Spread Compression Skipped the Lower Middle Market

Over half of sponsor-backed direct lending deals priced below 500 basis points in Q3 2025, a record [1]. Spreads at the top of private credit are compressing fast, and the $100 billion in new capital raised in the first half of 2025 [2] is accelerating it. But almost all of that pressure is concentrated in the large-cap market. In the lower middle market, the spread premium over large-cap actually widened to 232 basis points in the same quarter [1]. The capital wave hasn’t reached the lower end, and that divergence is the story most market commentary is missing.

A Different Market at the Lower End

For lenders operating in the $10M to $50M deal range, working with companies running $5M to $25M of EBITDA, the dynamics are materially different.

The structural reason is straightforward: you can’t write a $75 million check into a $12 million EBITDA regional services business. The deals are smaller, the diligence is more bespoke, and the sourcing depends on relationships built over years. The capital flooding the upper market simply can’t deploy at this level with the same efficiency. Muzinich described the lower middle market as “structurally attractive” for exactly this reason: less competition translates to better pricing, tighter structures, and stronger lender protections [3]. We see this directly in our own deal activity. The covenants in recent LMM transactions aren’t the covenant-lite structures common in the syndicated market. They carry real enforcement mechanisms. And LTV ratios have held steady even as valuations elsewhere crept toward 12x.

While large-cap spreads compress to post-crisis lows, the LMM premium has actually widened. The capital wave hasn’t reached the lower end, and that’s the whole point.

What the Non-Accrual Numbers Actually Tell You

None of which means the LMM is without risk. Non-accruals across private credit ticked up to 0.9% in Q3 2025, and LMM funds posted the highest rates in the segment [4]. KBRA projected the lower middle market default rate at roughly 3% by year-end 2025 [5]. These are real numbers.

What matters is what happens after a credit hits non-accrual. Realized losses across the segment remain minimal. First-lien fair market values are near par. When a credit gets into trouble at the LMM level, the lender and sponsor are usually in the same room working through it, not filing competing motions in bankruptcy court. Heron Finance’s Q1 2026 benchmark report confirmed this: net realized credit losses have remained stable and within historical norms even as non-accruals ticked up [4]. The distinction between “stressed” and “impaired beyond recovery” is real, and it gets lost in the headline data.

Healthcare is worth calling out specifically. Several recent stress cases have concentrated in physician practice management and labor-intensive services where staffing costs spiked and margins compressed [6]. Healthcare is not a single sector. The sub-sectors reliant on hourly clinical labor have faced a genuinely difficult 18 months, while other corners of healthcare remain healthy. Lenders who treat the sector as a monolith are going to get burned.

When a credit gets into trouble in the LMM, the lender and sponsor are usually in the same room working through it, not filing competing motions in bankruptcy court.

Where Value Shifts in 2026

Carlyle’s credit outlook made a point that resonated with us: private credit will “reward insight and depth, not just capital” [7]. That’s been the reality in the LMM for years. But it’s becoming the reality across the broader market, and we think the implications favor specialized lenders with genuine sector expertise over platforms built primarily for deployment speed.

PineBridge described their ideal LMM borrower as “attractively boring and basic” [8], and we’d mostly agree, with one addition: the best LMM credits right now aren’t boring at all. They’re in sectors that appear unremarkable from the outside (B2B services, niche manufacturing, specialty distribution) but where the companies are executing real growth strategies. Tuck-in acquisitions, geographic expansion, technology adoption in businesses that had operated on spreadsheets and handshakes for decades. These companies don’t make headlines, but they’re where the real value gets created in private credit.

The best LMM credits aren’t “boring.” They’re in sectors that look boring from the outside but where real growth is happening underneath.

On the deal pipeline: PE dry powder remains above $1 trillion [9], hold periods are stretched, and the baby boomer succession wave continues to push founder-led businesses to market. We expect 2026 to bring more activity at the smaller end, where succession-driven transactions don’t require the same macro confidence as large leveraged buyouts.

The setup is favorable for disciplined LMM lenders: spreads that still compensate for the credit work, covenants that still offer real protection, building deal flow, and competition that hasn’t arrived in force. The question isn’t whether the opportunity is there. It’s whether managers have the relationships, the judgment, and the discipline to capture it.