Perhaps unsurprisingly, lower middle market lenders generally reject the idea that smaller businesses are inherently riskier borrowers. We discussed this in a recent Unicrunch column. 

We also recently wrote about HVAC roll-ups, a fixture of the LMM space which some say is “white hot” right now. We delved into some of the risks in the HVAC market but also found plenty of evidence that these businesses can be stable and deliver strong growth without taking excessive risk.

It makes sense that market participants are looking for simple frameworks to assess risk. After all, back in the ZIRP era, you could make a lot of money from following simple rules like ‘buy the dip’. Low interest rates obscured many gory details.

In today’s more challenging environment, as lenders triage large and diverse portfolios, there’s a certain attraction to a simple rule like ‘smaller companies are more likely to default’. It’s entirely possible that this forecast is accurate, but with 2024 looming, it’s worth exploring the debate.

Middle-market merits

Moody’s research finds that the quality of a borrower’s financial position is a better indicator of credit risk than its size. Other data shows that senior debt in the LMM space has historically experienced lower credit losses than other segments of credit markets. 

Part of this, according to lower middle market sources, has to do with stronger lender protections in the LMM space.

"Covenants tend to be more robust in the lower middle market versus the upper middle market," said Joe Taylor, head of capital markets at PineBridge Investments. For that reason, measuring LMM defaults against larger borrowers is “not an apples-to-apples comparison,” he said.

For what it’s worth, the Q3 figures from Proskauer’s private credit default index show that, for the moment, the lower and upper end of the market are faring about equally in terms of defaults.

We should note that this doesn’t talk about recoveries after default, and that stronger covenants can often lead to better recoveries for creditors in that scenario.

Vintage variations

Of course, maximizing your recovery only matters after a default. Ideally, you want to avoid defaults altogether. And on that note, most LMM lenders would say that they are often more conservative than their larger-cap counterparts.

“It is really hard to recover from a realized loss in a debt strategy,” said Taylor. “So for every private credit asset manager, their top priority needs to be principle preservation."

There’s more to this debate than just covenant quality and business stability. One of the points in KKR’s argument is that larger companies are often better protected from downside risk — they are often more diversified, have better competitive advantages, greater scale, cheaper cost of capital, owners with deeper pockets, etc. etc.

Smaller companies are more vulnerable on many of those points. But that vulnerability could have a flipside, in that it may also make them less inclined to take risky moonshots in pursuit of huge growth.

Simply put, there are so many considerations impacting credit performance that it’s hard to apply rules of thumb. Value and risk may even pop up in unexpected areas or difficult vintages — such as the 1947 Bordeaux.

That year (or so we’ve read) a warm and dry summer made it difficult to regulate temperatures, sometimes ruining potentially great wines. Yet, that vintage also produced famed Pomerol “holy grails”: some of the most prestigious wines on the market, such as Petrus, Lafleur and Vieux Chateau Certan. 

Sommeliers, please write in if we’re missing any. Back to credit, though, the point is that the devil is in the details. 

Lenders who binged indiscriminately on deals with loose terms and hasty diligence may be left with a nasty hangover; equally, those who turned down swathes of the market by applying simple rules of thumb may regret missing a few parties.