2.1 Borrowers

Every loan has two sides. Before you can understand how private lenders make money, or how they lose it, you need to know who they lend to. Borrowers shape everything about a private loan: its size, its terms, its risk and its price.

This lesson looks at the main kinds of private credit borrowers, how the market has expanded to larger companies, and why borrowers choose private lenders even though they usually pay more.

The middle market

Most private credit borrowers are middle-market companies. These are businesses that are too large to be small businesses but usually too small to borrow easily in the public bond or broadly syndicated loan markets.

There is no official definition of the middle market. Many lenders use a company's EBITDA (earnings before interest, taxes, depreciation and amortization) as the yardstick, and each firm draws its own boundaries. Lenders often split the market into three bands:

• Lower middle market: the smallest companies. Loans are smaller, fewer lenders compete, and lenders can often negotiate tighter terms.
• Core middle market: the heart of the market, where many direct lending funds focus.
• Upper middle market: larger companies that could sometimes borrow in the syndicated market instead. Competition is fiercer and terms are often looser.

Middle-market borrowers come from many industries. Software, healthcare services, business services and industrial companies are common, but lenders finance almost any business with steady cash flows. Lenders generally prefer companies with predictable revenue and a strong market position, because a loan is repaid from the company's future cash.

Sponsor-backed borrowers

A large share of private loans go to sponsor-backed companies. A sponsor is a private equity firm that owns or controls the company.

Sponsors typically buy companies through a leveraged buyout (LBO). In an LBO, the sponsor pays for the company with a mix of its own equity and borrowed money. The debt sits on the company's balance sheet, and the company's cash flows pay the interest. A private credit fund often provides most or all of that debt.

Direct lenders like sponsor-backed deals for several reasons:

• Repeat business. Sponsors buy many companies. A lender that works well with a sponsor can win many deals from it.
• An equity cushion. The sponsor usually puts in substantial equity, which absorbs losses before the lender does. The lender is repaid first if things go wrong.
• Professional owners. Sponsors have experienced teams that can support a struggling company, replace management or put in more money.
• Good information. Sponsors run a structured process and provide detailed financial data.

But the sponsor is not usually a guarantor. If the company fails, the sponsor is not generally required to repay the loan. Lenders still depend on the business itself.

Non-sponsored borrowers

Non-sponsored borrowers are companies without a private equity owner. They may be owned by founders, families or management teams. Some lenders specialize in this segment.

These deals can be more work. There is no sponsor running the process, so the lender often has to find the borrower itself and gather the information it needs. Owners may be less familiar with complex loan terms. In return, competition is often lower, and lenders can typically earn a higher spread and negotiate stronger protections.

Non-sponsored borrowers use private loans for many purposes: buying out a retiring partner, funding an acquisition, paying for expansion or refinancing a bank loan.

The move into larger deals

Private credit began in the middle market, but it no longer stays there. As funds grew larger, private lenders gained the capacity to lend large amounts. Groups of lenders, often called club deals, can together provide financing that once only the syndicated market could supply.

This became especially visible during periods of market stress, such as 2022, when banks were reluctant to underwrite large syndicated loans. Some larger sponsor-backed companies turned to private lenders instead. Today private credit and the broadly syndicated market compete for many of the same large borrowers, and some companies move between the two as conditions change.

Why borrowers choose private lenders

Private credit usually costs more than a syndicated loan or bank loan. So why do borrowers choose it? The main reasons are:

• Speed. A private lender can often close in a few weeks.
• Certainty. The lender commits to the terms directly. There is no risk that weak investor demand forces a change in pricing.
• Flexibility. With one lender or a small group, the borrower can renegotiate or ask for more money more easily. Many loans include a delayed-draw term loan, a commitment the borrower can draw later, often to fund acquisitions.
• Confidentiality. The borrower's financial details and loan terms stay private. No public rating or offering document is needed.
• A single relationship. The borrower deals with a lender it knows, not with many investors who may trade in and out of the loan.
• Access. For many smaller companies, the public markets simply are not an option.

An example

The following example is illustrative.

Consider two borrowers approaching the same direct lending fund.

Northfield Components is being bought by a private equity firm. The sponsor runs a competitive process among several lenders and wants a committed unitranche loan (a single loan combining senior and junior debt) within a month, plus a delayed-draw facility to fund planned add-on acquisitions. The fund wins the deal by offering certainty and flexibility, though competition keeps the spread moderate.

Harlow Foods is family-owned. The family wants to buy out a cousin's stake. The fund's team meets the owners several times, helps them assemble the financial information and structures a loan with tight covenants. With fewer competing lenders, the fund earns a higher spread.

Both are middle-market loans. They differ in how the deal is sourced, the level of competition, and the terms the lender can negotiate.

Key terms

• Middle market: Mid-sized companies, too large to be small businesses but too small to borrow easily in public markets. Definitions vary by lender.
• Sponsor: A private equity firm that owns or controls a company.
• Sponsor-backed borrower: A company owned by a private equity sponsor.
• Non-sponsored borrower: A company without a private equity owner, such as a founder- or family-owned business.
• Leveraged buyout (LBO): The purchase of a company using a mix of equity and a large amount of borrowed money.
• Equity cushion: The owners' equity that absorbs losses before lenders do.
• Club deal: A loan provided by a small group of lenders together.
• Delayed-draw term loan: A loan commitment the borrower can draw later, often for acquisitions.

Key takeaways

• Most private credit borrowers are middle-market companies, split roughly into lower, core and upper bands.
• Sponsor-backed companies are owned by private equity firms and are a large share of the market.
• Non-sponsored companies take more work to lend to, but often offer higher spreads and stronger terms.
• Private credit has grown into larger deals and now competes with the broadly syndicated market.
• Borrowers pay more for private credit in exchange for speed, certainty, flexibility and confidentiality.