US private credit: Beware the blurring of the loans

March 27, 2025

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With growing convergence between upper middle market private credit and the broadly syndicated loan market, the lower middle market could prove a valuable diversifier for investors, explains Michael Smith.

Having spent the best part of two decades working in the US private credit market, two questions are often top of mind for the investors I meet: “What do you see happening to the illiquidity premium, and are creditor protections getting stronger or weaker?”

These questions are valid. After all, private credit Is supposed to offer a premium over publicly traded bonds and loans to compensate for the relative illiquidity of the asset class. And, from a creditor perspective, being able to negotiate terms on a bilateral basis with borrowers should afford you the power to ensure deal structures include robust protections.

But in certain segments of US private credit, particularly the upper-middle market, I worry that these characteristics are being eroded to the point where we may soon be talking about an illiquidity discount rather than premium, and covenant packages that offer little in the way of protection for investors.

Competition equals convergence

In echoes of the convergence between high-yield and leveraged loan markets in the early 2000s, lines between the upper middle market private credit segment and broadly syndicated loans (BSLs) are becoming blurred. Competition is clearly a good thing for borrowers able to access both markets, but less positive for lenders and their investors.

One noteworthy trend over the past year or so has been refinancing of large private credit deals in the BSL market. In a recent S&P Global report, the agency assessed private loans of between US$400 million to US$1.3 billion refinanced through the BSL market and observed a median spread reduction of 250 basis points.¹

Although financing through private credit may still have advantages in terms of speed and certainty of execution, lenders in the upper-middle market segment are having to accept lower margins on these bigger deals to compete. S&P notes that the spread between private credit loans and BSLs has tightened to less than a percentage point within business development portfolios.² That is not much of a premium when considering the relative lack of liquidity and transparency on private loans vs the BSL market.

Furthermore, there is growing evidence that upper-middle market lenders are competing aggressively on covenants in credit agreements. In S&P’s analysis of 300 borrowers who executed private credit agreements in 2024, while 97% of loans under US$350 million included financial maintenance covenants, this drops to just 40% for deals of over US$750 million, as Figure 1 highlights.

Trouble ahead?

True, the lack of maintenance covenants is not as high as the 93% of BSLs without them,³ but the direction of travel is a concern. Covenants are there for a reason – to protect lenders and their investors. Remove them and you take away one of the key characteristics of private credit.

Investors cannot be complacent given signs of credit deterioration in parts of the market. Of 2,000 privately-owned companies assessed by Kroll Bond Rating Agency, 113 are on its default ‘red list’ and could face serious difficulties this year. Over a quarter of those companies have interest coverage ratios of below 1.0x. If rates remain close to current levels, the agency said, “this subset of obligors will become a budding concern in 2025”.⁴

If we were to see an increase in defaults among larger private companies, the relative lack of structural protection will mean lower recovery rates for investors. For new first-lien debt issued in Q4, S&P estimated the average recovery rate at 64%, well below the historical level of around 80%.⁵

Again, default rates are not currently flashing red but will need to be monitored over the course of the year. According to Proskauer’s Private Debt Index, defaults increased to almost 2.7% in Q4, up from less than 2% in Q3.⁶ Defaults for companies with EBITDA of over US$50 million more than doubled, from 0.8% to 1.7%, while companies in the lower-middle market (EBITDA of less than US$25 million) saw a modest fall in defaults, from 2% to 1.8% (Figure 2). These figures compare favourably to the 5.3% default rate for US BSLs in 2024.⁷

However, it is worth noting that these figures do not account for payment-in-kind (PIK) debt, which allow borrowers to defer interest payments until the loan must be repaid. Such deals are rare among lower-middle market companies, but increasingly common amongst larger borrowers (Figure 3).

Depending on your viewpoint, PIK notes either offer additional flexibility to borrowers or are simply a means of ‘kicking the can down the road’ to avoid short-term pain and, in the worst-case scenario, default.

When a little goes a long way

As a lender, we focus on supporting well-run businesses in the lower-middle market. In what is a large and diverse market segment, we believe we can negotiate more favourable terms to protect our investors and find potentially attractive risk-adjusted returns that provide a genuine illiquidity premium. What I see in the upper-middle market does nothing to change my opinion of where the best value can be found.

While the decline in base rates is resulting in a decline in spreads in all parts of the US credit market, the spread between lower-middle market loans and middle-market loans has remained relatively constant for much of the past decade.

Contrary to perceptions that small is necessarily risker, the premium in the lower-middle market is not the result of a higher probability of default, as mentioned previously; nor does it come with higher leverage, as Figure 5 illustrates.

Trump 2.0

As with his first term in office, Trump 2.0 will be nothing if not eventful. Right now, the focus is all about tariffs, and details have yet to emerge on policies to boost domestic growth. As the saying goes, ‘the situation is fluid’, but I remain confident that lower-middle market companies are more than capable of responding to new market dynamics, even if optimism has inevitably been impacted in recent weeks.⁸

As far as tariffs are concerned, these are mainly focused on countries and regions that the US sees as a competitive threat in strategically important industries. As in Trump’s first term, China is perceived high on the list of threats, but over the past couple of years, a significant number of our portfolio companies have proactively adopted a ‘China +1’ sourcing strategy, transferring their suppliers to Cambodia, Vietnam and Thailand.

Despite being small, these companies are sophisticated enough to think about sourcing and how tariffs will impact margins and have been proactive in finding solutions. 

Furthermore, there is a push domestically to support ‘Made in America’ manufacturing. If this movement gathers momentum, there could be opportunities in businesses that stand to benefit.

Consumer concerns

My primary concern right now is not tariffs, but developments among US consumers that were already becoming apparent long before Trump’s election victory. The reality is that consumer spending is being driven by baby boomers and the rich. According to recent analysis by Moody’s for a special report published in The Wall Street Journal, the top 10% of earners account for almost half of all US spending, the highest level since records began, and represent almost a third of GDP.⁹

 

“My primary concern is not tariffs, but developments among US consumers that were already becoming apparent long before Trump’s election victory.” Michael Smith

 

In the 12 months between September 2023 and September 2024, Moody’s noted that the top 10% of earners increased spending by 12%, while spending by working class and middle-class households fell.

While financial markets are currently pricing in 2 or 3 rate cuts for 2025, inflation remains stubbornly sticky and any significant increase in costs related to tariffs could give the Federal Reserve pause for thought. High inflation hits low earners particularly hard, reducing their disposable income and making it more difficult to service their debts.

Recent Federal Reserve Bank of New York data showed that total household debt in the US increased by US$93 billion in Q4 last year and now stands at US$18 trillion, while delinquencies on auto loans and credit cards are creeping up.¹⁰

B2B over B2C

From a lending perspective, there is good reason to be cautious about companies whose fortunes are tied to the consumer, which is why we are looking more at durable businesses in B2B segments.

We also see opportunities in non-sponsor businesses that have been shut out of traditional loan markets as banks increasingly focus on asset-based financing.¹¹

Investors hopeful that 2025 might finally see a material increase in M&A-related financings could end up disappointed. While I expect activity to pick up this year, we will need to see uncertainty around inflation, interest rates and the broader policy regime ease off for that to happen.

That said, with around 200,000 companies in the US middle market,¹² I am optimistic that 2025 will provide plenty of opportunities. And, if the start of the year is any guide, there won’t be a dull moment.

 

“From a lending perspective, there is good reason to be cautious about businesses whose fortunes are tied to the consumer.” Michael Smith

 

 

References

1.S&P Global, ‘U.S. Leveraged Finance Q4 2024 Update: Outperforming Private Credits Thrive After BSL Transition,’ January 31, 2025
2.S&P Global, ‘Private Markets: How Will Private Credit Respond To Declining Yields?’ December 4, 2024
3,4.Kroll Bond Rating Agency, ‘Private Credit: 2025 Outlook,’ January 14, 2025
5.S&P Global, ‘U.S. Leveraged Finance Q4 2024 Update: Outperforming Private Credits Thrive After BSL Transition,’ January 31, 2025
6.Proskauer, Q4 2024 Private Debt Index, January 21, 2025. The Proskauer Index tracks senior-secured and unitranche loans in the United States, and in Q4 comprised 825 loans representing US$152.8 billion in original principal amount.
7.Fitch Ratings, ‘U.S. Distressed and Default Monitor: January 2025,’ January 31, 2025
8.National Federation of Independent Business, ‘Small Business Optimism Recedes in February, March 11, 2025
9.The Wall Street Journal, ‘The U.S. Economy Depends More Than Ever on Rich People,’ February 23, 2025
10.Federal Reserve Bank of New York, Household Debt Balances Continue Steady Increase; Delinquency Transition Rates Remain Elevated for Auto and Credit Cards, February 13, 2025
11.Columbia Business School, ‘The New Banking Landscape: How Securities Have Overtaken Traditional Lending,’ July 25, 2024.
12.National Center for the Middle Market, as of March 2025

 

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