Middle market credit: We’re gonna need a bigger boat

Middle market credit: We’re gonna need a bigger boat

Time to read: Minutes
Stephen Czech

Stephen Czech

Managing Director, Head of Private Debt Middle Market

A $4 trillion appetite for middle market credit faces a retreating base of conventional financing sources. For direct lenders, it’s an opportunity more attractive than any I’ve seen in six credit cycles of investing.


  • Current opportunity: Many banks and business development companies (BDCs) have withdrawn from the middle market, giving direct lenders the ability to negotiate better pricing and stronger covenant packages at lower leverage multiples.
  • Why direct lending: Making private loans to middle market companies is a simple, transparent investment strategy that offers the potential for attractive, contractual risk-adjusted returns that are uncorrelated to public markets.
  • Navigating tradeoffs: Because of the illiquidity of middle market loans, the potential to earn a return premium and the need for independent valuations are key considerations. Furthermore, heightened economic uncertainty underscores the importance of thoughtful loan structures, portfolio monitoring and in-house workout experience.

What is the opportunity in direct lending today?

There’s a scene late in the 1975 film “Jaws” when Police Chief Brody gets his first real look at the massive Great White that’s been terrorizing his beaches and mutters to Captain Quint that their little trawler is no match for what’s coming. That’s pretty much the boat US middle market lenders are in right now. 

Middle market companies tend to be too small to access the broadly syndicated leveraged loan and high yield bond markets, but too large for regional and community banks. That leaves them with three primary sources of debt capital: commercial banks, BDCs and private direct lenders. Due to a perfect storm of circumstances, two of the three types of lenders are being driven out of the market, just as  $4 trillion in secured floating-rate credit is scheduled to mature over the next five years (Exhibit 1, left chart).

Exhibit 1: Filling the capital void
Direct lenders face a massive addressable market as trillions in loans mature while conventional lenders retreat
Exhibit 1: Filling the capital void

As of 10/31/22. Source: Federal Deposit Insurance Corporation (FDIC), Federal Reserve Bank of St. Louis, Pitchbook/LCD, Morningstar LSTA US Leveraged Loan Index. Middle market defined as companies with $75–500M in annual revenue and $7.5–50M in annual EBIDTA.

Reduced competition has put investment groups like Czech Asset Management, L.P., in position to secure better terms at lower leverage multiples.

In commercial banking, consolidation has shrunk the number of US banks from approximately 14,000 in 1985 to just over 4,000 in 2022, and banks have drastically scaled back the amount of commercial and industrial loans they hold on their balance sheets (Exhibit 1, right chart). BDCs haven’t been able to take up the slack, as rising interest rates have created major portfolio problems for many levered lenders and their borrowers (see below).

With conventional lenders retreating, borrowers are in a tough spot. We’ve heard from both private equity firms and borrowers that BDCs rarely have the capacity to offer new loans, and many won’t even extend additional credit for existing deals. Our sources indicate that some BDCs are even asking borrowers to refinance their loans with other lenders in order raise liquidity needed to service their dividend payments.

This is great news for private direct lenders, who are now among the few remaining viable sources of capital for the 30,000 borrowers that constitute the middle market. Over the past year, a combination of reduced competition and growing economic uncertainty has allowed direct lenders to negotiate better pricing at lower leverage multiples (Exhibit 2). 

That being said, many direct lenders have been caught up in the industry’s shift toward covenant-lite deals, giving investors fewer protections. We still require full maintenance covenants, as we believe they provide a critical early warning system for detecting deterioration in a borrower’s financial health, which can help mitigate the risk to investors.

Taking these factors together, there has not been a better environment for direct lending in my professional lifetime, creating the potential for better-than-average risk-adjusted returns. And because of the risk-based capital and liquidity requirements of commercial banks, I expect investor interest will increase as more and more lending moves to the private market.

Why are commercial banks and BDCs retreating from the middle market?

Post–financial crisis regulations have made middle market lending less economical for commercial banks.

  • Dodd-Frank and Basel III require large commercial banks to maintain minimum liquidity and risk-based capital cushions — making bank credit more expensive, less flexible and less available for middle market borrowers.
  • Middle market loans tend to be highly illiquid and therefore do not count toward the ratio of a bank’s liquid reserves to its assets.
  • Middle market loans are considered high-risk assets due to their lack of liquidity and small borrower size, increasing the amount of risk-based capital a bank must hold in reserve.  
  • Under President Biden, bank regulators in various organizations have said the Trump administration went too far in relaxing rules around the living wills that banks must conduct each year to prove they can withstand a downturn. Whether that assessment is fair or not, the mere possibility of additional regulations has led many banks to further reduce their exposure to the middle market. 

Rising interest rates have created portfolio challenges for BDCs and leveraged private direct lenders.  

  • In the mid-2010s, a wave of BDCs and new private lenders — often coming from capital market groups’ loan sales and syndication desks — were able to raise massive capital even without a track record or experience running a fund.
  • We observed that many of these funds rushed to deploy capital at the expense of asset quality. Now they’re stuck with mediocre portfolio companies that are even worse off amid higher interest rates and rising labor costs.  
  • The abundance of government-supplied liquidity in 2020 and 2021 allowed direct lending funds to skirt these issues. But in 2022, rising inflation, supply bottlenecks and soaring interest rates caused significant portfolio problems.
  • Today, many BDCs trade below NAV1 and aren’t able to issue new shares to grow or to pay down debt if needed. Nor can they turn to debt markets, as higher rates have driven up the cost of capital for both BDCs and borrowers, making the BDC business model less competitive.
Exhibit 2: Recent loans have been issued at higher spreads with lower leverage multiples
Traditional middle market unitranche loan, split lien
Exhibit 2: Recent loans have been issued at higher spreads with lower leverage multiples

As of 12/31/22. Source: Valuation Research Corporation (spreads, multiples), Wall Street Journal (Libor).

What is it about direct lending that seems to appeal to investors? 

Direct lending offers the potential for attractive risk-adjusted returns that are uncorrelated to public markets.

I think there are a few things, starting with its simplicity. In direct lending, capital is used to fund a loan, which then generates monthly payments of interest, principal and fees, which in turn are distributed to investors once a quarter. There is no added risk or complexity from derivatives, “black boxes” or Black-Scholes models. That makes direct lending well suited as a core holding. 

Direct lending also never has an “off-season.” Unlike the cyclical nature of mezzanine or equity capital, there is always a need for secured floating-rate debt. The only thing that changes over the course of a cycle is how borrowers use the proceeds. When the economy is good, companies might use these proceeds to invest in equipment, make acquisitions or implement stock buybacks. In a downturn, they’ll use the capital to cover basic expenses and working capital.

But perhaps more than anything right now is the desire for assets that are uncorrelated to public markets. It’s been decades since inflation was a serious issue, and investors are discovering how pervasive and corrosive it can be. Senior secured floating-rate loans sit at the top of the capital stack, secured by collateral that tends to increase in value with inflation. Higher collateral values increase the potential proceeds in the event of a liquidation, while also raising barriers to entry for potential competitors.

What questions come up most often about direct lending?

A lot of our conversations surround liquidity and valuations, as well as questions about deploying capital into a potential downturn. These are important issues that can impact an investor’s experience, depending on how a manager structures around key tradeoffs.


Commercial and industrial loans made to smaller businesses have no natural secondary market, so there is no way to monetize them in a short period of time (if at all). As a result, direct lending funds typically require long lockup periods of five or ten years. Because capital will be unavailable during this period, investors will typically seek to earn a meaningful return premium, assessing factors such as a manager’s track record and investment philosophy, as well as the market opportunity. 

A direct lending manager can also mitigate illiquidity by calling capital only when needed in the early stages of the investment period, much like private equity funds do. The “IRR clock” and management fees only begin when capital is deployed (not when it is raised), and cash flow from interest payments begins immediately, mitigating the early period of negative returns (the “J curve”) often associated with certain private investments.


A byproduct of illiquidity is the challenge of accurately determining asset values. Since our inception in 2010, we have had every loan in the portfolio valued every quarter by an independent valuation provider that has broad reach that gives them a good vista of market dynamics in terms of pricing, structures and covenants.

Lending into a potential downturn

Direct lending can be well suited to deploying capital in times of uncertainty, as the lender is typically able to get higher spreads and better covenants at lower leverage multiples. However, anyone can lend money — it’s getting it back that matters. Underwriting criteria, loan terms and ownership structure can all have a major impact on performance when working through challenging economic periods.

We use a rigorous 11-point underwriting process — developed over 30 years and six credit cycles — to vet potential borrowers. We also deal primarily with first-lien secured loans, which means we’re in front of the line to recover capital in the event that assets need to be liquidated. More importantly, we own 100% of every tranche in which we invest, so we are able to act quickly and unilaterally to step in and work with a borrower if things don’t go according to plan.

Being the sole lender allows us to act quickly and unilaterally if a loan becomes impaired.

This approach of owning the entire loan was one of the first decisions I made when forming Czech Asset Management, L.P. It’s a philosophy influenced by my studies at the University of Chicago Booth School of Business and Professor Douglas Diamond, who was awarded the Nobel Prize in Economics in 2022 for his research on banking crises. His research showed, among other things, that during bank failures, the practice of transferring loans from one group to another (and to another) reduces recovery, prolongs workouts and hurts both the underlying companies and lenders in the process. In our experience, these risks are much lower when only one lender is involved.

With one loan, one document, one negotiation and one decision-maker, we can step in within hours to begin maximizing recovery, avoiding prolonged situations of uncertainty that may further erode a company’s value. Moreover, the same team that underwrites a loan monitors the loan, which includes monthly financial reports and management calls in addition to quarterly site visits — something we do for every portfolio company.

One other factor to consider is whether a loan includes a built-in mechanism to change pricing based on a borrower’s business, financial and structural risk, as measured by its leverage. Our loan agreements automatically adjust credit spreads up or down based on borrower performance. We call this “symmetrical pricing.” Borrowers benefit because they know what the pricing will be if they perform better or worse than expected, while investors benefit from lower portfolio churn and a return potential commensurate with the given risk.


The developments of the past year are leading many investors to reassess exposures across public and private markets. We believe direct lending can be an attractive core-holding solution, enhanced by its competitive position within the middle market landscape.

1. Direct lenders are the last major source of capital standing as middle market borrowers look to refinance $4 trillion in loans maturing over the next five years.

2. Direct lending is easy to understand — uncomplicated by derivatives, “black boxes” or Black-Sholes models, fitting well within a core-holding allocation.

3. Risks related to liquidity, valuations and economic uncertainty can be mitigated by careful structuring and underwriting.

To learn more about direct lending opportunities, please contact your Voya IM representative.

Investing with an experienced team

Czech Asset Management, L.P., part of the Voya Investment Management family, is a single-strategy investment group focused solely on making direct loans to middle market companies. Our mission is to generate attractive contractual risk-adjusted returns, with a primary objective of capital preservation. 

  • An established fundraiser with a global investor base of public and private pension funds (including Taft-Hartley plans), endowments, foundations, religious organizations, family offices and high-net-worth individuals
  • Average of 33 years experience in credit and corporate finance among the senior investment team, bringing in-house expertise in sourcing, structuring, underwriting, monitoring and restructuring
  • Extensive sourcing contacts developed over 30+ years of relationships with private equity firms, investment banks and intermediaries, now augmented by Voya IM’s additional resources and business lines
  • A preferred lender in the US middle market, able to commit to and hold loans up to $200 million and providing flexibility to borrowers regarding covenants, amortization, interest rate composition and maturity
  • Borrowers subjected to a rigorous 11-point underwriting process that has been refined over decades, giving us a deep understanding of the underlying businesses and their private equity sponsors

About the author



Stephen J. Czech, Managing Director, Head of Private Debt Middle Markets, has over 34 years of credit and corporate finance experience — including sourcing, structuring, underwriting, monitoring and restructuring corporate loans — and has been managing direct lending credit funds for 20 years. Mr. Czech founded Czech Asset Management, L.P., in 2011, which was acquired by Voya IM in 2022. Before that, he served as Managing Director and Portfolio Manager of SJC Onshore Direct Lending Fund, L.P., and the SJC Offshore Capital Finance Fund, L.P. (collectively, “SJC”), subsidiaries of Morgan Stanley Investment Management, and was a Managing Director and Portfolio Manager of Gottex – SJC. In 2003, Mr. Czech founded Contrarian Capital Finance, L.P., where he created and managed a direct lending fund with a strategy nearly identical to the one employed by Czech Asset Management, L.P. Prior to his time at Contrarian, Mr. Czech led the Mezzanine Finance Group at Credit Suisse First Boston. He also served as a member of the Leveraged Finance Group at Donaldson, Lufkin & Jenrette; a Senior Credit Officer of ABN AMRO’s Leveraged Finance Group; and a Vice President at Banc of America Securities. Mr. Czech received a BS from Marquette University and an MBA from the University of Chicago Booth School of Business.

Mr. Czech and his family are significant donors to, and advocates of, causes related to: (i) terminally ill children; (ii) active-duty and retired Navy SEALs and their families; (iii) tradesman (e.g., carpenters, electricians, plumbers, painters, contractors, welders, pipefitters, riggers and hospitality industry workers) and first responders (e.g., police, firefighters and EMTs); and (iv) scholarships for underprivileged high school students throughout the United States. Mr. Czech is the founder and Co-Chairman of The Mikey Czech Foundation; a lifetime member of the Navy SEAL Foundation National Leadership Council; a member of the Advisory Board of The University of Chicago Booth School of Business; a lifetime member of the University of Chicago’s Founders Circle, Maroon Loyalty Society and Chicago Society; a laureate member of the Dean’s Society of the University of Chicago Booth School of Business; a member of Villanova University’s President’s Club, Matthew Carr Society and Parents Executive Committee; a member of the Aesculapian Society of the Harvard/Dana-Farber Cancer Institute; a member of the Harvard/Dana-Farber Cancer Institute’s President’s Circle; and a member of the Harvard/Dana-Farber Presidential Visiting Committee for Pediatric Oncology.



1. As of 01/20/23. Source: Czech Asset Management, L.P., analysis of the 15 largest publicly traded BDCs based on Bloomberg data and public financial disclosures.


This information is proprietary and cannot be reproduced or distributed. Certain information may be received from sources Voya Investment Management (Voya IM) considers reliable; Voya IM does not represent that such information is accurate or complete. Certain statements contained herein may constitute “projections,” “forecasts” and other “forward-looking statements” that do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial data. Actual results, performance or events may differ materially from those in such statements. Any opinions, projections, forecasts and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. Nothing contained herein should be construed as (i) an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Voya IM assumes no obligation to update any forward-looking information. We deem all third-party sources to be reliable but cannot guarantee accuracy and completeness. Past performance does not guarantee future results.


Principal risks: All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. High yield securities, or “junk bonds,” are rated lower than investment-grade bonds because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. The strategy may use derivatives, such as options and futures, which can be illiquid, may disproportionately increase losses and may have a potentially large impact on performance. Foreign investing poses special risks including currency fluctuation, and economic and political risks not found in investments that are solely domestic. Risks of foreign investing are generally intensified in emerging markets. As interest rates rise, bond prices may fall, reducing the value of the share price. Debt securities with longer durations tend to be more sensitive to interest rate changes. Other risks include, but are not limited to, credit risks, other investment companies’ risks, price volatility risks, inability to sell securities risks and securities lending risks.