The Economic Outlook for Midsize Businesses Amid Recession Fears
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Hey, everybody. I'm Telus Demos. I write for the Wall Street Journal's Heard on the Street. And you're listening to WSJ's Take on the Week, the weekly show where we give you a leg up on the worlds of money and investing. Each

Each week, we bring you conversations with insiders and from inside the Wall Street Journal's newsroom about stocks, bonds, crypto, and everything in between. And this week, we are joined again by a guest host. My longtime colleague, Miriam Gottfried, is filling in for Gunjan Banerjee while she is away. Miriam, I guess...

Officially, you cover private equity and private markets, but you have been at the Journal for years. We worked together. No, we never worked together at Heard, but you used to write for Heard on the Street, right? We were like ships on the night at Heard on the Street. What did you cover for Heard on the Street? I covered media, telecom, and retail for Heard on the Street, so a wide swath of the fun parts of the economy.

Well, speaking of the economy, it is an economic smorgasbord this coming week. We've got a charcuterie board. Delicious. A little bit of this, a little bit of that. Let's dig in. We've got coming up this coming week, we have the PMIs, the Case-Shiller Home Price Index, durable goods, more home sales data, quarterly retail trade reports. The Fed's favorite inflation measure, the PCE. And what I think is interesting about all of that is that this is really, I would say, the first major batch of economic data that

The Trump administration really has to wear. This isn't just like leftovers from, you know, kind of what Biden was up to at the end of his term. This is now Trump's economy and these are his economic indicators. What do you think people are looking for as this data rolls in? I mean, I think the big question on everyone's mind is, are we heading for a recession? And people will be parsing through the data to see the earliest signs that they can see of that.

if it's happening or how the economy is already reacting to the news of these tariffs that are about to roll out. Well, but I feel like tariffs haven't really, I mean, just because there's such a, they're in a state of flux, right? To be mild about it. Probably that the tariffs themselves aren't going to show up in this data. But what is something that might? What is something that we might actually start to see? Well, I mean, just the fear of tariffs could start to show up in the data. Consumers could already be pulling back. People could already be saying, you know what?

I'm just worried that prices are going to keep rising. I'm going to hold on to my cash. I'm not going to spend as much. And consumer spending is a huge portion of our economy. And that uncertainty has economic consequences, right? Like you said, somebody not doing something is consequential, right? Maybe a company is not hiring, something like that.

Yeah, a company might not be hiring, might not be investing in technology, which trickles down. It trickles down through the rest of the economy. I mean, one area where I think Wall Street is really keyed up on in terms of certainty and uncertainty is what goes on in boardrooms, right? Like what are corporations doing and how does that translate into the banking business, right? Yeah, I mean—

I think that uncertainty for banking usually translates into a lack of M&A. It's a pretty direct correlation, right? That's why one thing I'm watching on the earnings calendar for this upcoming week is investment bank Jefferies. They report their fiscal first quarter this coming week. Their main businesses are advising on M&A, trading, you know, raising money for companies, things like that. And what's interesting about them is that their calendar, their fiscal quarter is

It kind of comes a little earlier than the calendar quarter for the other banks. And so they're kind of an early read on what is going on on Wall Street. And so I think we know that, you know, we see in the data that so far this year, U.S. M&A volumes kind of tracked by Deologic are –

running behind where they were at this point last year. And people thought that Trump might be bringing back the deal boom with the incoming administration. And so far, it maybe hasn't quite materialized. But there have been a few notable exceptions. The Journal reported this past week, for example, that Google parent Alphabet agreed to acquire cybersecurity startup Wiz for $32 billion. So that might break the dam on the deals and get them all flowing again.

Yes, and we know that Wall Street loves nothing more than to move in a herd, right? So maybe one deal will kind of open those floodgates. That's definitely the hope of bankers. That's certainly the hope of bankers. And so what I'll be looking for out of Jeffries is any commentary they give around the outlook for what are they hearing from their clients,

Are we seeing this – that the tracks are being laid for lots of deals and maybe they're just kind of waiting for a little more. OK, now we know what tariff policy is going to be. Now we can pull the trigger. I think also interesting – and this will be very interesting for the banks that are coming up. What's going on in the trading business? Because all that uncertainty translates into market volatility. We've seen plenty of that lately. And so that can be good for Wall Street traders, right? I mean they're the ones who are –

facilitating that trading. So they might be making money in that way. But before we get to bank earnings season, which, you know, really kicks off in April, we have another season starting and that's baseball season. I guess it already officially started. I don't want to acknowledge that because my team, the Cubs, were, you know, the sacrificial, uh,

lamb for the Dodgers when the officially season opened in Japan. Sorry about that. Yeah, well, you know, whatever. It's just two games. It's just two games. But everyone else really kicks off stateside on Thursday. Well, the San Francisco Giants just did a big deal. What, like a trade? Like they...

Maybe a late free agent signing? No, actually a private equity deal. Your world, your world. My world. It often collides with sports and it did in this case. The investment firm Sixth Street, which is known as a private credit

giant, but also does private equity, took a stake in the San Francisco Giants. That's actually very on point with what's going on in baseball and in sports in general. But not all sports are created equal, right? I mean, the MLB has kind of been falling behind a bit in popularity when it comes to TV and broadcasting, right? It's not the NFL. Right. There was an article recently in the journal by our colleague Jared Diamond, who covers baseball and has been a

longtime Wall Street Journal sports reporter. The article is so good, we put the link in the show notes. I highly recommend you check it out. But what it was making the case is that, I'll read a little bit to you. Many U.S. sports leagues these days are awash in unprecedented amounts of money from television networks and streamers.

And then there is Major League Baseball. ESPN recently and MLB broke up right after many years of broadcasting MLB games on ESPN. ESPN had a message for the league, which was that, you know, America's most prominent sport, the national pastime, has declining TV right values. So that's why I think, you know, this season and whether or not, you know,

The Dodgers love him or hate him are kind of the showcase franchise these days with, of course, the big global star Shohei Otani. We'll see if their success can kind of translate into maybe more interest in baseball and it seems like they really need it. Help them negotiate some some some nice TV deals. But.

Let's stay focused for the moment on the macro picture, the economic story that I think everyone is interested right now. We've talked a lot about the economic impact of tariffs on big companies, the biggest global S&P 500 companies. But I think we should dig into what's happening specifically with what we kind of call mid-sized businesses. Because mid-sized businesses, though you may not know their names, they are a big piece of the economy. There are

in the neighborhood of 200,000 companies in the U.S. that have annual revenues between $10 million and $1 billion, which, believe it or not, $1 billion kind of makes you mid-sized businesses these days. And they collectively employ on the order of like 48 million people. That's according to the National Center for the Middle Market, which, by my calculations, is kind of

almost 20 million more people than work at S&P 500 companies. That's quite remarkable. And so with that as the backdrop, we decided that one way to look at this was to talk to someone whose business is all about mid-sized companies and their financial health. So we called up Michael Smith,

who is the co-head of credit at Aries Management, which is a giant in the world of private credit investment. And you may not know this, but private credit is really lending money to mid-sized companies in a lot of cases, and in Aries' case in particular. So if some of those companies aren't doing so hot right now, it's a problem for this guy and anyone who invests money with him. Good thing we called him up. Yep. Well, let's see what he thinks about the state of things after the break.

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And everything else you need to know leading up to tax day on Your Money Briefing. So we are talking today about an important piece of the American economy, mid-sized companies. And for that conversation, we are joined by Michael Smith. He is the co-head of credit at Aries Management, which is a private credit investment firm, an investment giant. Thank you.

Aries currently lends to over 500 companies and they employ collectively tens of thousands of people. Michael, welcome to the show. Thanks for having me. So, Michael, just to get you started, when you read the headlines about tariffs, of which we've had many recently, what is your immediate thought about, you know, which kinds of companies it will affect and how it will affect the companies that you lend to?

Yeah, good question. Obviously, very topical today. We get a lot of input from the companies that we invest in. When I hear tariffs, I think about global businesses in particular that are probably a little bit more affected than the middle market. But also,

companies where the inputs are being tariffs. Think steel, think timber, think things like that that are coming into businesses that tend to be a little bit more industrial on the end market side. But to your point, it affects everybody there. All products have inputs and everybody's very much talking about it. So there was a lot of talk leading up to the tariffs that they were going to be a negotiating tactic on the part of the Trump administration.

Were you advising your borrowers on how to prepare for the possibility that they weren't a negotiating tactic as it seems like maybe they weren't? Well, again, I think a lot of us thought they were or that maybe the bark was going to be bigger than the bite. It's actually really come to fruition in a serious way. Now, for how long they are in place or what would remedy the situation, I think a lot of us are still a little bit in the dark.

I think the thing about tariffs and us is we're talking to borrowers who are potentially looking to make an investment. Nothing really new from our perspective about how we were thinking about that. I know our team and a lot of others in the middle market have been investing in this asset class for 20, 30 years. My team has been together for 27 years.

So you've seen a thing or two. We've seen a thing or two. And I always say that the diligence is cumulative, right? So when Obama was coming into office, everyone thought healthcare was going to shut down and that every business was going away. So how would that happen and what would happen to a company that you are a

currently have an investment or one that you wanted to make an investment in. So having lived through Clinton, two Bushes, now two Trump administrations, a Biden and Obama, I think we've become very attuned to asking the right questions. So even having lived through it in a more modest environment in the first Trump administration, it was something that was very keen to us. We were all throughout last year talking about tariffs with our existing companies

and further emphasizing it as we look to make new investments. I wonder, though, if right now there's just a sort of constellation of things happening that would be worrisome for companies that, again, like have just less

They're big but not gigantic, so just have less resources. And so we're talking about other policies that might be hitting at the same time as tariffs, right? You have government spending cuts if your biggest customer is the government. You also have what's going on with immigration, right? If there's deportation that impacts labor costs, which I know is something that we've had prior guests on the show talking about, could all of those things start to –

basically put together what is kind of like a recessionary series of policies that could start to kind of worry you about your company. Yeah. I think a lot of people are talking about lowercase r recession or potentially an uppercase R recession. What is the difference between a lowercase r recession and an uppercase? I'm not sure I know the difference, but either a deep recession or just some sort of mild recession. It's funny.

You try to pick a point in time where the confluence of events might create something like that. Yet every time I go back and then look in the rearview mirror, there always seems to be four or five things going on that you have to diagnose and think about as you're making investments or looking at existing portfolios. If you go back a year and a half,

We didn't know what the Fed was going to do. The rates were going up and you didn't know where that was going to stop. You had high inflation. So you had borrowers that were facing higher interest rates in a very recessionary environment. And now you have tariffs and a different regulatory regime that you're trying to figure out. And so...

It always feels like the ones that are in front of you might be the most difficult, but you continue to work through them and just, again, like I said before, take those inputs and put them into your investment process. And over a cumulative period, you have lots of data points in order to be smart about what you're doing.

So ARIES lends to a number of companies across a large number of sectors. Is there one that you think will be particularly hard hit by tariffs? And if so, is that one that you could avoid right now? Yeah. The consumer is very much in question right now. Is that consumer going to get weak? So that would probably be one industry that we have some exposure to that we're trying to figure out.

Initial data, even through February, tells us that the consumer is still strong. And a lot of that's just about jobs. So people have jobs, they're optimistic, and the consumer starts. Once you start shifting into some of these more industrial industries, we are seeing weakness, whether that's because of the labor market. So home building, autoworkers, that type of stuff, where you're not unionized and you have

You might have a shortage of labor or the threat of immigration could take away some of your workforce. And then things like aerospace where you have heavy steel inputs and other industries like that. We're definitely looking at those a little bit more skeptically as we always do, but even in the broader markets, those are some industries where we think it could happen. Okay. So you focused maybe more on the services economy.

One input cost though to all those businesses that is hard to avoid is – and you mentioned it, interest rates, right? The cost of credit. And so if there's inflation, whether it's tariff-driven or has other sort of drivers, that will probably cause interest rates to go up. And a lot of the companies in the middle market, especially the ones that you lend to, are by their nature like leveraged, right? Meaning they borrow more than maybe the typical company.

How much wiggle room do your companies have to deal with what I guess we are all sort of thinking about now as technology?

higher for longer interest rates, right? We've talked about this a lot on the show. The Fed is probably not going to cut rates very aggressively. Some people might say even if at all this year. What does that mean for your market? Yeah, it was something that as rates were going up, that was very much a concern. We use things like interest coverage ratios, which would be your cash flow or profitability over your interest rates.

and your debt service coverage. So meaning how much cash you have to cover your interest costs. Yes. And so if you had $100 million of cash and $50 million of interest expense, you'd have a 2.0. Got it. And we saw ratios in middle market companies go from 2.7 to 1.7. That still indicated that we had

Fair amount of wiggle room. Were there other companies that got down to 1.4, 1.5? Yes. And you looked at them more carefully as you're going through your monthly review of the company. And to what extent do you think that the companies in your universe have the ability to kind of pass on those interest rate costs to their customers, right? Because I –

So, you know, I was looking at some numbers from KBRA, the ratings agency, and they were talking about how in 2024 it looked like the trend was a lot of middle market borrowers in the private credit sphere were kind of growing their profit margin even as their top line kind of revenue growth slowed a little bit. And so they were kind of saying like there was a real emphasis on profitability. And to me, that looks like, well, maybe they'll just say, oh, OK, our costs went up.

We'll just pass that along to our customers. Do they have that kind of pricing power, middle market companies? Some do, some don't. I would say most of the companies that, again, if we're looking at these non-cyclical businesses do. So a software business can absolutely pass it on. But that might be an annual contract where you probably have to wait a year. So that was the lag. As rates were going up, it was kind of only on an annual basis could you increase your price.

On the healthcare side, more complicated because you have to go back to your insurers and say, what am I going to get reimbursed? That could have been anywhere from a 15-month to a 24-month lag in order to get that price there. So most of them do have that pricing pressure. There are other businesses that were allowed to easily pass that upon by just raising their price to the wholesale vendor or whoever that is.

It's a fascinating question today because you obviously want to sell your products or your services. And with tariffs, if you think that this is just the dog barking loud as opposed to the bite and you think that they're going to be very short term in order to achieve goals, which I think, as you mentioned, was something we all thought to start.

Do you go raise your prices quickly in order to recoup that margin or do you try to wait? So I think companies today are dealing with that situation of I can pass it on, but do I want to take my price up and then if the tariffs go away, take it back down? Do they ever take it back down?

That's a good point, too. And again, that's where some of the pricing pressures as interest rates have come down and labor has come back a little bit. Some of them have just increased their margins. But that's a lot of the discussions that are going on in the boardroom. Do we take it up? Do we take it up some where we think we can leave it? Do we take it up to recoup everything and then bring it down a little bit? Those are discussions super topical today from investors.

all borrowers and very much so the middle market buyers where they're maybe trying to grow share and grow their business. That's somewhere where you don't want to take your price up to the highest point right away. You're trying to attract customers and get them to use your products. But it could be an opportunity. Could be an opportunity for sure. So I want to switch gears a little bit and talk a little bit about your business. Aries Capital Corporation is by most measures the largest publicly traded BDC company.

which is a business development company. These are publicly traded loan vehicles, basically, publicly traded lenders. And BDCs are becoming a pretty big asset class. You guys are among the first to do them. And some wealthier investors might also be hearing from their financial advisors about non-traded BDCs, which is another thing that's becoming more popular.

So how much middle market exposure should the average investor have? You have BDCs on the one hand, you have these non-traded BDCs. Is there any reason that I, as a regular investor, need to own this stuff? Obviously, you should consult with your financial advisors. What is the right for them? Yeah, what exposure do you get? The exposure you get across most of those funds is exposure to a diversified pool of middle market companies that are paying their interest. You collect that interest. And as a

BDC pay that on? Is it typically more interest than you might get from like a big company that issues a bond? Like is that kind of the reward for risk? The historical norms across the business would say that from a regular leverage loan in the broad market that trades, that the private loan will generate somewhere between 150 and 300 basis points of premium. So that's a couple more points of interest versus what you might get in other parts of the debt. Correct. Okay.

And so it's just a nice growing part of the leveraged finance universe, but still just a portion of everything that's going on as companies are looking for financing needs. And these companies are not going public, right? No.

Or at least until they get much bigger. So this is really like one of the only ways to get access to these kinds of companies. Yeah, definitely. And that trend has been going on for the past 20 years. It's a function of the distributed capital markets, the broadly syndicated loan market and the high yield market.

continuing to focus on larger and larger companies where they can issue larger amounts to debt to them that is more liquid. Diversification, the only free lunch in investing. Absolutely. As we always say around here. But what does that middle market ultimately represent for the economy? How significant is that? I guess what I want...

investors to come away with is a sense of like, what am I missing? Or what should I be thinking about when I'm thinking about this segment of the economy? Because it's significant, right? Yeah, it is. And listen,

This is not venture capital. We're not trying to find the next great thing, the next great technology and lending to them. While I think these might be companies that you already interact with. These are companies that have cash flow of greater than $20 million and could be the software that they use at the dentist office. It could be the ERP system you use at work. It could be a company

a great number of any things that you don't really see the brand or the name, but you're interacting with them in your daily lives probably a couple hundred times a week, you know what I mean, and doing that. And our job is to go look at as many of those companies as we can. So we dedicate a lot of resources

towards having hundreds of people calling on different companies and private equity communities to try to find thousands of deals that then we pick our one or 200 that we do a year to build those portfolios of three, 400. Do you do this in your personal life? Do you go out to dinner and you're drinking from a cup and you notice, oh, we landed that. Is this a new coffee mug maker? There's definitely some empirical diligence that goes on. Well, we're going to take a final break. And when we come back, we've got...

One more question from Michael Smith of Aries Management. All right, Michael, welcome back. Now, in 30 seconds or less, based on what you see from your vantage point, do you see indicators that make you think a recession is coming? I would say that all the data that I've seen today show companies still growing, still both on the revenue perspective and on their EBITDA perspective.

And I do not see that happening in the short term. There's a lot of inputs that are going to come, as we talked about, from the current administration and the behavior that they have over the next six months. I think that could change that. But, you know, everything that we're seeing from a data perspective is indicated that companies are healthy, growing and performing well. All right. Well, thank you. Let's keep looking at the data. The data will never lie.

Michael, thank you so much for joining us. Thank you.

This has been everything you need to know to take on your week. This show is produced by Trina Menino, Jessica Fenton, and Michael LaValle with help from Jess Jupiter. Michael LaValle and Jessica Fenton are our sound designers. Michael also wrote our theme music. Aisha Al-Muslim is our development producer. Scott Salloway and Chris Zinsley are the deputy editors. And Philana Patterson is the head of news audio for The Wall Street Journal. For even more, head to WSJ.com. I'm Telus Demos. And I'm Miriam Gottfried. Until next time.

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