Private market assets have increasingly become a go-to investment for financial advisors. 401(k) plan access, newer interval funds and other evolving investment pathways to alternatives are opening the private credit market to broader participation.
In particular, direct lending offers a compelling entry point for financial advisors working with clients looking to expand into private credit. As credit alternatives enter a new chapter featuring a wider network of eligible investors, we believe advisors will realize that the best outcomes for their clients will not necessarily be derived from the largest funds (where deal size and putting massive amounts of capital to work quickly can influence the investment decision process). Instead, the best long-term outcomes will be offered by managers who have developed an expertise in relationship-based lending and identifying the most attractive opportunities within the broader direct lending market.
Research has shown that over the past two decades, direct lending has quietly outperformed broader public markets on a return-per-unit-of-volatility basis, while delivering consistent current income and downside protection.
The lower middle market, which we define as businesses with roughly $5 million to $50 million in EBITDA, is a segment of direct lending where relationships drive deal flow. Lower middle market companies require more flexible solutions than those available from traditional bank financing, yet are often overlooked by the largest private credit lenders, who are more focused on rapidly deploying large amounts of capital. Further, the U.S. lower middle market is not just a niche. With an estimated 5x as many potential borrowers in this segment of the market vs. larger companies, it is a large part of the broader U.S. economy, according to data from NAICS Association and Capital IQ. We believe that is where the opportunity lies.
In our experience, lower middle-market direct lenders typically provide senior secured loans that are generally structured with lower leverage, meaningful financial covenants, and more lender-friendly documentation. These loans are floating-rate and typically provided to sponsor-backed companies after a thorough diligence process.
At this size, disciplined direct lenders have the opportunity to engage directly with management teams and sponsors during underwriting and negotiate protective terms. Relationships also provide an opportunity for active portfolio management, which may help to mitigate losses should a borrower underperform expectations.
In the direct lending space, strong sponsor relationships consistently fuel repeat deal flow. In fact, lenders with long track records tend to generate substantial deal volume through established sponsor relationships. This relationship-based lending creates a pipeline of recurring investment opportunities. They create a feedback loop of trust, access and insight that larger, syndicated markets cannot replicate.
To fully capitalize on the opportunity presented by direct lending as an asset class, financial advisors should recognize lower middle market direct lending’s value proposition, and understand the rigorous underwriting process, and the structural protections available in this segment of the market.
It is no secret that investors and financial advisors are broadening their horizons beyond the traditional 60/40 portfolio. In our view, with public fixed income currently becoming rate-sensitive and equities increasingly correlated to fixed income, direct lending can represent a chance to provide clients with diversification, high current yield and reduced volatility to investment portfolios.
For advisors, direct lending is more accessible than ever and can play a defined role in client portfolios. However, as in all private markets, achieving strong performance requires partnering with managers who bring experience, consistency, and a strong track record, including periods of market scrutiny and volatility.