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Large cap private equity sponsors are increasingly targeting middle and lower middle market deals, drawn by relative insulation from macroeconomic volatility and greater portfolio diversification. However, as they bring large cap structuring expectations into this space, they face a fundamentally different lending environment. Lower middle market lenders (both institutional and private credit), who prioritize capital preservation and tighter controls, can conflict with sponsors’ expectations for flexibility, operational independence, and growth-oriented capital structures. The negotiation dynamic between a sponsor’s ambition and a lender’s caution has become one of the defining characteristics of today’s lower middle market deal landscape.
This tension is particularly acute in areas where lenders perceive potential credit leakage, where value could exit the credit structure or risk could increase during a downturn. These differing perspectives can create friction in documentation and deal terms. The following table highlights key areas of negotiation, outlining how sponsor expectations from large cap deals often clash with the risk frameworks governing lower middle market credit decisions.
Key Negotiation Points Between Sponsors and Lenders
| Negotiation Point | What It Is | Sponsor Perspective | Lender Perspective |
|---|---|---|---|
| Baskets in General | Permitted dollar amounts or thresholds that allow borrowers to take certain restricted actions (like making investments, incurring debt, or paying dividends) without lender consent | Push for larger baskets and greater flexibility to pursue certain restricted actions without lender consent | Seek tighter controls and smaller baskets due to less cushion in smaller deals; want to prevent cash leakage that could impair debt service coverage |
| Available Amount Basket | A cumulative basket that grows over time based on retained earnings, equity contributions, etc. | Prefer access to capital that scales with performance; want multiple sources to build the basket (contributed equity, asset sales, excess cash flow) with minimal restrictions on use | Focused on tightly controlling what builds the basket and when it’s usable (including certain conditions for usage); often without a starter basket |
| Grower Basket | A basket sized as a % of EBITDA or assets rather than a fixed amount. | Prefer dynamic, performance-linked flexibility | Favor fixed-dollar caps to limit exposure during volatility |
| Limited Condition Transactions | Allows covenant testing at signing (rather than at closing) for acquisitions. | Critical for certainty in M&A execution without the risk of a failed acquisition due to covenant breaches | Want real-time testing to ensure no deterioration between signing and closing |
| Restricted Subsidiaries | Subs designated as outside credit group and therefore excluded from covenant calculations and collateral requirements | Want flexibility to ringfence or spin off assets | Insist on tighter definitions to preserve collateral and reduce off-balance risk; in lower middle market deals, even small leakage can be material |
Ultimately, these negotiation points reflect deeper philosophical differences: large sponsors prioritize operational agility and value creation optionality, while lower middle market lenders prioritize credit protection and downside resilience. As more institutional capital flows into this segment, understanding and navigating these dynamics will be essential for both sides of the table.
