Swedroe: Private Credit Performance

Understanding the opportunities and risks of the private credit market.

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:

• Measures of relative performance suggest private credit funds have performed about as well as or better than leveraged loan, high-yield and business development company indexes.
• Direct lending funds have relatively low beta and positive alpha compared with the leveraged loan or high-yield indices.
• Direct lending funds’ low correlation with benchmark indices may indicate diversification benefits relative to other credit strategies.
• The pooled internal rate of return (IRR) for all vintages and strategies was 8.1%, roughly on par with return expectations for equities over this period.
• Direct lending (excluding mezzanine) was the best-performing of all strategies, with an 11.8% annual pooled IRR.
• Sharpe ratios suggest that mezzanine, all direct lending and direct lending (excluding mezzanine) have the highest risk-adjusted returns over the 2004-2016 period.

All of the above is very positive. However, unfortunately, at least until now, individual investors have been able to access this asset class only through hedge-fund-type vehicles, private partnerships with fees of typically 2% per annum plus 20% of profits.

It is interesting to note that Cliffwater, which provides investment advisory services to endowments, foundations, retirement systems and financial institutions, has filed for an interval fund that will invest in direct lending to middle market companies.

The ability to provide term loans that are held in nonliquid form (unsecuritized/not rated) was made possible by the SEC’s approval of the interval fund structure. Funds such as Stone Ridge’s alternative lending fund (LENDX) already invest in the direct business lending space, though LENDX’s involvement is limited to small business loans (as well as direct-to-consumer and student loans). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.)

Cliffwater’s fund will allow investors to access the middle market lending asset class and earn the credit and illiquidity premiums. If we assume operating expenses of 0.25%, the registration statement indicates the total expense ratio around 2.25% on net investor assets (NAV). However, assuming the fund uses leverage (up to a 50% regulatory limit), the effective fees will be lower.

This is because the fund’s expenses are charged only on the net assets (not the gross assets, which include the leveraged assets). If 50% leverage is used, the effective fee would be about 1.5%; with 40% leverage, it would be about 1.6%; and at 30% leverage, about 1.75%.

While even 1.5% is not cheap relative to typical mutual funds or ETFs, it is cheap relative to the fees charged by current providers, which Cliffwater found to be about 3%. In addition, investors need to be aware that this is a different type of vehicle/asset class, as you are not investing in public securities.

Cliffwater is basically running a bank, acquiring directly originated loans from a pool of investment managers it has worked with in this space for many years. Loans will typically be five years in maturity and carry floating-rate loans (eliminating term/inflation risk).

An Index To Measure The Space

Cliffwater has also created the Cliffwater Direct Lending Index (CDLI), which seeks to measure the unlevered, gross-of-fee performance of U.S. middle market corporate loans, as represented by the asset-weighted performance of the underlying assets of BDCs, including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. Stephen Nesbitt’s (CEO of Cliffwater) paper “The Investment Opportunity in U.S. Middle Market Direct Lending,” published in the Summer 2017 issue of the Journal of Alternative Investments, provides a good introduction to the subject.

The development of the CDLI addressed the problem facing investors of a lack of a historical performance record or index for middle market loans. As of June 30, 2018, the CDLI included over 6,000 corporate loans representing $94 billion in fair value. The CDLI Total Return Index includes three components: income return, realized gain/loss and unrealized gain/loss. Descriptions and returns can be found at the index’s website or at Bloomberg.

The combined asset-weighted universe is composed almost entirely of floating rate loans, with 55% senior first lien and 45% second lien or other more junior securities. The loans are well-diversified across industries. Although stated maturities are most commonly five years, the effective maturity averages three years as a result of principal prepayments. The following data, from Cliffwater, covers the period September 2004 through June 2018.

The table provides a few highlights. First, the CDLI has a yield premium of about 4%. That can be viewed as a liquidity premium—investors are compensated for the lack of liquidity. Investors who are willing and able to sacrifice liquidity for at least some portion of their portfolios have historically been well-compensated for doing so, in this and other asset classes.

Second, relative to the two public alternatives, the CDLI has provided superior risk-adjusted returns while also taking significantly less inflation risk. Note that the difference in yields between the CDLI and the S&P/LSTA Leveraged Loan Index is a better measure of yield spread, because interest income for both is floating rate, whereas in the Barclays High Yield Bond Index is fixed rate.

While not addressed in the above table, losses from defaults negatively impacted returns by about 1.1% per year. This is roughly equal to realized losses for broadly syndicated bank loans and below a -1.4% loss ratio for high yield bonds.

Finally, it is important to note that, typically, the valuation process for direct loans is performed quarterly, which, not surprisingly, results in dampened volatility (including lower maximum drawdowns) and changes that lag public market valuations.

To address this issue, Cliffwater used a lagged beta framework to statistically unsmooth the asset returns for the direct lending. Doing so raised the standard deviation of direct lending from 3.7% to 5.9%. Doing so also slightly raised the correlations (discussed below) to leveraged loans and high-yield bonds.

Returns

Following are the calendar year total returns for the CDLI, high-yield bond and leveraged bank loan indexes. Data is from Cliffwater.

Cliffwater also analyzed correlations and found that the annual correlation of the CDLI to:

• Public equities was about 0.7
• Treasury bills was about 0
• Barclays 3-5 year Treasuries was about -0.6
• S&P/LSTA Leveraged Loan Index and the Barclays High Yield Index was about 0.7
• Barclay’s Aggregate Bond Index was about -0.3

Thus, direct lending has not only provided strong risk-adjusted returns but diversification benefits.

We have one more important point to cover. The low level of risk exhibited by a portfolio of direct loans and the availability of financing leads many investors to apply leverage to loan assets. BDCs, for example, were created by congressional legislation and are permitted to use up to 200% leverage (recently increased from 100%).

Virtually all BDCs take advantage of a full one turn (100%) of leverage, and many are considering increasing that to the new two turns. The use of leverage increases risk and drawdowns while also increasing expected returns. Note that interval funds are allowed to use only 50% leverage (one-half turn), a prudent amount given the low level of volatility of this asset class.

Summary

For those investors willing and able to sacrifice liquidity, the asset class of private credit presents an interesting diversification opportunity. Shortly, investors will be able to access the asset class without the hedge-fundlike fees that have been associated with it in the past. In addition, there is now an index against which to benchmark a fund’s performance.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.