Highlights on the Reality in the Middle Market Today

On May 7, 2024, Morrison Foerster’s New York City office co-hosted a Private Markets Pop-Up with Kayo Conference Series, an event that brought together professional women across the private credit and private equity markets for curated networking, educational content, and a supportive community atmosphere.

The event featured a panel discussion, moderated by Morrison Foerster’s Finance partner Tammy Davies, titled “Fact or Fiction? Predictions, Trends, and Reality in the Middle Market Today.” The panelists discussed the current investment landscape and their 2024 – 2025 outlook for the private markets, candidly addressing the concerns of many in the private equity and private credit ecosystem regarding market conditions and providing predictions on emerging opportunities.

Below are a few highlights and lessons learned from the panel.

Sluggish Market Drives Competition

Repricing and refinancings dominated in the first half of 2024. Due to the persistent gap between the valuation expectations of buyers and sellers in the private equity market, new platform activity has been sluggish. That sluggishness has translated to aggressive competition among private credit funds for the assets that private equity sellers bring to market, leading to low conversion rates on a deceivingly promising pipeline of opportunities. Aggressive competition has compressed spreads across the board, and this confluence of factors has resulted in diligent underwriting losing to a market demanding higher leverage.

The pressure to underwrite higher leverage, circumspection notwithstanding, has been driven by the need of many private credit managers to deploy capital as the market remains frothy with approximately $400 billion of dry powder. Despite a slower start to 2024 than most would have preferred, much of the discourse around the state of private equity in the second half of the year remains optimistic. The results of both the KPMG 2024 M&A Survey (encompassing responses from 50 managers of U.S.-based private equity funds and 150 corporate executives) [1] and the S&P Global Market Intelligence 2024 Private Equity Survey (encompassing responses from 370 global private equity, venture capital, and limited partner respondents across North and Latin America, Asia, the Middle East, and Africa)[2] reflected the upbeat sentiment among firms. However, the private equity and private credit market in the second half of 2024 might remain less active than many expect. Sentiment and reality may well differ as a realistic expectation is that muted deal activity will likely continue into the latter half of the year due to challenging economic conditions. Seeking strategic opportunities to deploy capital will continue to be necessary to remain active in the market.

Reactions to Continued Liquidity Concerns

In a crowded and competitive market, thoughtful structuring can be invaluable to seeing positive returns when liquidity concerns are rampant at the corporate level. For the right credit, opportunities to provide junior capital with payment-in-kind (PIK) interest allow a borrower to preserve its cash and can be valuable for sponsors and borrowers in a high interest rate environment. Delayed draw facilities can be useful for sponsors and borrowers seeking a buy-and-build growth strategy, with assurance of capital availability so long as certain conditions are satisfied. Unitranche structures with a first-out bank revolver remain popular with borrowers for the lower blended rate compared to a private credit senior secured facility.

Any structuring discussion in 2024 requires a nominal discussion of mezzanine debt—in vogue for its attractiveness to highly leveraged companies that need to closely manage their maximum total net leverage ratio. Mezzanine debt deals are predicted to significantly increase in 2024, due to higher-for-longer interest rates, tighter credit conditions, and shrinking access to senior debt and unitranche loans for a variety of reasons.[3]

Nonetheless, mezzanine debt financing has been much more prevalent with upper-middle market sponsors and in the broadly syndicated loan market than in the core and lower middle market, where a mezzanine debt strategy makes up a smaller percentage of a lender’s overall portfolio. The higher risk inherent to the core and lower middle market can make mezzanine debt less attractive in most circumstances except for the right credit opportunity and the right lender who has the appetite to appreciate some thoughtful structuring.

However, although thoughtful structuring is a major factor to remaining competitive in the current market environment, the extent to which private equity sponsors value their credit partners’ reliability to close a deal cannot be underscored enough. The private markets have always been a relationship‑driven ecosystem, and when the pressure is on, the most dependable and trustworthy relationships are where deals get done.

Ongoing Evolution of Private Credit

Return of the Leveraged Lending Market

In 2024, banks have steadily regained their leveraged lending market share, bringing renewed competition to private markets. Not only is the broadly syndicated loan market making a comeback, but banks have also strategically partnered with private credit funds in joint ventures to access private credit market opportunities to generate coveted M&A fees.  

However, the middle market need not be threatened by the return of the broadly syndicated loan market or the increase in bank activity generally. For many private equity sponsors in the middle market, private credit provides more efficient access to additional liquidity throughout the term of an investment. Within the private credit market, a borrower can economically increase a term loan with one or a small club of lenders. Although interest rates may be higher than the broadly syndicated market, access to additional debt is considered by many sponsors to be a worthwhile trade as it provides a hedge against inflation, high-risk adjusted returns, and diversification benefits, among other results. Additionally, viability in the broadly syndicated loan market is ratings-dependent, and many middle‑market deals simply do not qualify. For those credits that may qualify, private equity sponsors have started to run a dual track process. As the broadly syndicated loan market comes back, we predict a reoccurrence of private credit second liens to provide capital efficiency for a borrower with a blended rate of debt service. The competitive co-existence of these two asset classes in the future will be healthy for the market.

Rise of Asset-Based/Asset-Backed Lending

As we quickly approach the dawn of the Basel III Endgame paradigm and the retreat of commercial banks from asset-based and asset-backed lending, private credit is gearing up to seize market share. In particular, the asset-backed asset class is a $20+ trillion market, and private credit has raised $5.2 trillion earmarked for asset-backed opportunities—a number which has been predicted to grow to $7.7 trillion over the next five years. This leaves a significant opportunity for private credit to step up to the plate.

Co-Investments

A sign of a maturing private market, limited partners have started to benefit from direct co-investment opportunities in private equity and private credit. The total capital raised for co-investments with private equity investment managers has increased from $6 billion in 2015 to $10.3 billion in 2022. Though fundraising has slowed since 2022, levels still remain historically elevated, gradually increasing over time. Co-investments are a key method by which limited partners optimize returns and decrease fees. Co-investments benefit general partners as well, helping preserve capital while retaining access to liquidity. However, there are still significant obstacles to co-investments becoming a standard and reliable source of capital. Limited partners are often hampered in their operational capabilities to match the speed by which a private transaction closes and in their risk appetite for a direct co‑investment when the opportunity presents itself.

Conclusion

While 2024 might be the year that the private market experiences its first real slump, the market’s inherent flexibility to actively adjust to a constantly changing environment will continue to drive growth and evolution. The current slowdown will ease as private equity and private credit funds alike reassess and recalibrate their strategy to remain competitive. As the private equity and private credit markets evolve and mature, we will undoubtedly continue to revisit the question of whether optimistic sentiment and reality truly align. Hubris isn’t for the faint of heart.

[1] 2024 M&A Outlook for Private Equity, KPMG.

[2] Private Equity and Venture Capital Industry Shows Resilience and Optimism in 2024 Amidst Shifting Market Dynamics according to S&P Global Market Intelligence survey, S&P Global Press, Apr. 29, 2024.

[3] See, e.g., Suzie Neuwirth, Mezzanine debt to grow in 2024, Alternative Credit Investor, Feb. 1, 2024; Madeline Shi & Abby Latour, Mezzanine debt re-emerges as senior lenders turn more cautious, PitchBook, Mar. 16, 2023; Madeline Shi, Mezzanine outpaces other private credit strategies, PitchBook, Feb. 9, 2023.