Financing the Missing Middle Market

Middle Market Definitions and Scope

• Golub Capital (Lawrence Golub): Defines middle market as U.S. companies with EBITDA between $5 million and $40 million.
• TCW (Rick Miller): Targets the upper end of the middle market, defining it as companies with minimum EBITDA of $15 million and loan facilities up to $250 million.
• BMO Capital Markets (Jim Moglia): Adopts a broad view ranging from deal sizes of $350 million down to $500 million, with a central EBITDA benchmark of $50 million (±).
• Jefferies (Adam Sokoloff) & Crestview Partners (Barry Volpert): Define the middle market broadly by enterprise value ($200 million to $2.5 billion) and EBITDA ($50 million to $200 million).
• Market Inefficiency: In Q1 2014, middle market loan spreads were approximately 110 basis points higher than large corporate peers, indicating significant pricing inefficiencies.

Lending Strategies and Competitive Landscape

• Direct Lending Focus: Golub Capital avoids "covenant-light" structures and regulated banking constraints, focusing on healthy businesses to minimize defaults while maintaining flexible, senior secured terms.
• Syndication Gap: TCW identified an opportunity created by the exit of European domestic lenders and the reduction of conventional banks post-2008, allowing them to underwrite larger ($75M–$250M) loans with fewer competing players.
• Capital Stratification: BMO notes that companies with EBITDA between $15M and $25M benefit from a mix of BDCs, regional banks, and CLOs to create a stratified capital structure, whereas sub-$15M EBITDA firms rely on local lending relationships.
• Risk Pricing: Debt investors accept higher rates and lower leverage for smaller companies due to the higher probability of business failure; BMO allocated $1 billion of its $6.5 billion fund specifically for club lending in smaller deals ($10M–$25M hold positions).
• Covenant Protection: Golub Capital distinguishes its performance through underwriting quality rather than covenants, though middle market deals generally offer stricter covenants than broadly syndicated, "covenant-lite" loans.
• Second Lien Risks: Lawrence Golub warns that second-lien investors are repeating past mistakes by assuming attachment points above 4x EBITDA; he notes that 55% loan-to-value ratios on companies with 10x EBITDA purchase prices are unsustainable if growth slows.

Private Equity Value Proposition

• Inverted Capital Cycle: Barry Volpert notes private equity firms prefer expensive credit environments to acquire companies at lower multiples, while favoring robust credit markets for exits and IPOs.
• Outperformance Data: Middle market private equity firms consistently outperform large-cap private equity funds in both IRR and multiple of money due to paying lower entry prices and utilizing less leverage.
• Value Creation Mechanisms: Sponsors add value by recruiting management, expanding international reach, and acquiring customers, leveraging the fact that middle market firms often lack the internal expertise of larger corporations.
• Exit Strategies: The preferred exit route has shifted from strategic sales to IPOs, particularly for growth companies, with sponsors utilizing smaller IPOs ($100M–$150M) to deleverage quickly and selling stock via early lockup lifts.
• Valuation Drivers: Middle market firms outperform because they buy at lower multiples (capturing illiquidity premiums) and sell to larger entities that can access cheaper debt to pay higher multiples.

Market Froth and Deal Flow Dynamics

• Credit Froth Indicators: Covenant-light issuance in the upper middle market and levered loan fund flows have reached 2007 peak levels, signaling potential froth despite tepid overall M&A activity.
• Deal Flow Paradox: Private equity firms report a lack of attractive targets despite high prices; this is attributed to firms holding on to underperforming assets from the 2005–2006 vintage while selling more recent, successful acquisitions.
• IPO Surge: The IPO market has become a primary exit strategy, moving from a "strategic alternative" to a top priority, with smaller growth companies successfully accessing public capital markets to deleverage.
• Fundraising Trends: Despite compressed returns, demand for middle market buyout and loan funds is at record highs; institutional investors are reallocating capital due to record distributions from prior funds and high public market valuations.
• Investor Behavior: Many new investors entering the middle market are not "natural" buyers but are fleeing lower-yield investment-grade assets, potentially creating future volatility if rates rise.

Macro Outlook and Future Risks

• Interest Rate Sensitivity: Barry Volpert argues that rising interest rates and moderate inflation would be positive for middle market returns, as nominal earnings growth would accelerate debt repayment on leveraged assets.
• Deflationary Concerns: The primary macro fear expressed by panelists is deflation or an economic seizure similar to late 2008, which would halt revenue generation and stress portfolio companies.
• Regulatory Environment: Regulation is identified as a key disruptor; non-bank lenders argue that regulations driving "froth" in the broader market are forcing capital into the more disciplined middle market.
• Survival Strategy: Successful lenders will be those with direct origination capabilities and deep underwriting discipline, avoiding commoditized "desk buyer" models that rely on passive lending.
• Relationship Dynamics: Private Equity firms are increasingly selecting lenders based on past performance in distress rather than price, favoring relationship lenders (like Golub) over traditional banks.

Economic Significance

• GDP Contribution: The middle market accounts for approximately 40% of U.S. GDP.
• Job Creation: From 1977 to 2011, the middle market was responsible for roughly 41% of private net job creation in the United States.