Stockholm (HedgeNordic) – The direct lending market has grown considerably since the financial crisis and institutional interest in the market continues to grow in the age of diminished expectations for other asset classes. One challenge for the investors considering to allocate capital into direct lending has been the absence of databases containing lending data, which limits their ability to estimate the risk-reward characteristics of the asset class for asset allocation purposes. This article reviews some published data on net-of-fees returns, default and recovery rates in the direct lending market.
How did direct lenders fare since the financial crisis?
The expansion of the direct lending market provides investors with new opportunities to earn returns ranging from mid-single digits to the high teens and higher. Just as with other private markets, however, tracking the market activity, performance, and default rates in the direct lending market is no easy task. The Cliffwater Direct Lending Index, which measures the unlevered net-of-fees performance of middle-market corporate loans in the United States offered by business development companies (BDCs), can give an indication of how the asset class has performed in recent years.
The Cliffwater Direct Lending Index, which tracks the performance of more than 6,000 loans with a combined value of $94.3 billion as of June 2018, generated an annualized return of 9.8 percent since the beginning of 2005 through June of this year. The historical performance of the index reflects three main components: income returns, which include contractual interest payments and price discounts direct lenders receive at loan issue; unrealized gains or losses stemming from changes in loan values as determined by valuation agents; and realized losses, losses on loan-specific defaults and recoveries that result in the write-off of the loan principal.
Historically, returns on direct lending have been less sensitive to movements in interest rates, but rising rates can lead to higher default rates among borrowing middle-market companies. Evaluating the return target of direct lending deals, vehicles or products, therefore, may not be enough. Investors need to examine the sources of direct lending returns by assessing possible default rates and recovery rates on assets invested in defaulting borrowers. This is particularly relevant in a rising interest rate environment, as many market observers including ratings agency Moody’s affirm that the strong demand for floating-rate leveraged loans in recent years has eroded credit quality and will result in an increasing number of defaults (and lower recovery rates) in an eventual economic downturn. Again, history can provide an indication of how the loans issued in the direct lending market will perform going forward.
The realized losses on the loans tracked by the Cliffwater Direct Lending Index averaged 1.1 percent per year since the beginning of 2005 through the end of last year, with realized losses peaking at 6.9 percent in 2009. Realized losses gradually leveled off from 3.0 percent in 2010 to zero in 2014, but losses started to pick up again starting with 2015. Realized losses increased from 0.7 percent in 2015 to 1.7 percent in 2017, with no signs of abating so far this year. Direct lending deals are associated with obvious credit risks, but annual income returns of 11.3 percent on average may well offset the downside stemming from loan defaults and write-offs.
Different sample, similar returns
The Cliffwater Direct Lending Index reflects the performance of direct loans only issued by business development companies, which are estimated to account for one-fifth of the direct lending market. Since BDCs form a relatively small sample of the overall direct lending market and represent only one type of direct lenders, other indicators may offer a more accurate picture of the market.
In a research paper “Performance of Private Credit Funds: A First Look” published in May of this year, several researchers evaluate the performance of a group of 476 institutional-quality private funds from the Burgiss database, including a subset of 155 direct lending funds, over the period of 2004 to 2016. The researchers found that direct lending funds earned an annual return of 9.2 percent in the 12-year period through the end of 2016 with a standard deviation of two percent. This compares with an average annual return of 7.4 percent and a standard deviation of 5.6 percent for the entire sample of private credit funds. In addition to direct lending funds, the cluster of private credit funds also includes distressed, mezzanine, generalist vehicles, among others.
The researchers also show that the correlation between the subset of direct lending funds examined in the study and the aforementioned Cliffwater Direct Lending Index stood at only 0.59 over the period of 2004 to 2016, which might indicate that the Burgiss database and the Cliffwater index are comprised of different components. Despite the relatively low degree of correlation, the direct lending funds included in both databases tend to exhibit similar returns over a long enough period of time.
Expectations from direct lenders going forward
The role of direct lenders is twofold. First, they represent a source of financing for small- and medium-sized firms seeking tailored lending solutions. Second, direct lenders offer investors a diversifying source of higher, less volatile (and perhaps, riskier) returns over a longer-term investment horizon. With interest rates slowing picking up, enthusiasm for direct lending products will likely endure. But what returns should investors anticipate from the asset class?
Expected returns from the asset class of direct lending are seen reaching high-single digits in the next decade. Investment advisor Cliffwater expects the private credit asset class to generate an average annual return of seven percent in the next ten years, with the asset class anticipated to eclipse the performance of both U.S. equities. Multi-family office Omnia Family Wealth also anticipates private credit to generate higher annual returns than U.S. equities and hedge fund vehicles in the next ten years. The ten-year expected return for private credit equals seven percent, whereas the expected returns for U.S. equities and hedge funds stand at 6.5 percent and 6.1 percent, correspondingly.
The search for defensive plays against escalating geopolitical risks, rising interest rates, and diminished expectations in other high-returning asset classes such as equities may continue to drive investor appetite for direct lending products. High-quality direct lending products can provide a combination of current income and protection against market-to-market volatility, but the risks associated with direct lending should not be overlooked. After all, default rates appear to be on the rise and interest rates have just started to pick up.
