Private Credit David vs Goliath - What’s better, lending to big firms or small firms? Only one one to tell, a stretched Biblical analogy.

The debate has been raging for centuries—or at least it feels like it. Do you really get paid more by diving into the Lower Middle Market (LMM), or is it all smoke and mirrors? Sure, there are other factors to consider: leverage, covenants, sponsors vs. non-sponsors, and maybe even how much eggnog the GP drinks, but let’s face it—returns are what we’re all here for.

Luckily, Cliffwater has done some great digging and provided interesting research comparing Upper Middle Market (UMM) borrowers (EBITDA $100 million+) to their smaller LMM counterparts (EBITDA $30 million or less). Disclaimer: this only covers the U.S. and specifically BDCs, so adjust your expectations if you’re reading this from anywhere else.

Link: UMM vs LMM?

Some thoughts :

A) Net Return Parity: Despite a 69bps yield advantage for LMM, higher GP fees and borrowing costs swoop in to ruin the party, leaving net returns practically identical:

• LMM: 9.51%
• UMM: 9.59% So the conventional wisdom that LMM always offers superior returns maybe not so simple. Turns out, Goliath fights back harder than expected.

B) Persistent Yield Advantage for LMM: LMM does consistently deliver higher yields, reflecting the premium investors demand for smaller, riskier borrowers. But as with all things small, it’s not without its tantrums.

C) Higher Non-Accrual Rates for LMM (2% Difference): LMM loans have higher non-accrual rates, translating to more volatility and bigger swings. Think of it as the roller coaster to UMM’s merry-go-round. Sure, it’s thrilling, but hold on tight!

D) Recovery Rates Favour UMM: UMM recovery rates (55%) absolutely clobber LMM (35%), proving that bigger borrowers pack stronger collateral punches. David may have his slingshot, but Goliath’s wallet is much, much bigger.

E) Unrealized Gains and Losses Correlation: Interestingly, both LMM and UMM show highly correlated unrealized gains and losses, suggesting that valuation methodologies are pretty much identical. In other words, the same playbook, just different-sized players.

F) PIK Income Surprises: UMM borrowers seem to love Payment-in-Kind (PIK), with deferred payments making up 8% of total income compared to 4% in LMM.

What Does This Mean for Investors?

1. LMM Provides a Gross Higher Yield – Make Sure You Keep It! Don’t let extra fees or leverage costs gobble up your juicy LMM yield advantage. After all, you’re here to earn, not donate.
2. Volatility vs. Stability: LMM’s higher yields come with greater volatility (non-accruals) and weaker recovery rates, making UMM safer for risk-averse investors. If you like to sleep at night, Goliath might be your guy- although come to think of it…it didn’t end well. So pick the right Goliath.
3. Cost Efficiency is King: Those "early bird discounts" on fees and smart leverage applications could mean the difference between champagne and sparkling water. Choose wisely.
4. 2025 = More Volatility: Buckle up! LMM return dispersion is expected to widen in 2025, making manager selection critical. Mediocre GPs will stick out like sore thumbs.
5. Know What You’re Paying For: Management fees are just the tip of the iceberg. Operating costs and leverage application can dramatically impact net returns, so dig into the details.

Love to hear anyone else’s thoughts or telling me how I’ve missed the point!

#PrivateCredit #DavidVsGoliath #stretched_analogy #Cliffwater