Private Direct Lending Offers Attractive Yields
Investors seeking higher yields and relatively low risk, and are willing to sacrifice liquidity, will find attractive opportunities in interval funds that invest in senior secured, middle-market loans, such as those offered by Cliffwater.
Before looking at those funds, let’s review the history of middle-market lending that drove those opportunities.
Over the past decade, there has been a fundamental shift in the fixed income landscape. Banks have been central to the creation of credit, driven by their ability to take in low-cost deposits and to loan money at higher rates. While non-bank loan channels have always coexisted with traditional banking, these channels were historically small niches in the overall economy.
That changed after the great financial crisis when new regulations limited the ability of banks to make traditional loans to U.S. middle-market businesses (generally defined as companies with EBITDA, or earnings before interest, taxes, depreciation and amortization, of between $10 million and $100 million and which are considered by many too small to access capital in the broadly syndicated market in a cost-efficient manner). “Shadow banking” emerged with independent asset managers funded by capital from institutional investors, replacing banks as providers of secured, first-lien commercial loans.
That trend continues to this day. The principal value of these non-bank originated loans is more than $800 billion.
As of December 31, 2020
Source: Standard & Poor’s Leveraged Commentary & Data
The growth in direct, middle-market loans originated by asset managers is partly explained by the growth in middle-market private equity. Based on Cliffwater LLC’s latest December 2021 survey of 53 direct-lending firms, collectively managing $570 billion in direct-lending assets, 79% of all middle-market corporate borrowers represented within their loan portfolios were private equity (sponsor-based) borrowers. Those loans are referred to as “sponsor-backed.” Private-equity sponsors often prefer to borrow from asset managers rather than traditional banks because asset managers offer faster speed, certainty of execution, and greater financing flexibility.
Characteristics of middle-market loans
Commercial loans made by asset managers or non-bank lenders typically have a five- to seven-year maturity, charge floating interest rates based on a reference rate (such as the secured overnight financing rate [SOFR]) plus an interest rate spread to compensate for the risk of loss from borrower default. The interest spread varies depending on many factors, including the perceived riskiness of the borrower, industry, loan-to-value ratio, seniority, covenants and other factors. In addition to interest income, lenders typically receive “original issue discount” (OID), a fee for originating and underwriting the loan. OID is received when the loan is issued in the form of lender proceeds that are generally 1% to 3% less than the final principal depending on the loan. This upfront price discount is generally considered additional interest income and is amortized over the life of the loan. In addition, middle-market loans receive fees for early loan prepayments, which can total a one-time 1% to 2% of the loan.
Middle-market loans are generally not rated, are considered non-investment grade and are not publicly traded. However, that doesn’t necessarily make them riskier from a credit perspective. For example, the average recovery rate for U.S. middle market senior loans between 1989 and 2018 was 75%—far higher than the 56% for senior secured bonds. As another example, while private debt default rates never rose above 2% in 2020 (during the COVID crisis), leveraged loan and high-yield bond default rates were around 4% and 10%, respectively. However, because direct private loans are not liquid investments, they carry an illiquidity premium, resulting in yields that are generally significantly higher than traditional broadly syndicated bank loans and publicly traded high-yield bonds. For example, 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. (The CDLI is an index, and it is not possible to invest directly in this index.) As of the end of the first quarter of 2022, the CDLI was yielding about 8.1%, 2.1 percentage points higher than the 6.0% yield of the Bloomberg High Yield Bond Index.
The high yields along with the relatively low default losses in its 2021 Q4 Report on U.S. Direct Lending, Cliffwater reported that realized losses since inception in 2004 were just 1.1% per annum) combined with the elimination of term (duration) risk—all loans are based on floating rates—have attracted investors.
Middle-market risks vary
Investors in middle-market loans can preselect the types of risks they want to take. For example, many investors choose what is generally accepted to be the least risky senior secured loans. In addition, loans backed by private equity firms (sponsored) generally have lower yields than those offered by non-sponsored borrowers because they are perceived to be less risky. Second-lien or mezzanine loans generally have higher yields compared to senior-secured loans, all else equal. Individually, these characteristics can account for yield differences of up to 2% or more. As expected, higher-yielding loans generally come with higher volatility, higher realized losses and higher management fees. In addition, private funds focused on senior-secured loans often use one to two turns of leverage, meaning gross assets are two to three times the amount of contributed equity investment in the fund, to enhance returns (while increasing volatility).
In its 2021 third quarter report, Cliffwater reported that since inception in September 2004, the Cliffwater Direct Lending Index (CDLI) had provided a net return (after realized and unrealized losses of 1.3%) of 9.5% per annum, 8.3 percentage points above the return on one-month Treasury bills – higher than the annualized equity premium has been over the long term and with far less volatility (though limited liquidity). Such returns have attracted investors, especially those concerned about inflation risk. In recent years, an important protection to lenders has been the interest rate “floor” generally associated with middle-market loans. A typical reference rate (such as SOFR) floor is 1%, protecting investors from zero or negative interest rates.
Until recently, investor access to middle-market corporate loans has been largely limited to institutional investors who allocate to alternative lenders through private partnership vehicles with high minimum commitments. Fees are not cheap, even for institutional investors, with asset-based fees averaging 1.0% to 2.0% combined with incentive fees ranging from 10% to 20% of interest income and net realized capital gains.
Business development companies (BDCs)
Smaller investors have been able to access middle-market loans only through private BDCs or exchange-traded BDCs. These SEC-registered vehicles offer attractive dividend yields, ranging from 7% to 10%. However, price volatility is high for the exchange-traded BDCs. And according to Cliffwater, fees average close to 4.75% of net assets.
Interval funds are a more recent option for accessing middle market loans. These are SEC registered investment funds designed to provide investors liquidity that better matches the underlying liquidity of fund assets by offering investors contractual liquidity, typically quarterly, with minimum liquidity amounts ranging between 5% and 25% of fund assets at each quarter’s end. In other words, if an investor sought full liquidity, he or she would be fully redeemed during such quarterly offering; however, if all other investors sought liquidity, he or she would be capped at the 5% to 25% pro rata amount during the redemption period.
In its 2022 Study on Private Fund Fees & Expenses for Direct Lending, Cliffwater updated its fee survey for investment management services for middle-market corporate lending, covering 49 of the largest direct lending firms managing $541 billion in direct lending assets. Following is a summary of its findings:
- Fees for private partnerships averaged 3.14% of net assets, up from 3.00% the prior year.
- Fees as a percent of net assets varied considerably across managers, ranging from 2.22% (10th percentile) to 4.15% (90th percentile).
- Thirty-five of the 49 direct lending managers (71%) charged fees on gross assets (GAV); the remaining 14 managers based their management fees on net assets (NAV).
- Manager use of portfolio leverage and greater exposure to lower middle market or non-sponsor borrowers were associated with higher fees, while greater exposure to first lien loans, sponsor-backed loans and larger loans were associated with lower fees.
- In a separate survey of direct lending partnership expenses, covering administrative, professional and other expenses, they found that expenses averaged 0.42% of net assets, bringing total direct lending fees and expenses to 3.56% (3.14% plus 0.42%).
The following table presents an “apples-to-apples” fee measurement protocol to better compare managers who have different fee structures. For example, some managers charge their management fee on net assets (not charging on the levered assets), while others charge on gross assets. And some managers charge a performance fee above a hurdle rate, while others do not.
The table shows one of the main reasons why my firm, Buckingham Strategic Wealth (BSW), looks at the Cliffwater Corporate Lending Fund (CCLFX) if a client desires to access the asset class. BSW believes its expenses are generally below that of the average fund, it charges on net assets, and it does not include any incentive fees. Other reasons include a very strong due diligence process in its manager selection (see chart at end), its high credit standards (focusing on senior secured loans backed by private equity firms) and broad diversification across managers with long track records in specific industries.
Performance of CCLFX
From inception in June 2019 through January 2022, the fund returned 8.64% per annum. By comparison, liquid loans, as represented by the SPDR Blackstone Senior Loan ETF (SRLN), the largest fund of its kind with assets under management (AUM) of $9.8 billion, returned 5.3% per annum; the index fund focusing on senior secured floating rate bank loans, Invesco Senior Loan ETF (BKLN) with $5.1 billion in AUM, returned 2.7%; and investment0grade bonds, as represented by the iShares Core U.S. Aggregate Bond ETF (AGG) with $88 billion of AUM, also returned 2.6% per annum.
As of the end of January 2022, CCLFX was yielding 7.3%. Compare that to the 3.9% yield of the Vanguard High-Yield Corporate Fund (VWEHX), the largest fund of its kind with $28 billion in AUM, which has similar credit risk. CCLFX had a 3.4 percentage points higher yield while it also minimized term risk because its loans are all floating, whereas VWEHX has an effective duration of about 4.5 years. As of this writing (February 24, 2022), in the Treasury market that difference in maturity (one month versus 4.5 years) would require an incremental yield of about 1.75%. Despite investors demanding a term premium, CCLFX yielded 3.4 percentage points more. The trade-off of that significantly higher yield and minimization of term risk is that investors sacrifice the daily liquidity available in VWEHX, BKLN and AGG.
For investors who don’t need liquidity for at least some portion of their portfolio (which is true of most investors), this is a very worthwhile trade – while not exactly a free lunch, it is at least a free stop at the dessert tray. For example, consider the retiree who is taking no more than their required minimum distribution (RMD) from their IRA account. Even at age 90, the RMD is not even 10%, and interval funds are required to meet liquidity demands of at least 5% every quarter. For such an investor, the illiquidity premium is worth considering.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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