How Private Debt is Reshaping Institutional Portfolios
Many have called the current high interest rate environment the “Golden age of private credit”. The yield on senior loans to medium sized companies in Europe currently stands at 10-12%1 in EUR. Such high returns compete with private equity in relative attractiveness and exceed the average return obtained on public equities. It is therefore not surprising that private debt is attracting a lot of attention.
While these might be exceptional times, the persistent inflation will require higher interest rates for a prolonged period. Additionally, stringent bank regulations and their reluctance to take risk will result in continued demand for private credit. In this article we discuss the growth and adoption of private credit in institutional investor portfolios.
Corporate direct lending, the largest subcategory of private debt, involves the credit provision to small and medium sized enterprises without an intermediator (hence “direct”). The asset class has only truly emerged after the Global Financial Crisis of 2008. This was a result of tighter lending standards and regulatory scrutiny on the banks. Alternative credit providers have filled this void in the market. The emergence of private equity as an attractive asset class (and also the main source of deal flow for private credit) has further added volume to the direct lending market.
1 Past performance is not a reliable indicator of future results.
Meanwhile, direct lending has grown to a size of USD 1.6 trillion, currently comparable in scale to the global high-yield market.
Direct lending can achieve an attractive yield of more than 10% in EUR in the current market environment2. The yield for these loans are composed of a floating base rate such as EURIBOR (or LIBOR for GBP loans) and a spread of 550-650bps. In addition, investors receive a one-off underwriting fee (OID) of typically 2-3%. Over the long run these loans have provided a 9.4% average return in USD (see chart below).
2 Past performance is not a reliable indicator for future results.
The oldest index representing direct lending is the Cliffwater Direct Lending Index tracking more than 14’000 loans in United States since 2004. The index has delivered 9.4% annualized return in USD since inception. As seen from the chart above direct lending index tracks the equity performance, albeit with a lower volatility and lower drawdowns.
Adding direct lending to a typical institutional portfolio (60% equities, 40% bonds) can lead to improved risk adjusted returns. As seen from the chart above, addition of 10% corporate direct lending reduces portfolio volatility while maintaining the returns stable. It is important to note that addition is done by using the equity budget while keeping the fixed income share of 40% unchanged.
While the private debt market offers more attractive risk adjusted returns than the public markets, the dispersion is much wider. According to the Preqin database, direct lending funds with vintages ranging from 2012 to 2019 exhibited a net IRR (Internal Rate of Return) of 10.7% to 6.6% spanning the first and third quartiles. The bottom performing funds delivered a net IRR of -4.8% during this relatively benign period. Therefore, a careful manager selection and monitoring is key.
When measuring the returns it is crucial to distinguish between IRR and return on capital. While IRR is often used as the primary measure of fund performance, we advocate for a greater focus on return on capital. IRR is subject to the timing of cash flows and is also known as the Time Weighted Return (TWR). Closed-end funds excel at boosting IRR by optimizing capital calls and distributions, but they fall short in delivering returns on committed capital. The following example clarifies this.
It is assumed that both funds invest into loans providing 8.0% return and that the loans are held at cost (i.e. no mark-to-market volatility). While both produce an IRR of 8.0%, the evergreen fund produces a total return on capital (RoC) of 1.76x vs 1.41x for the closed-end fund. In other words the evergreen fund could produce the same total return as the closed-end fund even if the underlying investment return were only 4.3%.
While evergreen funds improve the return on capital, investors should be mindful of liquidity provisions of these funds. Some solve it by providing limited redemptions every quarter resulting in liquidity mismatch. Such mismatches can lead to funds suspending redemptions in times of crisis. We believe that the most suitable solution, which matches the liquidity of the fund with the underlying investments, is the creation of run-off share classes.
The asset class currently offers 10-12% returns1 in EUR with lower volatility than High Yield bonds. The introduction of direct lending into investment portfolios can decrease portfolio risk while keeping the returns unchanged. Furthermore evergreen allocation instead of a closed-end fund approach can result in as much as 60% higher return on capital.
Considering the current macroeconomic environment this might be one of the more attractive times to invest in direct lending. Baloise believes this market including its unique features is here to stay and should be considered as a building block of a long term strategic asset allocation.
To maximize the benefits of investing in direct lending, investors should consider the following points:
- This asset class can offer strong risk adjusted returns and diversification potential.
- To mitigate return dispersion, careful due diligence and manager selection is needed.
- An evergreen exposure allows for efficient capital use through recycling.
1 Past performance is not a reliable indicator of future results.
Author
Viktoras Vatinas
Senior Portfolio Manager
Mail