down between a turn and a turn and a half, as equity contributions account for the balance. A re-emergence of covenants and more rigorous documentation – such as tighter incurrence tests and fewer EBITDA adjustments – collectively provide enhanced protections at the same time yields are climbing.

Dry Powder
Finally, private debt continues to pick up share from commercial banks. This was already occurring due to the dependability of private credit but has only picked up steam following the collapse of Silicon Valley Bank and Signature Bank.

With roughly 200,000 companies in the middle market and more than $1 trillion of capital available to PE sponsors, lenders who support this activity should enjoy an extended runway to meet these financing needs for the foreseeable future. For advisers seeking access to the middle market, the opportunity should accommodate increasing demand.

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