The Opportunity in Private Corporate Credit Investing
For traditional fixed-income investors seeking higher yield and/or inflation protection, private, senior secured, sponsored debt provides an attractive alternative.
Private, floating-rate corporate debt – debt that is originated without the use of a bank or other financial intermediary – is one of the fastest growing alternative asset classes, right behind private equity, as it provides both higher yields and an inflation hedge. The growth of the private credit market exploded after the global financial crisis of 2008-2009 as private credit rushed to fill the gap that the banking industry was no longer able to fill because of the distress of its balance sheets. Tightened capital standards made loans to middle-market companies unattractive for banks, shutting out most small- and middle-size companies from the bank 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.
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 only $4.4 trillion invested in private equity. Further fueling the growth of the market was the historically low level of interest rates – private credit offered the potential for higher returns in exchange for giving up liquidity. Further impetus was provided by concerns about the risks of rising inflation – private credits are floating rate (with reset dates typically of either one or three months), thus offering a lower level of volatility than traditional fixed-rate debt, and the shorter duration offers inflation protection. And finally, in recent years there has been a trend in the publicly traded institutional loan market toward less creditor downside protection as more covenant-lite loans were originated. By October 2021, covenant-lite loans represented about 91% of the institutional loan market and 86% of outstanding leveraged loans in the S&P/LSTA Leverage Loan Index, according to S&P Global. Thus, private credit not only offered higher yields but superior credit protection in many cases.
Corporations also found 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 for management to do a workout with only one or a few lenders compared to a large number of lenders in a public bond offering.
The risks associated with investing in senior (first lien), secured (collateralized by the firm’s assets), sponsored (backed by private equity firms) private corporate debt funds are the same as those with publicly traded corporate debt regarding credit risk and credit-spread risk (the risk that spreads widen). Private credit does entail a third risk of illiquidity. Various risk premiums related to private credit have been estimated by Cliffwater, an investment adviser and fund manager specializing in alternative investments:
- Broadly syndicated loans – a credit risk premium.
- Directly originated, upper middle market – a liquidity risk premium.
- Non-sponsor borrowers – a governance risk premium.
- Lower middle market – a size risk premium.
- Second lien, subordinated debt – a seniority risk premium.
The table below converts Cliffwater’s estimated risk premiums to yields (as of March 2022):
The risk premiums are additive, starting with the risk-free rate as measured by the rate on U.S. Treasury bills. For example, as of March 31, 2022, Cliffwater estimated the total risk of the five risk premiums to be 13.5%. Just like all risk premiums, these five premiums are time varying. For example, Cliffwater found that disregarding the risk-free rate, the sum of all five premiums declined from 15.95% on June 30, 2016, to a low of 12.09% on June 30, 2019. However, spread compression had reversed, with risk premiums collectively rising to 13.5% at the end of March 2022. It is also important to note that from a risk perspective the CDLI is broadly diversified by industry:
There is one other risk issue we need to address. While private loans made by asset managers or nonbank lenders typically have a five- to seven-year maturity, their effective life is much shorter due to repayments. The following chart shows that the effective life is typically only around 2-2.5 years, although in periods of crisis, repayments dry up as merger and acquisition activity slows, resulting in effective life lengthening. The shorter average effective life reduces the risk of defaults and credit losses.
Having reviewed the risks, we now turn to examining the benefits.
The following are among the benefits of senior, secured, sponsored private credit:
- Significantly higher yields than public debt (higher yields don’t guarantee higher returns).
- Inflation protection due to the floating-rate nature of the loans (with either one- or three-month reset dates).
- Improving diversification by adding an illiquidity premium, resulting in lower correlation with stocks and traditional bonds, and lower correlations than if using broadly syndicated loans or high-yield debt.
- Greater credit protection against credit risk:
- o Compared to publicly traded corporate debt, private loans have seniority.
- o Private loans are typically collateralized and have two types of covenants that protect creditors: incurrence covenants, which protect creditors against the borrowing company taking on additional debt; and maintenance covenants, which protect creditors against management action that would increase leverage in the capital structure or violate a debt coverage measure such as the debt service coverage ratio or the interest coverage ratio.
- o The private equity sponsor may provide support for the company receiving the loan to protect their equity investment.
The following table from a 2018 study by Nuveen shows the superior credit performance of private middle market loans in general. Note the lower default and loss rates as well as the higher recovery rates on middle market loans as compared to broadly syndicated loans and high-yield bonds. Senior, secured, sponsored middle market loans have experienced a better credit history.
For investors who don’t need liquidity for all their assets, the trade-offs have historically been very favorable. For example, the research team at Nuveen that authored the 2018 study “Private Debt: The Opportunity for Income and Diversification with Illiquid Assets” concluded that the inclusion of private debt enhanced the risk-adjusted performance of a portfolio that included only the traditional asset classes of public stocks and bonds. They also found that even constraining private debt to a practical fixed allocation, risk-adjusted performance still improved.
Thanks to Cliffwater and its 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 for 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 we see in the chart below:
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. Note that 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. Note also the lower realized and unrealized losses incurred by the CDLI-S.
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 the 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.
Investors interested in implementing a senior, secured, sponsored private credit strategy should consider the Cliffwater Corporate Lending Fund (CCLFX), an interval fund. As of the end of July 2022, the fund had $8.8 billion in assets under management. Using the backtest tool from Portfolio Visualizer, from inception in July 2019 through August 2022, the fund returned 8.4% per annum with a standard deviation of just 2.2%, producing a Sharpe ratio of 3.25. The worst-case drawdown, which occurred during the COVID-19 crisis, was only 2.2%. As of the end of July, the current yield was 8.4%. The expense ratio (ER) was 1.64%. Cliffwater does use leverage within CCLFX (the regulatory maximum is 0.5 times net assets). However, fees are applied only to net assets, not gross assets; fees are not applied to levered assets. Assuming 30% leverage (the fund’s long-term target average), the 1.64% ER becomes 1.26 (investors are paying $1.64 per $100 of their assets, but the fund would have $130 of assets, and $1.64 on $130 of assets is 1.26%). Thus, the effective ER is 1.26%, not 1.64%. In contrast with many other direct lenders, CCLFX does not charge a performance fee.
The following chart shows the fund’s return compared to two relevant benchmark indices:
In addition to comparing CCLFX’s return to that of the two benchmarks, we can also compare its returns to the Bloomberg U.S. Aggregate Bond Index, which returned -0.13% per annum, and to the return of the Bloomberg U.S. High-Yield Bond Index B, which returned just 1.39% per annum. And finally, we can compare CCLFX’s 8.11% per annum return to that of Invesco’s Senior Loan ETF (BKLN), which invests in senior secured syndicated bank loans with floating rates. As an ETF, the fund is daily liquid and has an expense ratio of 0.65%, significantly lower than the stated expense ratio of 1.64% for CCLFX. From inception in July 2019 through August 2022, CCLFX returned 8.4% per annum with a standard deviation of just 2.2%, while BKLN returned just 2.8% with a much higher standard deviation of 6.2%. The difference in returns to a great degree reflects an illiquidity premium.
Limited liquidity of interval funds
As an interval fund, CCLFX provides limited liquidity (at intervals). While purchases can be made on any business day, redemptions can be requested four times per year, in the first month of each quarter. Any individual investor can request a 100% redemption. The fund will meet redemption requests of all investors in full if they total not more than 5% of net assets. If quarterly redemptions amount to more than 5% of assets and sufficient liquidity is not available to meet the redemptions, available cash will be prorated across redeeming investors.
Senior, secured, sponsored private credit can be an attractive asset that provides current high yield while also providing protection against the risks of rising inflation. In addition, the asset class has a strong credit history. For those investors who don’t need daily liquidity for at least some significant portion of their portfolio (likely true for almost all investors), the currently very large illiquidity premium, while not a free lunch (there is credit risk), can be viewed perhaps as a “free stop at the dessert tray”!
Larry Swedroe is the chief research officer of Buckingham Wealth Partners and Buckingham Strategic Wealth.
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