It’s no secret that persistently low yields in public fixed income over the past decade have pushed investors farther out on the risk spectrum to achieve their goals. Private markets offer an alternative in direct lending, a segment of private credit in which non-bank lenders make loans to privately owned companies. It may be viewed as an area that has consistently delivered better yields than public fixed income strategies, including high yield and bank loans, often with less risk (Exhibit 1).
Some institutional investors increasingly regard private credit, and direct lending in particular, as a long-term holding – in some cases, a significant one. The Arizona State Retirement System, for example, recently announced an increase in the plan’s direct lending allocation to 17% of the $41 billion pension fund. According to Arizona’s senior fixed income portfolio manager, the allocation attempts “to replicate what we could do in the public markets but in the private world… with superior due diligence, superior covenants and superior returns.”1
Exhibit 1: Cliffwater Direct Lending Index, High Yield Bond, and Leveraged Loan Yield-to-Maturity Comparisons, Sep 2004 to Sept 2019
Source: Cliffwater, “2019 Q3 Report on U.S. Direct Lending 2019 Q3 Report on U.S. Direct Lending.” For illustrative purposes only.
Extensive due diligence mitigates credit risk
Experienced and disciplined private credit managers are typically able to achieve strong downside protection because the privately negotiated nature of their transactions permits them to conduct extensive due diligence on potential borrowers. This process allows a lender to assess the credit quality of a company by thoroughly evaluating critical factors such as its cash flow profile, quality of revenue, competitive positioning within its industry, and the strength of its management team. This process is extensive and can take four to eight weeks, in contrast to syndicated loan buyers who typically rely on materials provided by the borrower’s underwriter and are often “term takers”— meaning they have little ability to perform independent due diligence.
As more direct lending strategies become available to high net worth investors, it makes sense to consider dedicating a portion of their fixed income allocation to the category. However, given the broad range of available strategies and the significant interquartile performance spread, it is imperative to invest with experienced fund managers and to stick with senior-secured, primarily first-lien debt to help mitigate potential risk. Mezzanine and subordinated debt tend to be more vulnerable to recessions and are unsuitable as a replacement for public fixed income.
Filling a void in middle-market lending
The private credit market has experienced dramatic growth in the past 15 years, with assets increasing tenfold since 2004.2 This growth came about as a result of ongoing regulatory changes, bank consolidation, and an increased focus on lending to large companies that drove an industry-wide retrenchment of banks from lending to small and mid-sized businesses. The subsequent void in middle-market lending was filled by private lenders. While some have expressed concerns about the rapid growth of private credit assets, we believe the supply and demand dynamic continues to favor lenders.
A significant return premium over public fixed income
Private credit strategies typically require a six- to eight-year lockup but offer a significant return premium over public fixed income strategies. The broad category of direct lending, including senior and subordinated debt, currently generates a 400-500 basis point yield premium over syndicated bank loans and high yield (Exhibit 1). However, direct lending focused strictly on senior loans is expected to generate a narrower yield premium (200 to 300 basis points).3 This comparison does not consider volatility that exists in daily priced public credit markets but is difficult to measure in illiquid, direct lending investments.
Private credit skeptics often point to concerns about the credit quality in private markets and the increasing prevalence of “covenant-lite” investments. While it’s true that covenant packages are getting diluted, direct lenders can still build strong structural protections into their loan agreements, including basic financial covenants and prepayment penalties. For example, in the first half of 2019, 60% of direct lending investments in the U.S. were “covenant-loose” while only 8% were covenant-lite.3 In contrast, over 75% of the outstanding syndicated leveraged loan market is covenant-lite.5 Public credit investors have limited ability to impose structural protections on newly issued credits, which are largely dictated by prevailing credit market terms.
Further, most direct lending funds invest in senior secured debt, including first lien and unitranche loans (which combine a company’s first and second lien debt into a single security). These lenders are therefore positioned at the top of the capital structure and have a priority claim in the event of a default.
Private credit provides clear advantages
Given the significant return potential and increased availability of direct lending strategies for individual investors, this area may be worthy of consideration for high net worth investors with a longer time horizon who are seeking attractive income with lower risk than is typical of high-yield public fixed income strategies.
The Cliffwater Direct Lending Index (CDLI) 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 Business Development Companies (BDCs), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements.
1) Private Debt Investor, “In the Desert, You’ll Find Private Debt’s Biggest Fans,” December 2019.
2) Source: Cobalt, Morgan Stanley Research, September 2019.
3) Ares Management, “Opportunities in Global Direct Lending,” April 2018.
4) Proskauer, “2018 Private Credit Insights,” January 2019.
5) LCD, S&P Global Market Intelligence, “Cov-Lite Leveraged Loan Outstandings Hit $922B," February 2019.
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