In the Middle: A market everyone should know about (but few do)
The U.S. market, worth $18 trillion, is by far the largest economy in the world. It is followed predictably, yet not-so-closely, by China at $11.4 trillion. In the third spot, however, is a market most have never heard of: the U.S. middle market economy.
With a worth of $5.9 trillion, the U.S. middle market economy surpasses Japan in size, yet there is never mention of it on CNBC or Fox Business.1 In fact, it’s an area of the market that I didn’t know anything about until a friend of mine introduced it to me several years ago. Years of research, along with investment of my own money and clients’ money, has led me to one conclusion: it is a market worth knowing about.
I really became excited about middle market investing during the first part of 2016. Recall in January and February when the U.S. stock market had its worst start of a year … ever! The energy sector, in particular, was in dire straits. Many companies knew they could survive, they just needed help and time. I remember saying to my partner, Brian, “can you imagine the deals that we could get in that area of the market? You could probably buy assets for .40 to .50 cents on the dollar with a 10 percent yield.”
Put differently, I was talking to Brian about taking advantage of the types of opportunities in the middle market.
The information below serves as a primer of sorts. I won’t pretend it’s all you need to know about the U.S. middle market, but my hope is that it sparks some thought.
What is the U.S. middle market economy?
It is the group of private U.S. companies that have annual revenues from $10 million to $1 billion. Every time you drive into the city for dinner, you likely pass several of these companies—EnergySolutions LLC and Sorenson Communications are two examples of Utah-based companies. Even still, the size of the market is rather astounding.
Within the U.S. middle market economy are approximately 200,000 companies that employee nearly 50 million workers and have $10 trillion in annual revenues. To give that some context, the S&P 500 has annual revenues of $10.7 trillion.2
What are the advantages of investing in the U.S. middle market?
There are three primary advantages of investing in this market. (Please note that these returns are historical in nature, past performance is not indicative of future performance.)
- Yield. The loans in this area of the market have produced an average 7 percent yield since 2010, making it one of the best opportunities for investors.4
- Growth. Over the past 15 years, middle market private equity funds returned 11.1 percent, nearly double the 5.8 percent return by the S&P 500.2
- Diversification. Investing in this area of the market limits global risk, as 87 percent of the revenue realized is based in the United States. (The S&P 500 realizes only 56 percent of total revenue from the United States.) If the U.S. economy continues to grow, these companies will, as well—independent of global trends.3
Why don’t more people invest in the U.S. middle market?
In my discussions with many of our clients and friends, I have found that most people don’t invest for these main reasons:
- Lack of knowledge. Most people don’t have any understanding of this market, let alone how to invest in it.
- Not knowing how to invest. This market is not as easily bought as an ETF or mutual fund. It is a more fragmented market, making transactions more fragmented. To invest correctly, you have to find the right money managers, whose track records and morals you trust.
- Lack of liquidity. The investments in this area of the market are not publicly traded on the NYSE. Typical investments allow a quarterly opportunity to get out, but that’s not a guarantee. At our firm, we tell people that an investment in middle market will typically have a holding period of three to five years.
- Potential for default risk. This is always the risk for any loan type product. The current default rates for the products we like are in the range of 1.70 to 3.50 percent.
What’s a typical portfolio allocation to this market?
The answer is not a one-size-fits-all approach. It depends on the goals, age and risk tolerance of the individual. For example, for someone with a 20- to 30-year time horizon with moderate risk, a 5 to 10 percent allocation to middle market may be appropriate. This would mean that 90 to 95 percent of their portfolio is still liquid.
What can be done with this knowledge?
Despite the historically high yields and consistent growth of the U.S. middle market economy, it remains largely overlooked as an investment opportunity. Increased regulation has reduced the amount of commercial investment and expanded a market for non-bank lenders. My hope is that by increasing awareness, consideration of—and often investment in—this market will be taken by more investors and investment managers.
Brett Pattison is an investment advisor and portfolio manager at Iron Gate Global Advisors. He specializes in options trading and value investing. He has taught tens of thousands of investors and other advisors all over the country how to manage money.
1 National Center for the Middle Market, 2Q 2016 Middle Market Indicator. The Middle Market Indicator is a quarterly business performance update and economic outlook survey conducted among 1,000 C-Suite executives of middle market companies. For the purposes of the 2Q 2016 Middle Market Indicator, the National Center for the Middle Market defined the U.S. middle market as U.S. companies having annual revenues from $10 million to $1 billion.
2 National Center for the Middle Market. Bloomberg.
3 National Center for the Middle Market, S&P Dow Jones Indices, and The Wall Street Journal. S&P 500 data shows 2015 revenue breakdown. Middle market data shows 2015 average.
4 Thompson Reuters LPC.