The great financial crisis triggered a tightening of banking regulation, which made loans to middle market companies unattractive for banks, shutting out most small- and mid-size companies from the banking market. In addition, the 2010 enactment of the Dodd-Frank Act made it increasingly expensive for small banks to operate, cutting off their supply of loans to small and mid-size companies. Private debt funds and collateralized loan obligation funds (CLOs) are two of the major types of non-bank intermediaries that stepped in to fill the gap.
Preqin, the foremost provider of data for the alternative asset community, estimated that at the end of 2021 private credit had about $850 billion in assets, behind the $4.4 trillion invested in private equity. Despite this large and increasing size in the U.S. and Europe, there is relatively little research on the private debt market, particularly compared to the bank and syndicated loan markets. The lack of information motivated Jorn Block, Young Soo Jang, Steven Kaplan and Anna Schulze to survey U.S. and European investors, primarily direct lending funds: 38 U.S. funds with assets of $136 billion and 153 European funds with assets of €180 billion (a combined total of more than one-third of Preqin’s estimate of the total market). The survey was conducted over the period August-September 2021. They asked the general partners (GPs) how they sourced, selected and evaluated deals, how they think of private debt relative to bank and syndicated loan financing, how they monitored their investments, how they interacted with private equity (PE) sponsors and how they viewed the future of the market.
They began by noting: “While there is no standard definition of private debt, we refer to private debt funds as investors that raise capital commitments through closed-end funds (like private equity) and make senior loans (like banks) directly to, mostly, middle-market firms. CLOs, in contrast, invest in syndicated loans that are typically arranged by a large commercial bank.”
Following is a summary of their findings:
- Respondents were very experienced, with a majority indicating they had more than 15 years of financial industry experience and at least 12 years in the private debt industry. The U.S. GPs tended to have more experience in private debt than the European GPs, with a mean number of years of experience in private debt of 12.8 versus 9.9, respectively.
- The average U.S. private debt investor spent 100 hours conducting due diligence per deal. The 100 hours was of a similar order of magnitude to the due diligence reported by venture capital firms.
- The largest capital suppliers to the funds were insurance companies, pension funds and high-net-worth individuals.
- The private debt market was different from, but shared characteristics with, the bank loan and syndicated loan markets.
- Roughly 25% of the U.S. respondents and 40% of the European respondents were affiliated with a PE firm; 45% of the U.S. respondents had a business development company (BDC), although they usually also had other funds.
- In the U.S. sample, 45% of the funds were BDCs, which are somewhat different from non-BDCs in that they are significantly larger with more private debt experience. They also targeted modestly (but not significantly) higher leverage.
- U.S. funds were primarily focused on buyout loans with secondary roles for recapitalizations and refinancings, markedly different from the debt purposes of European investors that were spread relatively evenly among buyouts, expansion and capital expenditure financing.
- Mean loan sizes were different, being markedly higher for the U.S. funds ($226 million) than for the European funds (€70 million).
- Both the U.S. and European funds typically provided loans with five to seven years maturity.
- Primarily provided cash-flow-based loans and believed they financed companies and leverage levels that banks would not fund.
- Primarily targeted profitable, modestly sized companies in a number of industries – the five leading industries were healthcare and life sciences, high tech (e.g., software/IT), industrial/manufacturing, consumer products, and media and telecommunications.
- Targeted firms of roughly similar size, with the U.S. managers averaging $289 million in revenue and 1,026 employees and the European managers averaging €170 million in revenue and 797 employees. Both sets of managers also targeted firms with meaningful operating margins, averaging 27% and 25%, respectively.
- Targeted unlevered returns with substantial premiums over the comparable risk-free Treasuries and BB-rated bonds that appeared high relative to their risk. The mean unlevered targeted internal rates of return in Europe and the U.S. were similar, at 8.70% and 8.16%, respectively. At the time of the survey, the German five-year bonds had interest rates of -0.7%; U.S. five-year Treasury notes had interest rates of roughly 0.8%; and U.S. BB-rated bonds, which are unsecured and of longer duration, had rates of roughly 3.2%. These risk premiums are more similar to equity risk premiums than bond premiums. Assuming total annual fund fees of roughly 3% would still leave an equity-like risk premium.
- Targeted gross levered returns of 9.55% (European funds) and 11.18% (U.S. fund) – reflecting the fact that the U.S. investors used more leverage in their portfolios.
- Used leverage, but appreciably less than banks and CLOs – 95% of U.S. funds used nonzero leverage, with an average leverage of 42% (median of 25%) of total capital, but generally did not exceed 60% of total capital (13% of funds). This was significantly less true of European funds – leverage averaged only 11% of total capital, with 67% of funds not using any leverage.
- Used and negotiated for both financial and incurrence covenants to monitor their investments, and the presence of private equity (PE) sponsors helped them lend more and craft more effective covenants. They also monitored their investments with periodic meetings and updates of financial statements and appeared to monitor them more frequently than did banks. The two most important negative covenants for U.S. debt managers, chosen by almost 80%, were limitations on “incremental debt” and restricted “payments,” implying that private debt lenders were concerned with risk shifting in the form of claim dilution or cash diversion. The European debt managers also reported that they negotiated negative covenants, but they varied more across the different types, with roughly 60% focusing on “payments,” 60% on “asset sales,” only 45% on “incremental debt” and almost 50% on “prepayment transactions.”
- U.S. and European funds were similar on many dimensions, but U.S. investors sourced largely from PE-sponsored deals (78%) and prioritized stable cash flows, while European investors sourced both from PE sponsors (42%) and independently (competing with banks), and considered management, the business and cash flows more equally – more like PE investors. Because PE sponsors are actively involved in firm operations and governance, their presence may have mitigated U.S. lenders’ concern over mismanagement. Lenders’ interactions with the PE sponsors helped with deal quality, with deal sourcing, and in reducing information costs (through repeated interactions), allowing private debt lenders to craft more effective covenants.
Why companies borrow from private lenders
In addition to private lenders providing access to credit that banks will not fund, corporations find benefits in private lending that are sufficient to offset the higher yields. Those benefits include:
- Speed of execution.
- No mandated public disclosure of proprietary information.
- Less ongoing disclosure requirements required for fundraising in the public market.
- Avoiding the time-consuming and expensive process of obtaining a rating from one or more of the rating agencies.
- The ability to customize the loan structure to meet the particular needs of the borrowing company, offering management greater flexibility.
- A borrower facing financial difficulties will find it is easier in a private debt transaction (with only one or a few lenders) for management to do a workout compared to a public bond offering (with a large number of lenders).
Historical credit loss evidence
Thanks to Cliffwater and its Cliffwater Direct Lending Index (CDLI), an asset-weighted index of more than 9,000 directly originated middle market loans totaling $223 billion as of March 31, 2022, we can review the historical performance of private direct lending:
The following chart shows the returns over trailing four quarters since inception:
By way of comparison, over the period September 2004-March 2022, while the CDLI returned 9.46%, the Bloomberg U.S. Aggregate Bond Index returned 3.58% and the Bloomberg U.S. High-Yield Bond Index B returned 6.08%.
The following chart shows the historical cumulative and annualized net unrealized gains and losses for the CDLI since inception in September 2004. An important observation related to unrealized losses and loan valuation is that unrealized loan write-downs in times of severe stress, like 2008 and 2020, have exceeded subsequent realized losses by more than twofold. Said differently, if unrealized losses reflect expected future realized loan losses, then valuations have been very conservative (high unrealized losses) relative to subsequent realized loan impairments. That is exactly what is seen here:
We now turn to examining the performance of the CDLI-S, which includes only senior secured loans.
The inception date for the CDLI-S was September 30, 2010 (compared to September 30, 2004, for CDLI), which is attributable to the post-2008 introduction of most senior-only direct lending business development company strategies. The following charts compare the returns of the CDLI-S from inception through March 2022 to those of the broader CDLI. The lower returns were accompanied by lower volatility, as the standard deviation of returns for the CDLI-S was 2.4 versus 3.0 for the broader CDLI. CDLI-S also incurred lower realized and unrealized losses.
Over the same period, September 2010-March 2022, while the CDLI-S returned 8.05% and the CDLI returned 9.80%, the Bloomberg U.S. Aggregate Bond Index returned just 2.52% and the Bloomberg U.S. High-Yield Bond Index B returned just 6.08%. The CDLI and CDLI-S indices produced significantly higher returns than the two credit indices and did so with lower levels of risk. The volatility of CDLI and CDLI-S was just 3.0% and 2.4%, respectively, versus 3.2% and 6.6% for the two credit indices. In other words, they were both much more efficient in delivering risk-adjusted returns, producing higher Sharpe ratios.
Private credit can be an attractive asset that has provided high yield and protection against the risks of rising inflation. In addition, the asset class has a strong credit history – specifically senior, secured, sponsored debt.
Larry Swedroe is the head of financial and economic research for Buckingham Wealth Partners.
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