Viewpoint  |  March 26, 2024

Small is beautiful: Opportunities in US direct lending

With higher rates and other pressures seeing US banks scaling back loans to small and medium-sized businesses, Michael Smith explains how private players can help fill the gap.

Small and medium-sized businesses are the life blood of the US economy, accounting for over 43% of GDP and more than 46% of private sector employees. On a net basis, they are also responsible for almost two thirds of new jobs.1

However, according to a recent Goldman Sachs survey of c.1500 small business owners in 48 US states, while 75% are optimistic about their financial prospects in 2024, 77% are concerned about their access to capital. Over half say they cannot afford to take out a loan given the current level of interest rates.2

That tallies with the latest Federal Reserve Senior Loan Officer Opinion Survey, which revealed banks are continuing to tighten lending standards for smaller firms as higher rates and stress in the commercial real estate market hit loan activity.3

Figure 1: Decline in US small bank commercial loans (US$ billions)

Source: Board of Governors of the Federal Reserve System (US), March 2024. For illustrative purposes only.

But while some banks are contracting, we see significant opportunities for private lenders to step in and provide growing businesses with tailored financing solutions.

Why we focus on the US lower-middle market

The US private credit market has roots dating back to the 1950s and is an entrenched part of the lending universe. The size and breadth of the US economy and its robust ecosystem for mid-sized companies has helped establish a large and diverse opportunity set.

There are around 180,000 companies in the US lower-middle market – businesses with revenues of between US$10 million and US$100 million4 – many of whom have historically sought financing from local or regional banks. With small banks holding around US$720 billion in corporate loan assets,5 the lower-middle market is a meaningful component of the US economy and bank capital.

Figure 2: Number of US businesses by revenue

Source: NAICS Association, as of March 31, 2023. Most recent data available used. For illustrative purposes only.

It is also the most active market segment, accounting for almost 2,800 M&A transactions annually on average and over 70% of total transactions between 2013 and Q3 2023.6 Despite this, purchase price multiples in the lower-middle market are approximately 2 times lower than larger businesses,7 allowing for less leverage, but with comparatively higher debt pricing, with around a 2%+ premium.8

Why bigger is not always better

Smaller does not necessarily mean riskier. According to a Moody’s study in 2021, it noted “the availability of rich data and modern statistical models enable investors to rethink traditional best practices of avoiding lending to smaller companies”.9

While Moody’s said size is a factor in credit risk assessments, especially for larger firms, other factors often play a more decisive role, including EBITDA/interest expense ratios, leverage, liquidity, sales growth, total debt/total assets and return on assets. “Strong financials, even for smaller companies, can lead to investment-grade credit quality. Company size affects credit risk, but the overall impact of financial strength is much more important,” concluded the authors.

These findings match our experience. The lower-middle market covers a wide variety of companies. In our view, private lenders can therefore be highly selective and still potentially generate attractive risk-adjusted returns: you do not need to chase yield with low-quality credits. The key is disciplined origination and rigorous credit analysis.

Keep it in the family

Many companies in the lower-middle market are family and founder-owned businesses where the key stakeholders have a deep-rooted interest in ensuring the company is a success. They are often businesses with solid balance sheets seeking funding for expansion or acquisition opportunities, not because they are distressed. We believe alternative lenders are well placed to provide flexible financing solutions to support these ‘buy and build’ and organic growth strategies.

We look to invest capital at low leverage in strong businesses with durable value propositions - companies that can potentially benefit from long-term secular trends unlikely to be impacted by an economic downturn. This currently includes companies in IT and business services, government contractors, and contract food and beverage manufacturing. We also like companies in certain pockets of the consumer discretionary sector that can withstand fluctuations in economic cycles.

Regional bank failures in the US and the ‘risk-off’ mode of some financial institutions have exacerbated the capital scarcity for lower-middle market companies. This, combined with the continued need for growth capital, could create a ‘capital vacuum’. At the same time, these conditions could set the stage for an unprecedented period in private credit.

References

1.U.S. Small Business Administration, as of March 30, 2023. Most recent data available used.
2.Goldman Sachs, ‘Glass Half Full’, January 31, 2024
3.Federal Reserve, ‘Senior Loan Officer Opinion Survey, January 31, 2024
4.NAICS Association as of March 30, 2023.
5.Federal Reserve Data Assets and Liabilities of Commercial Banks in the United States - H.8 as of March 2024
6.Baird’s perspective on the Global M&A Environment – Global M&A Quarterly as of October 2023. Most recent data available used.
7.Baird’s perspective on the Global M&A Environment – Global M&A Quarterly as of October 2023. Most recent data available used.
8.SPP’s Middle Market Leverage Cash Flow Market at A Glance – February 28, 2024
9.Moody’s Analytics, ‘Middle Market Lending Does Not Always Mean High Risk’, December 2021

Material Risk: This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of and may change without notice.

---------------

Important Information

Muzinich and/or Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. Muzinich views and opinions.  This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall. Emerging Markets may be more risky than more developed markets for a variety of reasons, including but not limited to, increased political, social and economic instability; heightened pricing volatility and reduced market liquidity.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

This discussion material contains forward-looking statements, which give current expectations of a fund’s future activities and future performance. Any or all forward-looking statements in this material may turn out to be incorrect. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Although the assumptions underlying the forward-looking statements contained herein are believed to be reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurances that the forward-looking statements included in this discussion material will   prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Further, no person undertakes any obligation to revise such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

United States: This material is for Institutional Investor use only – not for retail distribution. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.

Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. 2024-03-22-13201