How much direct lending capacity is in the middle market? Welcome to one of the most frequently asked (and most challenging) questions in the world of leveraged lending.

Several factors make this question topical. First, banks are being forced to scale back their ambitions in “risky loans” as regulators bury them with restrictions. Non-regulated entities – BDCs, insurance companies, hedge funds, finance companies and pension funds – see the exit of banks as a vacuum to be filled. This trend is compounded by investors’ belief that the middle market offers benefits other asset classes do not: better yield, conservative structures and lower volatility.

Middle market firms such as GE, Ares, Golub and Madison – leaders in the space for over a decade – have been joined by other entrants, including Monroe, NXT, Fifth Street and Prospect. These companies began with one or two funds, often backed by LP investors. To enhance capacity they launched structured vehicles, such as CLOs and public BDCs, all dedicated to providing private credit to medium-sized entities.

These strategies required considerable equity investments over time, so lower-cost alternatives emerged. Separate managed accounts became increasingly popular. Insurance companies, for example, gave firms capital to invest in subsidiaries of the management companies.

Creating multiple funding pockets – we’ve dubbed it the cargo pants strategy – allowed middle market arrangers to compete effectively against banks (see Chart of the Week).