There are ~200,000 midsize U.S. companies with 100+ employees1
- Collectively, they represent ~1/3 of U.S. economic output
- Same size by output as Germany or Japan
- 99% of them are private
These midsize companies are the U.S. “middle market”2 and make up the beating heart and soul of the U.S. economy.
The vast majority of these companies are private, not publicly traded. This means that they cannot be accessed through traditional ETFs or mutual funds, but only through private equity and private credit investments.
In this piece, we highlight this important component of the U.S. economy and its relevance to the U.S. investment landscape.
Number of U.S. public and private companies by annual revenue
Middle-market companies typically experience stronger growth than large-market companies.
The U.S. middle market in private equity
The middle market is often considered the “sweet spot” for private equity investors.
Compared to small-market private companies, middle-market GPs3 are typically large enough to have meaningful resources to invest in growth and weather economic turbulence. Their portfolio companies are typically more established than smaller companies, with diversified customers and geographies that can make them less sensitive to economic fluctuations.
Compared to large-market private companies, middle-market companies typically have more room to grow their market share and expand their playbook across geographies.
The middle market is more fragmented than the large market. There are roughly 25x the number of privately held middle-market companies to choose from vs. privately held large-market companies. A larger opportunity set means more potential for GPs to generate alpha.
As JP Morgan reports, purchase multiples are lower for middle-market companies vs. large-market companies (10.4x vs. 12.4x–12.9x) and leverage levels at purchase are lower (3.2x–4.6x vs. 5.9x), seeking to provide better value and helping to lower risk.4
Returns for middle-market private equity have historically outperformed the large markets, with middle-market net returns broadly in line with small-market private equity, but without the low-lows that sometimes accompany small-market funds.
Finally, there may be more exit options for middle-market private equity GPs. Middle-market companies are small enough to be a target of large-market GPs and digestible to strategic acquirers, while often large enough to make an IPO into the public markets an option.
PE returns by size
Source: Preqin, as of August 2024. Data is the most recent decade of vintages 2012–2022 (excluding 2023 and 2024 vintages, which are not yet mature enough).
The U.S. middle market in direct lending private credit
Significant bank consolidation started in the mid 1990s and led to the retrenchment of lending to small and midsize companies.
Bank loans by deal count
As a result, bank loan size has generally increased over the years. This has left a gap or white space for middlemarket lending into which private lenders have stepped.
Rolling 3-year bank loan deal size
We believe supporting the U.S. middle market is incredibly important for the economy, and it has been the most fruitful part of the private lending market from an investment perspective.
Size differences
Different loan and company sizes have different barriers to entry. For example, to work with larger companies, a lender needs to be able to put large amounts of capital to work and compete against other large lenders, banks and public markets. To put the same amount of capital to work with smaller companies, a lender needs a larger team with depth and breadth of relationships to source deals and maintain relationships.
Many lenders prefer to lend to large companies where they can get scale. Doing large deals typically requires a smaller deal team and fewer originators doing larger dollar transactions.
On the other hand, working with smaller companies generally takes a larger team to cover more relationships. For example, to originate $1 billion in loans, a lender can do one $1 billion loan or twenty $50 million loans—essentially 20x the work to loan the same money.
This works if the lender has a large team in place, but it is tough to do when a lender is starting off and wants to originate large quantities of money. So, many direct lenders of size stick to making larger loans, even though that means competing with banks and other large lenders in a more competitive market.
Despite the greater work required to lend to smaller companies, there is typically a payoff in the form of more favorable spreads, better incumbency and ability to scale businesses as they grow over time. We believe those private lenders with the largest and most experienced teams are best positioned to provide the strongest performance.
For example, in today’s environment we are seeing a ~70 bps spread between smaller EBITDA5 and larger EBITDA borrowers. (See graph below.)
This spread has persisted through various market environments, though it can change over time, as we illustrate below.
1st lien middle market/large cap spread
So there is a payoff for lenders that are able to work below the level of the largest companies, in what we call the middle market.
Less competition can also lead to better terms for lenders. For example, higher Secured Overnight Financing Rate (SOFR) for loans to smaller borrowers can protect lenders in the case of falling interest rates.6
| EBITDA range | Floors | Delta |
|---|---|---|
| <$25M | 1.03% | 0.25% |
| $25-50M | 0.91% | |
| $50-75M | 0.90% | |
| $75-100M | 0.80% | |
| >$100M | 0.78% |
We typically also see lower leverage levels in loans to smaller borrowers, reducing the risk of the deal.
| Status | Leverage | Delta |
|---|---|---|
| <$25M | 4.60x | -0.62x |
| $25-50M | 4.82% | |
| $50-75M | 4.95% | |
| $75-100M | 5.12% | |
| >$100M | 5.22% |
Defaults by size vary over time. Smaller companies had a harder time during Covid...
...but have had lower defaults more recently.
If everything is perfectly equal between a large company and small company, it is true that the larger company will tend to be less risky. But rarely are the terms the same between larger and smaller companies—typically lenders get better terms, better protections and more covenants from smaller borrowers.
That said, we would still do both loans! Great companies can be found across the size spectrum, and we believe that lenders that are equally comfortable working across the smaller, middle and large markets hold an advantage.
As an illustration, below we show observed terms between different-sized borrowers over the past four years.
Ares U.S. senior direct lending investments by company
| EBITDA range | |||
|---|---|---|---|
| <$50M | $50M-100M | >$100M | |
| Originations | 65% | 22% | 13% |
| Spread | 6.04% | 5.90% | 5.57% |
| Leverage | 5.14x | 5.16x | 5.40x |
| Yield per unit of leverage | 2.39% | 2.20% | 1.78% |
Further, portfolios can reduce idiosyncratic risk through greater diversification across more loans. Because of the fixed upside on a loan, differentiated returns come from minimizing losses. As a result, we believe it is difficult to be “over-diversified” in credit, assuming the same underwriting standards are applied across all loans.
Conclusion
At 1/3 of U.S. economic output, the U.S. middle market is a critical part of the economy. However, with 99% of middle-market companies privately held and not within the largest name-brand private funds, they are so rarely included in investors’ portfolios.
Given the attractive growth rates and larger spreads the middle market typically experiences, we believe investors should look for ways to incorporate both U.S. middle-market equity and U.S. middle-market direct lending private credit.
