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The window of opportunity to invest in Direct Lending
Strong fundamentals and technicals provide momentum for the Direct Lending segment of Private Debt
The Private Debt (PD) market has experienced significant growth since the global financial crisis and now boasts a market size rivaling its public market peers – broadly syndicated leveraged loans and high yield bonds. In this article, we compare the characteristics and main drivers of valuations for a key pillar of the private debt market, senior Direct Lending, with public debt. We also outline our conviction in its current investment prospects.
Higher reference rates have provided the largest marginal contribution to prospective returns, while credit spread risk premium has remained largely stable. We are constructive on the ultimate credit risk facing Direct Lending due to a demonstrated ability of established lenders to work out and restructure troubled credits, therefore pro forma loss-adjustment to current yields should be contained. Overall, therefore, investors in Direct Lending should be amply rewarded for allocating to contemporary vintages and avoiding the lower issuance and higher realized losses facing public credit markets.
Chart 1: Private Debt market development
Source: Klarphos, Preqin & Fitch, as of Dec 2022
Before comparing Private Debt with public market debt, it is necessary to more precisely define our terminology. Private Debt consists primarily of 1st-lien senior, bilateral loans to privately-held companies (so called senior Direct Lending or ‘DL’). While there are other significant segments within PD such as Mezzanine, Opportunistic, and Asset-Based Lending, this article will focus on this largest component of DL. Traditionally used to finance small and medium-sized companies (i.e., $10 million to $100 million in EBITDA), the DL market can be further split into loans to core middle market borrowers (‘MM’, $25-100 million EBITDA) and credit extended to lower middle market entities (‘LMM’, below $25 million EBITDA).
In recent years, upper-middle market companies (‘UMM’, above $100 million EBITDA), which typically relied exclusively on public credit markets for capital, have increasingly utilized PD as a funding source. This is largely driven by PD’s high level of customization and fast, reliable, and confidential execution. The trend of increasing deal sizes has also been observed in the PD space in recent years.
Private Debt financing can be divided into sponsor-backed and non-sponsor-backed lending. Sponsor-backed lending pertains to loans originated to companies which are owned by a private equity firm. Since the start of the pandemic, sponsor-backed lending accounts for the lion’s share of total PD lending at 80-90% (Source: Deloitte Private Debt Deal Tracker Spring 2023; S&P Leveraged Commerntary & Data (LCD)). Turning to public market debt, the broadly syndicated leveraged loan market (‘BSL’), historically the primary financing source for large buyout deals, consists of 90% broadly syndicated loans and 10% large mid-market loans. Both leveraged loans and high-yield bonds (‘HY’) are issued via syndication, have ratings from major agencies, and offer reasonable secondary market liquidity under normal market conditions.
An unambiguous distinction does not exist between the public and private credit markets, as an increasing number of UMM borrowers use PD as financing means in addition to traditional public market capital solutions.
(Melissa & Doug, a US toy producer and traditional BSL borrower, tapped PD in early April 2023)
Table 1: Key features of Private Debt and comparable asset classes
Source: Klarphos June 2023
Double digit returns with stable risk premia
Senior Direct Lending yields have recently returned to double digit territory of 10-12%, while prospective returns for high yield and leveraged loans have increased to 8.7% and 9.8% respectively, as of June 2023 (Source: Bloomberg US High yield Index and Morningstar LSTA US Leveraged Loan 100 TR USD). The main contributor to higher PD returns has been the increase in the policy rates. Over the past 18 months, SOFR has increased by 500+bps in the US while Euribor has moved by 415bps in Europe (Source: Bloomberg, 3 month Sofr and Euribor, from 3rd Jan 2022 to 30th June 2023).
In the current high-return environment, investors need not to be so dependent on tactical trading or capital recycling for performance generation; instead, they can put more focus on strategic asset allocation. To that end, Direct Lending stands out as an asset class with low correlation to other public market asset classes, and as an all-weather source of return.
Chart 2: Total return history of credit indices
The current macro regime further strengthens the case for Direct Lending vis-à-vis public market alternatives. A persistently elevated discount rate is detrimental to both fixed coupon bonds and equity valuations over the medium- and long-term; the mark-to-market of liquid and publicly-traded securities in investors’ portfolio holdings can lead to a near-term negative impact on portfolio returns.
Primarily issued as floating-rate loans, Private Debt has limited duration risk and is not subject to mark-to-market. It is, therefore, particularly compelling for investors to gain exposure in the current regime. Leveraged loans carry mark-to-market risk. PD loans are predominantly unrated assets, and therefore do not suffer the negative technicals that are triggered by rating downgrades. The risk premium for Private Debt remained stable over the recent quarters, compared to an approximately 180bps widening in leveraged loans from September 2022 to March 2023 (Source: Cliffwater Q1 US direct lending report).
While DL investors benefit the upside during rising rate environments, it should not to be forgotten that they also enjoy downside protection via rate floors which are usually negotiated into underlying bilateral loan agreements. At current rate levels, these embedded floors represent negligible option value; however, a floor could provide valuable return enhancement should monetary policymakers embark on aggressive easing if a recession occurs in the coming year(s). Indeed, investors should not dismiss the possibility that we could once again return to the low-rate environment of years past.
Chart 3: Development of PD risk premia
Source: Cliffwater Q1 US direct lending report
Lenders in the DL space are able to provide flexibility and bespoke solutions to borrowers and therefore earn a higher credit spread than similar public credit products. Cliffwater estimates that the risk premium between direct lending and BSL was 236bps as of Q1 2023, more or less stable relative to the prior two quarters and slightly lower than the peak level of 278bps before the hiking cycle started. The stability of such spreads suggest a well-balanced supply-demand dynamic in the Private Debt market, as highlighted by the relatively prodigious dry powder of 28% of the total $1.5 trillion PD market (Source: Preqin, as of Dec 2022).
Continuous balance sheet de-risking and regulatory overhaul led to a decade-long banking sector retrenchment from mid-market lending. Furthermore, the US regional banks’ turmoil in early 2023 further exacerbated the already lowered bank lending market share, creating an even larger financing gap between borrowers and traditional bank lenders. PD is in great position to benefit from this growth opportunity with tailwinds of high base rate returns.
Chart 4: Private debt return composition
Source: Cliffwater Q1 US direct lending report. Risk-free rate is 4 quarters trailing T-bill yield
Current Direct Lending risks – contained but must still be carefully treated
The recent increase of pro forma return in PD is not necessarily a reflection of commensurately higher credit risk. Even though the definitions of public and Private Debt can be subjective, one empirical difference lies in whether or not a loan is bilateral in nature. In turn, this feature can have significant impact on the risk profile and process of risk remedy. Private Debt allows the origination of bespoke loans between borrowers and lenders, resulting in loans that can be more closely monitored and managed. In times of financial distress, private lenders become directly involved in the work-out of troubled loans, providing restructuring or rescue means to either prevent default or maximize recovery value upon such an event.
In the case of HY and BSL, a majority of investors’ consents are typically required when documentation changes are needed. Such processes can be lengthy and costly for both borrowers and investors, and may prohibit any major renegotiation of loan terms to resolve borrowers’ financial stress. From 2005 to 2022, the Cliffwater Direct Lending Index annual average loss ratio was 1.04%, comparable to Fitch’s leveraged loan loss ratio of 0.99%, and significantly lower than Moody’s high yield loss of 2.35%.
In mid 1990s banks were the primary funding source for Corporates with 2/3rd market share, while non-bank lenders represent the other third; today, the situation has inverted with non-bank lenders providing 2/3rd of total corporate loan funding, while traditional banks represent the remainder.
Another key difference between public and Private Debt lies in covenants. PD loans typically enjoy full covenants, which define a set of borrower obligations during the life of a loan. There are three main types of covenants: affirmative covenants (defines what borrowers must comply with), negative covenants (defines limits borrowers must abide) and financial/maintenance covenants (defines the financial performance measures that borrowers must maintain on a regular basis).
Financial/maintenance covenants are crucial measures which may enable lenders to detect loan quality deterioration early. Breach of such loan covenants may lead to technical default and empower the lender with rights to reset loan terms and obtain greater influence over the borrower. While having financial/maintenance covenants are standard practice for PD loan facilities, HY and LL documentation is typically cov-lite. Such cov-lite loans are designed to be more borrower-friendly, protecting borrowers from credit deterioration by reducing or eliminating lender protections. Cov-lite documentation erodes lenders’ influence and control and may lead to lower recovery in case of financial stress.
PD lending standards are improving with generally tighter financing conditions in the market. For example, average leverage ratios decreased from 5-6x Debt/EBITDA, to 4 or 5X, lower LTV from 40-50% to 30-40%, and covenant protection on higher EBITDA business.
Despite favorable positioning relative to public credit markets, DL investors should be astutely aware that material risks will apply, even to vintages as attractive as the current one. In particular, interest coverage ratios (ICRs) will be challenged with all-in yields on credit so high. As waves of maturity walls come due in the coming two years, leveraged borrowers will face increasingly stringent financial conditions and default rates and severities may deteriorate significantly, even for Direct Lending GPs with savvy workout and restructuring capabilities.
Chart 5: Loss ratio comparison
Source: Moodys Annual default study – Corporate default rate 2023; Fitch Leveraged Loan historical default ratio and 2007-2021 average emergence price; Cliffwater Direct Lending Index (realized credit losses)
Liquidity considerations for Direct Lending
One common reservation with investing in Private Debt is its illiquidity. For public market securities, liquidity can be straightforwardly indicated by a security’s bid-ask spread, which is a dynamic measure that changes subject to market’s risk taking sentiment. Unlike in the public credit market, there is no market making in Private Debt. Some take the PD spread to public market securities (PD spread) as an indication of PD illiquidity risk premium.
Cliffwater shows the spread between BSL and PD at 236bps. In our view, this spread represents not only illiquidity risk premium, but also a complexity risk premium for lenders to provide a bespoke solution to borrowers. The PD spread reflects secondary market supply-demand, as well as the risk taking capability of the lender throughout different economic cycles. While in good times the liquidity of public market credit can be an added benefit, under stress, investors may lack the liquidity when it is most needed. A decrease in market liquidity often coincides with low risk appetite, which may trigger forced selling in securities that are subject to mark-to-market requirements. In contrast to public market debt, Private Debt is not subject to mark-to-market and in most cases is held to maturity. Private Debt can, therefore, enjoy an advantaged position to avoid a liquidity-driven valuation negative feedback loop.
The legal maturity of a loan is the final date by which a borrower must repay the entirety of principal due. In practice, corporate borrowers may choose to prepay their loan earlier, often subject to some penalty schedule, leading to a shorter effective loan life.Private Debt lenders tend to hold their loans until maturity or prepayment. The weighted average effective loan life was approximately 3 years over the past decade (Source: Cliffwater Q1 US direct lending report), much shorter than the 5 to 7 years legal final maturity of the loans.
A lower repayment propensity has been observed since the recent rate hikes, resulting in an increase in the effective life to approximately 5 years. The effective life of the underlying loans in the fund directly influences the distribution pattern of drawdown funds. Investors of drawdown funds need to manage recycling of capital and, as a result, bear reinvestment risk. An Evergreen Fund structure that provides investors regular access to liquidity can play a very beneficial role in smoothing the J-curve effect and providing a stable and targeted allocation in PD.
In recent years, secondary market trading in alternative funds has gained traction. A well-established secondary market benefits both buyers, who want exposure to a portfolio with visibility to avoid the J-curve effect, and sellers, who need to raise liquidity.
The March 2020 US Treasury Market Crisis and September 2022 UK LDI Crisis, despite having different trigger events, were both examples of even the most liquid market instruments having their limitations and quickly entering a downward spiral with mark-to-market mechanisms.
Low volatility and drawdowns in Private Debt is advantageous during market stress
Volatility is regime-dependent, and during bear markets volatility tends to spike more frequently and remains at higher levels than during benign environments. It is arguable whether the current market is on a recovering path or heading towards a double dip. Private Debt deserves to be on investors’ radars as an investment alternative providing all-weather returns.
With monthly or quarterly valuation frequency and the non-mark-to-market feature, Private Debt is, by design, less volatile than public market investments. In an unstable market with elevated rate levels, Private Debt and, senior Direct Lending in particular, serves investors well with stable high returns which are less impacted by outlier events. Drawdowns in Private Debt have been much shallower than those in high-yield and leveraged loans, for instance.
Chart 6: Risk reward diagram of credit markets
Source: Cliffwater, Bloomberg, Preqin, Klarphos; time period: September 30, 2004 to September 30, 2022; Data extracted as of March 1, 2023; Klarphos Opportunistic Credit Index is a simulated index, equally weighted using 50% Preqin Private Debt – Mezzanine Index and 50% Preqin Private Debt – Distressed Index
Chart 7: Historical drawdowns per asset class
Source: Cliffwater, Bloomberg, Preqin, Klarphos; time period: September 30, 2004 to September 30, 2022; Data extracted as of March 1, 2023; Klarphos Opportunistic Credit Index is a simulated index, equally weighted using 50% Preqin Private Debt – Mezzanine Index and 50% Preqin Private Debt – Distressed Index
Seize compelling investment window by allocating to Direct Lending
Direct lending has historically provided investors with both compelling return potential and downside protection in the form of sound capital preservation. In the current environment with high yields and strong deal documentation, direct lending investors are more-than-adequately compensated for bearing credit and liquidity risk.
Private Debt is expected to maintain its current growth trajectory and continue to fill the funding gap left by the ongoing bank retrenchment from broadly syndicated loans. A volatile high-rate environment creates structural tailwind for floating-rate and non-mark-to-market asset classes, such as Private Debt. At Klarphos, we recommend that investors take advantage of the current window of opportunity to gain exposure in Private Debt and strategically allocate to the asset class over the medium to long-term investment horizon.
Important Information
This document is informative purposes only. It does not constitute research, investment advice nor solicitation to invest in any investment product or service that Klarphos offers or may offer in the future in any jurisdiction. The information contained herein is based on projections, estimates and/or other financial data and has been prepared internally by Klarphos. Opinions expressed therein are current opinions as of the date of this document only and are subject to change at any time without notice.
No representations are made as to the accuracy of the observations, assumptions and projections. No subscriptions to any Klarphos products are possible based solely on this document. Any investment decisions should be made in accordance with the legal documentation of a fund such as its offering memorandum.
Klarphos is not entitled to provide any tax or legal advice.
Past performance is not indicative of future returns. There can be no assurance that the strategy objectives will be realized or that the strategy will not experience losses. Target returns are hypothetical and are neither guarantees nor predictions of future performance. There can be no assurance that the target returns will be achieved.
Klarphos is an Asset Manager specialized in customized portfolio solutions and advisory services for institutional clients based in Luxembourg. Klarphos concentrates its asset management on Alternative Investments and also provides advisory services for strategic asset allocation and ALM optimization. The asset manager employs an international team of specialists and is regulated by the Luxembourg financial regulator CSSF as an Alternative Investment Fund Manager (AIFM).
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