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Opinion Private credit
The character of your sourcing determines your portfolio’s destiny
by Randy Schwimmer
Randy Schwimmer
Vice chairman
Churchill Asset Management
Private credit should rediscover its middle market roots
When conversations revolve around AI, mega-software M&A and datacentre infrastructure, it is easy to overlook the arena that accounts (per JPMorgan) for 30% of all private sector employment and 33% of annual business revenues. But as private credit investors grapple with AI transition risks, elevated leverage and weaker structures in large-cap portfolios, the core middle market is getting second and third looks.
As investors return to the asset class with a middle market lens, they need to understand what made the best direct lenders successful. To shelter portfolios from future macro events, they learned from the lessons that past economic cycles taught them.
The earliest origins of private credit came from traditional commercial bank lending in the 1970s and 1980s. Designed to serve regional companies that lacked the size and scale to access the broadly syndicated loan or high yield markets, origination was driven by relationships. Founder- and private equity-owned borrowers banded together with like-minded lenders they trusted to provide their significant capital needs.
Lending models began to diverge
These lenders often shared a similar approach to evaluating risk and credit underwriting, informed by decades of experience with their clients. This began to change, however, as buyout financings in the late 1980s and early 1990s pushed leverage higher. Non-bank lenders such as finance companies carved out specialty areas in healthcare, technology, consumer goods and light manufacturing. They also worked closely with operating partners in niche sectors (think car washes) ripe for consolidation.
Then came the GFC. The worst downturn since the Great Depression swept away long-held assumptions about portfolio construction. Luxury brands underperformed compared to value brands. Lower leverage didn’t save loans to cyclical businesses. And product purchases dependent on financing were impaired.
The credit managers who survived the GFC learned from their mistakes. Industry screens for the all-cycle playbook required constant vigilance and updates. The 2015 oil crisis, pandemic-induced inflation and supply-chain shocks, rate hikes and tariffs all tested underwriting models.
The character of your sourcing determines the destiny of your portfolio. Bank/bond replacement strategies revolve around momentum sectors where funds trade in and out of positions. On the other hand, buy-and-hold lenders target companies with strong, predictable free cashflows in sectors offering natural buffers against headline risks. This favours service-oriented businesses and specialised manufacturers.
Those lessons don’t just inform how deals get underwritten — they decide where capital should live in the first place. Portfolio construction for private credit in its most resilient form is found in the middle market. Borrowers are ‘ground-level’ businesses — LALO (light-asset, low obsolescence) — that grow even when the economy doesn’t. If you hold loans for the long run, they must perform in any market.
Diversification changes sector priorities
Today, ‘old economy’ sectors such as pest control, vet clinics and HVAC services are commanding higher purchase price multiples. That’s because they help diversify otherwise tech- and software-heavy portfolios, improve deal leverage and enhance the cash equity share of buyouts.
Investors can also learn portfolio allocation lessons from veteran private credit managers. One is guarding against outsized commitments, particularly in the early stage of fundraising when a large loss can puncture returns. The same is true of sector risk. Cyclicals are the first to be hurt in a recession and the last to recover.
Another lesson is emphasising commercial over consumer. Demand trends for the latter have never been tougher to predict. Also, services over manufacturing. Specialised manufacturers with leading market shares can find a place in a private credit portfolio, but rising labour expenses and tariffs have made input costs challenging. Services tend towards higher margins, allowing for more leverage and investment growth.
We are at an inflection point for private credit. For investors looking to enter (or re-enter) the asset class, the virtues of the middle market (sector stability, private equity alignment and all-weather portfolio construction) should be comforting. Throw in long-established private credit benefits (senior secured positions, stronger covenants and relative risk-reward premiums), and you have an arena with the staying power for whatever market challenges come your way.
