European private debt: Good things come in small packages

February 21, 2025

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While upper-middle market companies navigate headwinds caused by global trade uncertainty, their lower middle market counterparts are proving remarkably resilient, explain Kirsten Bode and Rafael Torres.

Journalists, economists and financial analysts continue to obsess over what the new US administration’s policy agenda will mean for economies, markets and businesses. Trade tariffs and supply chain disruption could cause headwinds for larger companies worldwide, including borrowers in the middle and upper-middle private debt markets.

We think these developments will be less impactful on European lower-middle market companies, who tend to be more domestic and regionally focused. In this broad and diverse part of the private debt universe, we continue to see plenty of opportunities to lend to good businesses and generate attractive risk-adjusted returns.

While falling interest rates may have a modest impact on total returns, we have yet to see loan margins in the lower-middle market being squeezed to the same degree as the middle and upper-middle market,¹ where competition among lenders continues to intensify.

Cutting through geopolitics

When constructing direct lending portfolios, managers assess opportunities from a top-down, sector and jurisdiction perspective and/or through bottom-up, company specific analysis. While we believe the latter has more bearing on alpha generation, keeping the big picture in mind plays a vital role in preserving investor capital. You do not want a big call on a sector or country to backfire.

Take the German automotive sector, for example. While still among the main engines of the German economy, intense competition has seen it lose its place as the world’s biggest car-exporting nation to China.² German industrial companies, along with peers in Spain and the Netherlands, have equally struggled to keep costs under control due to rising energy prices since the start of the Russia-Ukraine conflict. This explains why we have limited exposure to German companies linked to autos or manufacturing – tariff uncertainty will do nothing to change our view.

Instead, our main focus is on bottom-up analysis and lending to well-managed and resilient companies we believe will be relatively immune to macro factors. We see opportunities in service sector companies with more predictable business models such as software, business services, pharma, healthcare, as well as niches in specialty retail companies such as pet food and goods retailers, where demand remains relatively consistent.

Yet even here, lenders need to be selective. While healthcare is broadly stable, drilling down into its sub-sectors can reveal areas that are more vulnerable to macro factors. For example, dental chains, which often have a capped revenue schedule, have struggled with wage inflation in recent years.

Rates: Two sides to the story

The direction of interest rates has opposing effects on origination and returns – rising rates tend to be good for investors but make the origination of new deals more challenging. That was certainly the case in 2022 and 2023 when the European Central Bank (ECB) aggressively increased rates to combat inflation.

The interest-rate environment has changed drastically in the past year. Since June 2024, the ECB has made 5 cuts to its key policy rate, from 4% to the current 2.75%.³ Macro uncertainty and a weakening economic outlook in Europe could spur further cuts.

For most borrowers, lower rates will reduce their cost of debt and improve interest coverage ratios – good news for all companies, but particularly those with higher leverage. Even for private credit managers with conservatively structured portfolios, it offers a positive overlay and results in an attractive risk-reward.

Falling rates should also improve deal economics for private equity sponsors. Dry powder (capital raised but not deployed) among European private equity sponsors increased 52.5% between 2019-2024, from US$249.4 billion to US$380.2 billion,⁴ and they are under increasing pressure from investors to deploy that capital.

This should provide investors with confidence that 2025 will finally see the long-awaited rebound in M&A (and related financing opportunities). This would follow the recent recovery in leveraged buyout and bolt-on acquisition financings, which accounted for over 70% of European private debt transactions in the 12 months to end June 2024.⁵

Figure 1: M&A remains key driver of private debt deals

As for the impact of lower rates on returns, it is important to remember private credit investors tend to focus on the spread over the base rate, not the underlying rate. In our view, this ‘illiquidity’ premium is likely to remain attractive versus public markets.

Institutional investors continue to be the mainstay of the buyer base, given their sophistication and risk tolerance.

We are also seeing increasing interest from the private wealth channel – private banks, high net worth individuals, retail and family offices - given the potential for attractive yields versus public markets. The wealth channel currently accounts for around 15.5% of European private debt AUM⁶  - we think the revamped ELTIF regulations and increasing proliferation of ‘evergreen’ private credit vehicles will drive further growth in this part of the market.

The lower middle market advantage

The European private debt market has grown significantly over the past decade or so. Most investor capital has been directed to strategies exposed to the upper and middle market segment, resulting in tighter spreads, looser deal structures, weaker covenants and significantly higher leverage.

The lower middle market, meanwhile, has largely avoided these pressures given higher barriers to entry and fewer competitors. Based on recent discussions with investors, we believe concerns around risk and diminishing returns in the upper and middle markets could attract more capital into the lower middle market, from institutions seeking diversification, higher spreads and lower leverage.

In an increasingly complex macroeconomic and geopolitical environment, the lower middle market continues to stand out as a resilient and attractive avenue for private credit investors. Its domestic focus should offer protection from global trade volatility and compelling investment opportunities.

As interest rates decline and investor interest in private credit grows, allocating capital to this segment could offer a way to balance risk and return. While selectivity remains crucial, the ability to tap into niche, service-driven industries with stable demand should continue to see lower middle market private credit provide significant opportunities and value.

References

1. Bloomberg, ‘Private Credit Is Eyeing Bigger Margins on Loans,’ August 10, 2024
2. Deutsche Bundesbank, ‘Weakness in the German automotive industry continues,’ November 20, 2024
3. European Central Bank, ‘Key ECB interest rates,’ as of February 2025
4. Preqin, The Future of Alternatives 2029, October 2024.
5. Deloitte, ‘Private Debt Deal Tracker Autumn 2024,’ November 2024. Most recently available data used.
6. KPMG, ‘Private Debt Fund Survey,’ October 23, 2024

 

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 February 2025 and may change without notice.

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