Swedroe: Private Credit Performance

November 21, 2018

Private credit funds invest in nonrated, debtlike instruments that have no readily tradable market or publicly quoted price. The lack of ratings and liquidity results in higher yields than on publicly traded, rated securities. Assets under management in such funds were growing rapidly until 2008. However, fundraising activity slowed significantly with the onset of the 2008-2009 financial crisis.

Post-financial crisis, opportunities to invest in private credit expanded dramatically as traditional bank lending was constrained during the credit crisis and alternative sources of risk capital stepped in to fill the void.

The historically low interest rate environment that existed over the past decade resulted in increased demand from institutional investors seeking yields, frequently with an embedded inflationary hedge (as loans are all floating rate), expectations for low volatility and low correlation with the rest of their portfolio, and the assumptions of an imbedded liquidity premium relative to traditional fixed-income investments.

The increase of both supply and demand for private credit has resulted in substantial growth in assets under management.

World Of Private Credit

There’s a wide spectrum of private credit strategies, including:

  • Business Development Companies (BDCs): BDCs are closed-end investment vehicles organized under the Investment Company Act of 1940. BDCs generally invest in small and midsize companies through debt and, to a lesser extent, equity securities and derivative securities.
  • Senior Loan Funds: Senior loan funds are closed-end vehicles that make senior loan investments in small and midsize companies.
  • Mezzanine Funds: Mezzanine funds are closed-end vehicles that typically make junior capital investments in small and midsize companies to fund acquisitions, growth, recapitalizations or buyouts. Mezzanine capital is traditionally a hybrid between debt and equity, taking the form of subordinated, unsecured debt or preferred stock.
  • Distressed Debt Funds: Distressed debt funds are closed-end vehicles that invest in debt securities of mid- to large-sized companies that are experiencing financial distress. Investments are made either by purchasing debt at steep discounts in the open market or from existing creditors.
  • Special Situation Funds: Special situation funds are typically closed-end vehicles that target investment in mid- to large-sized companies undergoing pricing or liquidity dislocation caused by financial stress or event-driven factors.

In the world of private credit, a distinction is made between funds that purchase loans originated by others and direct lending funds—funds that cultivate proprietary relationships to source transactions and make investments.

Direct lending generally covers loans made to U.S. middle-market companies without the traditional intermediary role of a bank or broker. Middle market companies are commonly defined as those with annual earnings (as measured by earnings before interest, tax, depreciation and amortization) between $10 million and $100 million.

Traditional direct lending investors include insurance companies, asset managers (on behalf of both institutional and individual investors) and specialty finance companies. According to a Cliffwater analysis of Federal Reserve, Barclays and J.P. Morgan Markets data, private direct lending provides about 4% of U.S. corporate debt financing.

Rapid Growth In Supply & Demand

An analysis by Preqin found that private credit assets under management have grown 16% annually since 2006, with most of that growth realized in the post-financial crisis period. By the end of 2016, investments in private credit approached $600 billion globally.

Further, according to a 2017 survey conducted by Pensions & Investments, U.S. institutional investors increased their commitments to private credit every year since 2010, reaching $18.3 billion in 2016. In 2017, global private credit funds closed on a record $118.7 billion of new fund commitments. Despite the rapid growth, little is known about the characteristics, including performance, of the asset class.

Evidence

Shawn Munday, Wendy Hu, Tobias True and Jian Zhang provide a first look at the absolute and relative performance of private credit funds with their study “Performance of Private Credit Funds: A First Look,” which appears in the Fall 2018 issue of the Journal of Alternative Investments.

The authors used the Burgiss database of 476 private credit funds with nearly $480 billion in committed capital, including a subset of 155 direct lending funds. The data is representative of actual investor experience because it is sourced exclusively from limited partners, avoiding biases introduced by sourcing data from general partners (GPs).

The Burgiss data includes exact size and timing of cash flows as well as precise to-date fund valuations, which are typically reported by each fund on a quarterly basis. The fund data are net of all fees—carried interest paid to the GP and fund-level leverage—and thus represent net returns to limited partners.

Following is a summary of their findings:

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