A new survey of private debt investors by Preqin and NXT Capital survey has found that 45% believe that the private debt market is at a peak, and that the coming months will see a correction. In response, investors are looking increasingly to US lower-middle-market direct lending** and counter-cyclical strategies. In fact, the survey reveals that many investors believe that US lower-middle-market direct lending will be less affected by a cycle change and other macroeconomic trends than private debt as a whole.

As a result, appetite for lower-middle-market direct lending in the U.S. has been growing, and a majority of investors plan to increase their allocations to the sector in 2018. Returns expectations for the sector are also relatively high: the majority of investors expect returns of 8% or more from unlevered funds, and more than 10% from levered vehicles, which is higher than for the private debt asset class as a whole.

Key U.S. Lower-Middle-Market Direct Lending Facts:

• Forty-five percent of private debt investors believe that assets are overvalued and that a correction is due.
• Investors believe US lower-middle-market direct lending will be more insulated from the economic cycle and other macroeconomic trends than private debt in general. Eighty-six percent believe this is a risk for private debt generally, but just 43% cite it as a risk for the US lower middle market.
• Eighty-six percent of investors have a dedicated allocation to US lower-middle-market direct lending, and a majority (56%) are set to increase their exposure over the next 12-24 months.
• Counter-cyclical strategies are also sought-after, with 46% and 37% of investors now viewing special situations and distressed debt funds respectively as presenting the best opportunities in the next 12-24 months. Thirty-four percent of respondents identified straight senior debt as presenting the best opportunities over the same timeframe.
• Beyond seeing US lower-middle-market direct lending as a potentially less volatile sector, the largest proportions of investors cited high relative returns (57%) and diversification (55%) as its key appeals.
• Returns expectations are high: 59% expect unlevered lower-middle-market direct lending funds in the US to return 8% or more, compared to 39% that expect the same for broader unlevered private debt funds.
• Similarly, 79% expect levered vehicles focusing on the sector to return at least 10%, compared to 60% that expect that standard for generic private debt vehicles.

“Given the widespread speculation about exactly where we are in the market cycle, it is not surprising to see that many investors are positioning themselves in anticipation of a correction. However, what is striking is the clear bifurcation of investor response – institutions are looking to the US lower middle market for safety while simultaneously moving up the risk/return curve in search of opportunity. In these circumstances, it is a mark of confidence in the sector that return expectations have remained so high, outstripping private debt as a whole. With such clear and widespread appetite, we can expect lower-middle-market direct lending in the US to be an increasingly active sector in the coming months,” said Tom Carr, Head of Private Debt Products – Preqin.

“It may be tempting to view U.S. lower-middle-market direct lending through the lens of an extended cycle, large capital inflows and a growing number of asset managers," said
Robert Radway, Chairman & CEO of NXT Capital: "But the Preqin/NXT Capital survey offers a more positive and compelling perspective. Investors recognise that US lower-middle-market direct lending offers them valuable benefits and market resilience, especially when they work with proven fund managers that have proprietary origination platforms and access to high quality deals. The next few years may present some challenges in terms of the rate of capital deployment among different managers and the inherent risks of lending at the peak of the economic cycle, but NXT firmly believes that US lower-middle-market direct lending will continue to mature as an asset class. Over time, it will become a standard component of many investors’ portfolios.”