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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
The essential resource for navigating the growing direct loan market Private Debt: Opportunities in Corporate Direct Lending provides investors with a single, comprehensive resource for understanding this asset class amidst an environment of tremendous growth. Traditionally a niche asset class pre-crisis, corporate direct lending has become an increasingly important allocation for institutional investors--assets managed by Business Development Company structures, which represent 25% of the asset class, have experienced over 600% growth since 2008 to become a $91 billion market. Middle market direct lending has traditionally been relegated to commercial banks, but onerous Dodd-Frank regulation has opened the opportunity for private asset managers to replace banks as corporate lenders; as direct loans have thus far escaped the low rates that decimate yield, this asset class has become an increasingly attractive option for institutional and retail investors. This book dissects direct loans as a class, providing the critical background information needed in order to work effectively with these assets. * Understand direct lending as an asset class, and the different types of loans available * Examine the opportunities, potential risks, and historical yield * Delve into various loan investment vehicles, including the Business Development Company structure * Learn how to structure a direct loan portfolio, and where it fits within your total portfolio The rapid rise of direct lending left a knowledge gap surrounding these nontraditional assets, leaving many investors ill-equipped to take full advantage of ever-increasing growth. This book provides a uniquely comprehensive guide to corporate direct lending, acting as both crash course and desk reference to facilitate smart investment decision making.
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Table of Contents
Cover
Introduction
NOTE
Acknowledgments
CHAPTER 1: Overview of US Middle Market Corporate Direct Lending
THE RISE OF NONBANK LENDING
DIRECT LENDING INVESTORS
NOTES
CHAPTER 2: The Historical Performance of US Middle Market Direct Loans
THE CLIFFWATER DIRECT LENDING INDEX (CDLI)
US MIDDLE MARKET DIRECT LOAN PERFORMANCE
YIELD ON DIRECT LOANS
NET GAINS (LOSSES)
NET REALIZED GAINS (LOSSES)
NET UNREALIZED GAINS (LOSSES)
TOTAL RETURN
NOTES
CHAPTER 3: Performance Comparisons to Other Asset Classes
RETURN
RISK AND MAXIMUM DRAWDOWN
CHAPTER 4: Current Yield or Yield to Maturity?
CURRENT YIELD
CHAPTER 5: Comparative Credit Loss Rates
CHAPTER 6: How Liquid Are Direct Loans?
CHAPTER 7: Credit as a Separate Asset Class
WHAT IS AN ASSET CLASS?
CREDIT AND ASSET ALLOCATION
PRIVATE CREDIT OPPORTUNITIES
NOTES
CHAPTER 8: Loans and the Theory of Credit
THE MERTON MODEL
VOLATILITY
RISK‐FREE RATE
TIME TO MATURITY
ESTIMATING LOAN RISK
ESTIMATING LOAN PORTFOLIO RISK
TESTING THE MERTON MODEL
MERTON MODEL WITH COVENANTS
NOTES
CHAPTER 9: Risk Premiums in US Middle Market Lending
METHODOLOGY
CHAPTER 10: Covenants and the Loan Agreement
CHAPTER 11: Should Direct Loan Portfolios Be Leveraged?
SIMULATED DIRECT LOAN PORTFOLIOS WITH LEVERAGE
DETERMINANTS OF FINANCING COSTS
CHAPTER 12: Business Development Companies
WHAT IS A BDC?
PRIVATE BDCS
PUBLICLY TRADED BDCS
BDC MARKET INDICES
BDC DIVIDEND YIELD
BDC TOTAL RETURN
NOTE
CHAPTER 13: Selecting Direct Lending Managers
SELECTION MATTERS
MANAGER DIRECT LOAN YIELD
CREDIT LOSSES ACROSS DIRECT LENDERS
TOTAL RETURN
DIRECT LENDING MANAGERS
ORGANIZATION
INVESTMENT STRATEGY
ORIGINATION
UNDERWRITING
LOAN CONSTRUCTION AND MONITORING
WORKOUT
PORTFOLIO CONSTRUCTION
LEVERAGE FINANCING
FEES AND EXPENSES
TRACK RECORD
CHAPTER 14: Loan Valuation
NOTE
CHAPTER 15: Investment Fees
DIRECT LENDING FEE STRUCTURES
COMPARISONS TO PRIVATE EQUITY
COMPARISONS TO BDCs
FEES AND ALPHA
NOTE
CHAPTER 16: Direct Lending and J‐curve Mitigation
CHAPTER 17: Portfolio Construction
DIRECT LENDING BENCHMARKS
THE IMPORTANCE OF A BENCHMARK
THE CDLI AS A PRIVATE DEBT BENCHMARK
DIVERSIFICATION
NOTES
CHAPTER 18: Expected Returns and Risks from Direct Lending
EXPECTED RETURN
EXPECTED RISKS
CHAPTER 19: Asset Allocation
CHAPTER 20: European Middle Market Direct Lending
KEY CHARACTERISTICS OF THE EUROPEAN DIRECT LENDING MARKET
EVOLUTION OF THE EUROPEAN DIRECT LENDING MARKET
CAPITAL STRUCTURE OF EUROPEAN DIRECT LOANS
RISK FACTORS
NOTE
CHAPTER 21: The Borrower's Perspective
US BORROWERS
EUROPEAN BORROWERS
CHAPTER 22: Other Private Debt Opportunities
REAL ESTATE DEBT
MEZZANINE DEBT
COLLATERIZED LOAN OBLIGATIONS (CLOs)
ASSET‐BASED LENDING
INFRASTRUCTURE DEBT
CONSUMER/MARKETPLACE LENDING
ROYALTIES
VENTURE DEBT
RESCUE FINANCING
REINSURANCE
LITIGATION FINANCE
NOTES
Conclusion
Glossary
List of Exhibits
Index
End User License Agreement
Guide
Cover
Table of Contents
Begin Reading
List of Exhibits
Chapter 1
EXHIBIT 1.1 Breakdown of the $10 trillion US corporate debt market.
EXHIBIT 1.2 Capital structure of a $40 million EBITDA company.
Chapter 2
EXHIBIT 2.2 Components of direct lending returns, September 2004 to December 2017.
EXHIBIT 2.3 Direct loan income as percent of loan asset value, rolling four quarters.
EXHIBIT 2.4 Net realized gains (losses) as a percentage of loan assets, rolling four quarters and cumulative returns.
EXHIBIT 2.5 Net unrealized gains (losses) as a percentage of loan assets, rolling four quarters and cumulative returns.
EXHIBIT 2.6 Direct loan total return as a percentage of loan asset value, rolling four‐quarter returns.
Chapter 3
EXHIBIT 3.2 Asset class cumulative returns (growth of $1.00), September 2004 to December 2017.
EXHIBIT 3.3 Direct lending drawdown during the global financial crisis, June 30, 2008 to December 31, 2010.
Chapter 4
EXHIBIT 4.1 Direct loan fair value versus par (principal) value.
EXHIBIT 4.2 Current yield and yield‐to‐three‐year‐takeout for the Cliffwater Direct Lending Index.
EXHIBIT 4.3 Yields and yield spreads for direct loans and high‐yield bonds.
EXHIBIT 4.4 Yields and yield spreads for direct loans, high‐yield bonds, and leveraged loans.
Chapter 6
EXHIBIT 6.1 Liquidity measurement for US middle market direct loan assets.
Chapter 7
EXHIBIT 7.2 Optimal allocations to stocks, interest rates, and credit.
EXHIBIT 7.3 Public and private credit opportunities by type.
Chapter 8
EXHIBIT 8.1 Merton model of debt costs and loan‐to‐value ratios for private debt.
EXHIBIT 8.2 Credit risk premium and firm risk.
EXHIBIT 8.3 Firm volatility (standard deviation) by industry group.
EXHIBIT 8.4 Credit risk premium and the risk‐free rate.
EXHIBIT 8.5 Credit risk premium and time to maturity.
EXHIBIT 8.7 Simulation results for hypothetical first‐lien and second‐lien loans.
EXHIBIT 8.9 Simulation results for hypothetical first‐lien and second‐lien loan portfolios.
EXHIBIT 8.11 Illustration of down‐and‐in option.
EXHIBIT 8.12 Debt costs with/without covenants (a theoretical representation using the Black–Cox model).
Chapter 9
EXHIBIT 9.1 Available risk premiums in direct US middle market corporate loans, December 31, 2017.
Chapter 11
EXHIBIT 11.3 Performance simulation for direct lending portfolios with leverage: September 2004 to December 2017.
EXHIBIT 11.6 Loan subordination and financing cost.
Chapter 12
EXHIBIT 12.4 Comparison of Cliffwater BDC Index and five‐year Treasury yields.
EXHIBIT 12.5 Cliffwater BDC index price premium or discount to NAV.
EXHIBIT 12.6 Comparison of market return and net operating return for Cliffwater BDC Index.
EXHIBIT 12.7 Comparison of price return and NAV return for Cliffwater BDC Index.
Chapter 13
EXHIBIT 13.1 Performance comparison of two direct lending managers.
EXHIBIT 13.2 Yield (interest income) by direct loan manager, 2005 to 2017.
EXHIBIT 13.3 Manager exposure to direct loan risk factors, at December 31, 2017.
EXHIBIT 13.4 Net realized gains (losses) for direct lending managers and the Cliffwater Direct Lending Index, by year.
EXHIBIT 13.5 Cumulative net realized gains (losses) for direct lending asset managers and the Cliffwater Direct Lending Index (heavy dark line): September 2004 to December 2017.
EXHIBIT 13.6 Total return for direct lending managers and the Cliffwater Direct Lending Index, by year.
EXHIBIT 13.7 Due diligence checklist for middle market direct lender.
Chapter 14
EXHIBIT 14.1 Price comparison for direct loans, high‐yield bonds, and bank loans, March 2004 to December 2017.
Chapter 15
EXHIBIT 15.1 Distribution of combined direct lending fees as a percentage of net assets.
EXHIBIT 15.3 Distribution of combined direct lending fees as a percentage of net assets.
Chapter 16
EXHIBIT 16.1 J‐curve comparison for direct lending and buyout funds.
Chapter 17
EXHIBIT 17.1 10th to 90th percentile distribution of state fund returns, 10 years ending June 30, 2016.
EXHIBIT 17.2 CDLI industry weightings as of December 31, 2017.
EXHIBIT 17.3 Russell 2000 industry weightings as of December 31, 2017.
Chapter 18
EXHIBIT 18.2 Expected return, risk, and correlations across asset classes.
Chapter 22
EXHIBIT 22.1 US mezzanine fund return (IRR) by vintage year through June 2016.
EXHIBIT 22.2 Model pricing of CLO notes and CLO equity.
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E1
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Private Debt
Opportunities in Corporate Direct Lending
STEPHEN L. NESBITT
Copyright © 2019 by Cliffwater LLC. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging‐in‐Publication Data:
Names: Nesbitt, Stephen L., 1953- author.
Title: Private debt : opportunities in corporate direct lending / Stephen L. Nesbitt.
Description: First Edition. | Hoboken : Wiley, 2019. | Series: Wiley finance | Includes index. |
Identifiers: LCCN 2018049404 (print) | LCCN 2018050703 (ebook) | ISBN 9781119501275 (Adobe PDF) | ISBN 9781119501169 (ePub) | ISBN 9781119501152 (hardback)
Subjects: LCSH: Investments. | Small business—Finance. | Bank loans. | BISAC: BUSINESS & ECONOMICS / Investments & Securities.
Classification: LCC HG4521 (ebook) | LCC HG4521 .N427 2019 (print) | DDC 658.15/2—dc23
LC record available at https://lccn.loc.gov/2018049404
Cover Design: Wiley
Cover Image: © belov1409 / iStock.com
To the ones who make it all worthwhile: Lisa, John, Blake, Amanda, twins Ford and Ellie, and a dog named Kitty.
Introduction
Corporate lending was traditionally the business of commercial banks, but the global financial crisis and ensuing regulatory backlash created an opportunity for nonbank private asset managers to replace bankers as primary lenders to a large swath of middle market businesses, primarily in the United States. The economic recovery, albeit slow, found many middle market companies looking for debt capital for growth or refinancing. With banks in retrenchment, these companies found asset managers to be willing lenders. Lacking the deposit capital available to banks, the new direct lenders in turn have sought capital from institutional investors hungry for yields closer to 10% than the 1–3% available from traditional sources. Though estimates vary, the size of the corporate direct loan market in the United States today is perhaps as high as $400 billion and growing.
This book is directed primarily toward investors interested in learning more about corporate direct lending. The author comes from the perspective of an investment consultant to institutional investors providing research and advice on asset classes, manager selection, and asset allocation. The book therefore follows the same path that fiduciaries to institutional capital walk in their own due diligence on a new asset class.
Chapters 1–6 collectively describe US middle market corporate direct lending, addressing the three characteristics that broadly define any asset class: return, risk, and liquidity. Private debt, including middle market corporate loans, has long been a mystery to investors for lack of credible historical data. The findings in this book would not be possible without a research effort launched several years ago to construct a database and index for direct middle market corporate loans and published in a major investment journal.1 That research covering return and risk is updated along with a new chapter addressing liquidity.
Chapters 7 and 8 take a detour of sorts. Chapter 7 argues that fixed income as an asset class is more appropriately divided into two separate asset classes: an interest rate (Treasuries) asset class and a credit asset class. Instead of stock and fixed income allocations, investors should think in terms of three asset classes: stock, credit, and Treasury bond allocations. Chapter 8 provides a theoretical foundation for the three‐asset view by splitting fixed income into separate credit and interest rate components using option pricing models developed almost 50 years ago by Robert Merton, Fischer Black, and Stephen Cox. Their concept that any credit instrument can be modeled as a risk‐free rate plus a put option forms the basis for sensitivity analysis and simulation to better understand the behavior of yield, return, and risk for various types direct corporate loans and the value of covenants.
Chapter 8 is particularly useful in setting up Chapters 9 and 10. Investors who first look at direct lending are surprised by, and suspicious of, their higher yields. Chapter 9 provides an explanation for the high yields in direct loans by dissecting them into six components, each associated with a distinct risk factor potentially found in loans, and each offering an extra yield, or risk premium, as compensation for the specific risk factor. This yield architecture provides investors with a method for understanding and comparing absolute yields.
Chapter 10 takes a closer look at covenants, a real concern in today's environment as covenants are being stripped from new loans in covenant‐lite deals. The theoretical presentation in Chapter 8 includes an application of the Black–Cox Model that gives a formulation for measuring the opportunity cost of covenant‐lite in yield‐equivalent units. Under one set of assumptions, for example, the Black–Cox model values a covenant package as being worth 1% in yield. Chapter 10 provides an inventory of what comprises a typical loan agreement, including the elements of a full covenant package. Its purpose is to provide the reader a practical knowledge of the types of covenants in a loan agreement that are covered from a theoretical perspective in Chapter 8.
Investments that go terribly wrong generally have too much leverage or involve fraud. Many investors in direct corporate loans apply some leverage to enhance return. Chapter 11 examines the impact of leverage on portfolio return and risk and provides guidance to investors on what leverage level might be appropriate. Unlike traditional stock or bond portfolios where return and risk characteristics are similar among managers, direct lending offers investors many options that can materially differentiate one portfolio from another.
Chapters 12–17 discuss alternative forms for investing in direct corporate loans and some of the practicalities. Business development companies (BDCs) are covered first because they are the most visible of direct lending vehicles. Other topics include manager selection, loan valuation, fees, and portfolio construction.
Having covered what direct lending portfolios might look like and how they work, Chapters 18 and 19 together show how institutional investors can use the data and findings covered in earlier chapters to validate long‐term allocations to direct corporate loans within existing diversified portfolios using standard asset allocation technology. Chapter 19 provides examples of optimized portfolios showing that allocations to direct lending, both unlevered and levered, enhance risk‐adjusted return.
The research focus contained in this book is on direct corporate lending in the US middle market. But the same financial events that created the direct lending market in the United States also occurred in Europe, though to different degrees. Chapter 20 provides an overview of the direct lending market in Europe with comparisons to the US market. Unlike Europe, direct lending in Asia is in its early development stages.
Chapters 1 to 20 examine corporate direct lending from the investor perspective. Chapter 21 gives the borrower's perspective. A frequent question is whether the growth in the direct lending market will become stunted by the reversal in bank regulation under the current administration. Results from a survey of private equity sponsors suggest that borrowers are unlikely to reverse course and again rely upon bank lending.
The book concludes with a view of direct corporate lending as part of a larger private debt market. Direct lending should be viewed as a core component with breadth of opportunity and characteristics that should make investors comfortable with it as a long‐term investment. Other private debt investments tend to be smaller in market size and might be viewed as core‐plus or specialty, with higher return potential but higher risk. Chapter 22 provides short descriptions of 11 types of private debt outside direct lending that might be considered as complementary investments to a dedicated private debt allocation.
Together these chapters hopefully provide the reader with a strong foundation to further explore the investment opportunities in corporate direct lending.
NOTE
1
Stephen L. Nesbitt, “The Investment Opportunity in U.S. Middle Market Direct Lending,”
The Journal of Alternative Investments
(Summer 2017).
Acknowledgments
There are several individuals to thank for their contributions. Jamil Baz at PIMCO directed me to the Black‐Cox model as a possible tool for measuring the impact of covenants on direct loan yields. His insight helped to shape Chapter 8. Alan Kirshenbaum at Owl Rock provided valuable direction in leverage finance for Chapter 13. And not least, the expertise and research of Jonathan Bock at Barings provided an important backdrop for the discussion of BDCs in Chapter 12.
I also acknowledge invaluable help from many professionals at Cliffwater LLC, including Eric Abelson, Mark Johnson, Pete Keliuotis, Eli Sokolov, Jeff Topor, Mark Williams, and Gabrielle Zadra.
Special thanks also go to the editors at John Wiley & Sons, Bill Falloon, executive editor, Michael Henton, senior editorial assistant, and Sharmila Srinivasan, production editor.
CHAPTER 1Overview of US Middle Market Corporate Direct Lending
This book focuses on the investment opportunity in US middle market corporate direct lending (or direct loans), a large and rapidly growing segment of the global private debt market. Direct loans are illiquid (nontraded) loans made to US middle market companies, generally with annual earnings before interest, taxes, depreciation, and amortization (EBITDA) ranging from $10 million to $100 million. These middle‐market corporate borrowers are of an equivalent size to those companies found in the Russell 2000 Index of medium and small stocks but, in aggregate, they represent a much larger part of the US economy compared to the Index. The US corporate middle market includes nearly 200,000 individual businesses representing one‐third of private sector gross domestic product GDP and employing approximately 48 million people.1
Exhibit 1.1 illustrates where direct corporate lending fits within the multiple sources of long‐term debt financing provided to US companies as of December 31, 2017. Long‐term debt financing to US companies totaled approximately $10 trillion. By comparison, equity financing to US companies totaled approximately $24 trillion.2
EXHIBIT 1.1 Breakdown of the $10 trillion US corporate debt market.a
Traded, investment‐grade bonds represent almost one half of corporate debt financing, but this debt is issued by the largest US companies. High yield (non‐investment‐grade) bonds and bank loans represent one‐half of investment‐grade bond issuance. These companies are also larger, with EBITDA over $100 million where scale allows them to access the traded broker markets. Bank commercial lending, the market where direct lenders compete, is $2.1 trillion in size. The US government, through government‐sponsored enterprises (GSEs) and agencies, makes direct loans to companies in generally depressed or subsidized industries, such as agriculture. These loans are estimated at $0.6 trillion.
The size of the direct lending US middle market loans is estimated to equal $400 billion, based upon Federal Reserve data and other sources. While small compared to traditional sources of corporate financing, the direct loan market has significant potential for growth if it can continue to claim market share from the bank C&I loan business.
THE RISE OF NONBANK LENDING
Commercial banks have been the traditional lenders to US middle market companies. The Federal Reserve reports that US banks hold roughly $2.1 trillion in commercial and industrial (C&I) loans on their balance sheets, which is mostly comprised of middle market business loans. Banks also make loans to larger companies that are not held on their balance sheets. Instead these larger loans are sold and syndicated across many investors, which are subsequently traded as private transactions in the secondary market. These traded loans are also referred to as broadly syndicated loans (BSLs), also known as leveraged loans. The size of the leveraged loan market is roughly $1 trillion, or half the size of bank C&I loans. These larger, traded bank loans have become very popular among institutional and retail investors through pooled accounts, mutual funds, and exchange‐traded funds (ETFs), providing a yield advantage to investment‐grade bonds while maintaining daily liquidity.
Loans to middle market companies are too small for general syndication and therefore are held by the originating bank. The investment opportunity in middle market loans for nonbank asset managers principally came about as an outcome of the 2008–2009 global financial crisis (GFC), and the years following, when increased capital requirements and tighter regulation on corporate lending made holding middle market corporate loans more expensive and restrictive for most banks. As banks decreased their lending activity, nonbank lenders took their place to address the continued demand for debt financing from corporate borrowers.
Direct loans are typically originated and held by asset managers that get their capital from private investors rather than bank deposits. Asset managers are regulated by the Securities and Exchange Commission and are not subject to the same investment restrictions placed upon banks. Investors are primarily institutional rather than retail, representing insurance companies, pension funds, endowments, and foundations. Retail investors have had access to direct loans mainly through publicly traded business development companies (BDCs), which are discussed in Chapter 12.
There are approximately 180 asset managers in the United States that invest in direct middle market corporate loans. Many of them began direct lending during and soon after the GFC and recruited experienced credit professionals from banks that either went into bankruptcy (Bear Sterns, Lehman Brothers) or had their activities sharply curtailed. GE Capital, the financing arm of General Electric, also faced important financial problems during the GFC. GE Capital, through its subsidiary Antares, was at one point the largest US nonbank lender. The subsequent exodus of credit and deal professionals provided significant intellectual capital to the nascent nonbank lending industry.
While banks continue to hold a key advantage over asset managers by having a low cost of funds (i.e., bank deposits), this is offset by higher capital requirements, which ties up shareholder equity, and restrictions on the type of business loans that can be made by banks and the amount of leverage they can offer to borrowers. While these regulations may ease over time, particularly with the more business‐friendly Trump administration, which could entice banks to re‐enter the market, the loss of talent during and after the GFC, and subsequent weakening of banks' relationships with borrowers, makes this a challenging prospect.
Finally, the growth of nonbank lending has also been helped by a new type of corporate borrower, the private equity sponsor. Private equity has seen steady growth since it began over 30 years ago but its role in the US economy has picked up significantly since the GFC, particularly in the middle market. These private equity–sponsored companies are professionally managed, use debt strategically in financing, and require timeliness, consistency, and flexibility from lenders as well as attractive pricing. The advent of direct lending by professional asset managers has given private equity sponsors an alternative and preferred source of financing. Currently roughly 70% of direct loans are backed by private equity sponsors.
DIRECT LENDING INVESTORS
Investor interest in middle market direct lending has been driven by several factors. First and foremost is their attractive yields, ranging from 6% for the least risky senior loans to 12% for riskier subordinated loans. These yields compare with 2–3% for liquid investment‐grade bonds, as represented by the Bloomberg Barclays Aggregate Bond Index, a widely used investment grade bond index, and 4–5% for broadly syndicated non‐investment‐grade loans, as represented by the S&P/LSTA Leveraged Loan Index, an index used to track the broadly syndicated loan market.
Investors are also attracted to direct loans because coupon payments to lenders (investors) are tied to changes in interest rates and have relatively short maturities (typically five‐ to seven‐year terms, which are typically refinanced well before the end of the loan term). The floating‐rate feature is particularly important in periods of rising interest rates. Interest rates for direct loans are set by a short‐term base rate (or reference rate) like three‐month London Interbank‐Offered Rate (Libor) or US Treasury bills, plus a fixed coupon spread to compensate for longer‐term default risk and illiquidity. Bank loan investors will see their yields increase as interest rates rise through quarterly adjustments to their base rate. In many respects, rising interest rates are beneficial for direct loan investors.
Conversely, most bond funds primarily hold fixed‐rate securities, whose yields do not adjust to rising interest rates. Instead rising rates cause bond prices to fall, in line with the duration of the bonds. A typical bond mutual fund has a five‐year duration, a measure of average bond life. In this example, if interest rates for bonds with a five‐year weighted average duration rise one percentage point, the bond fund will experience a 5% decline in value (five‐year duration multiplied by 1% interest rate increase), offsetting any benefit from increased yield. Direct loans have only a three‐month duration and a one‐percentage‐point increase in rates will have only a temporary 0.25% (25 basis point) price decline. The direct loan yield will reset at the next calendar quarter and its value will return to par.
Direct loans generally have a shorter life than their five‐ to seven‐year maturities suggest, which can be both good and bad. The average life of a direct loan has averaged approximately three years, much shorter than their stated maturity due to their being refinanced from corporate actions, such as acquisition of the borrower by another company, or prepayment by the borrower to get a lower interest rate. The good news is that direct loans are not as illiquid as their maturity suggests. At a three‐year effective life, one‐third of the loans pay off every year, which makes their liquidity profile attractive compared to private equity funds, whose effective life is seven to nine years on average.
However, if prepayments result from the borrower refinancing at a lower interest spread, then the lender is potentially worse off in terms of future yield, which causes the price of the loan to decline. Most loan documents include prepayment penalties, which go to the lender (investor), but these do not always provide sufficient compensation for the foregone income.
Most US middle market direct corporate loans are backed by the operational cash flow and assets of the borrower. Companies generally borrow from one lender whose security in case of default is all borrower assets but for trade payables and employee claims. The lender is said to have a senior, first‐lien claim in default. Some companies have additional lenders whose claims in default come after the senior lenders have been paid off. These are subordinated, second‐lien lenders who receive additional interest income for the greater risk of loss they take.
Direct Lending Illustration
Exhibit 1.1 illustrates a balance sheet of a middle market company with $40 million in EBITDA. The company is worth $360 million, or nine times (9x) EBITDA. Companies generally have a small amount of revolving credit for working capital purposes. “Revolvers” allow the borrowing company the right to draw capital as needed, paying an interest rate on amounts drawn as well as a fee on undrawn capital. These can be direct loans provided by an asset manager but, since they entail a high degree of servicing relative to the interest rates charged, are typically provided by a bank.
Most debt capital in our example is provided by a senior, first‐lien, direct loan equal to $160 million, which equals 4x EBITDA. This direct loan has first claim on assets in bankruptcy excepting trade receivables, which would satisfy any revolver amount outstanding.
The company also has a $40 million second‐lien loan in place equal to 1x EBITDA but subordinated to the first lien and revolver debt. Historically, banks provided the senior first‐lien loan and nonregulated, nonbank institutional investors provided the subordinated second‐lien loan. Direct lending has increasingly left the nonbank asset manager to provide all debt financing, perhaps with the sole exception of the revolver, for middle market companies.
Companies can also have unitranche loans in place that combine first‐ and second‐lien loans into one. Unitranche loans have become more common in recent years as borrowers seek a single source of debt financing.
Finally, equity financing equal to $160 million provides the remaining capital that completes this company's balance sheet. Equity has historically been provided by the owner operator but increasingly it is the private equity sponsor that provides equity capital and who also puts in place professional managers to run the business.
The type of lending illustrated in Exhibit 1.2 is often referred to as leveraged finance because the amount of debt represents a higher multiple (leverage) of EBITDA than might be typical of investment‐grade debt of a large multinational company. Rating agencies typically assign a non‐investment‐grade rating to direct loans. This is due to the higher debt leverage multiple, the relatively small size of the borrower, and the private ownership of the company, as opposed to public listing. Consequently, direct loan performance is more closely correlated to non‐investment‐grade junk bonds, or broadly syndicated bank loans, rather than investment‐grade corporate bonds found in indices like the Bloomberg Barclays Aggregate Bond Index.
EXHIBIT 1.2 Capital structure of a $40 million EBITDA company.
With this overview as an introduction, Chapter 2 provides a detailed description of the historical investment characteristics of US middle market direct loans.
NOTES
1
National Center for The Middle Market,
1Q 2018 Middle Market Indicator
, which defines the middle market as businesses with revenues between $10 million and $1 billion, which equates approximately to a $2 million to $200 million EBITDA range assuming a 20% gross operating margin.
2
Federal Reserve Z-1 tables.
a
Federal Reserve Z‐1 tables; Cliffwater LLC estimates.
CHAPTER 2The Historical Performance of US Middle Market Direct Loans
THE CLIFFWATER DIRECT LENDING INDEX (CDLI)
Most asset classes become institutionalized only after a long maturation period that permits discovery of both return and risk. That discovery process also involves the establishment of a database of unbiased information on the asset. For example, the Center for Research in Security Prices (CRSP) database served that early role in the study of stock performance, as did the Capital International database for international stocks, and the Salomon Brothers database for corporate bonds.
A major challenge for investors considering US middle market direct lending has been the lack of data upon which to understand long‐term return and risk. Commercial bank C&I loans or direct loans held by insurance companies might be valuable sources of information, but these records are proprietary and not kept in a form that is conducive to the rigorous performance analysis available for other asset classes. As a result, investors who have engaged in direct lending have relied primarily upon the attractive yields available on current private corporate loans and the performance records of a few asset managers who have engaged in middle market direct lending over an extended period of time. Currently investors might collect and compare the performance records of direct lending managers, but these records suffer from being self‐reported, with inconsistencies in loan valuation, asset quality, use of leverage, and time period.
Fortunately, a significant and growing segment of the direct lending market consists of loans originated and held by business development companies (BDCs), where quarterly Securities and Exchange Commission (SEC) disclosures provide a vast amount of loan (asset) information, including listings of individual loans and quarterly valuations conducted by independent valuation firms. The information provided is comprehensive enough to calculate quarterly performance measures for direct loans that include income return, price return, and total return. It is from these SEC disclosures that a corporate direct loan database has been constructed by Cliffwater LLC, together with a performance index called the Cliffwater Direct Lending Index (CDLI). As of December 31, 2017, the CDLI represented over $91 billion in direct loan assets covering over 6,000 loans from 74 individual public and private BDCs managed by the largest direct lending asset managers.
The loans captured by the direct loan database and the Cliffwater Direct Lending Index are a significant subset of the direct lending universe (∼25%),1 and importantly, represent loans that are originated and held to maximize risk‐adjusted return to shareholders/investors.
The items below describe the construction of the Cliffwater Direct Lending Index:
Index base date. September 30, 2004.
Index launch date. September 30, 2015.
Data universe. All underlying assets held by private and public BDCs that satisfy certain eligibility requirements.
Index reporting cycle. All index returns and characteristics are reported with a 2.5‐month lag to allow sufficient time for release of SEC filings.
BDC eligibility.
SEC regulated as a BDC under the Investment Company Act of 1940.
At least 75% of total assets represented by direct loans as of the calendar quarter‐end.
Release SEC 10‐K and 10‐Q filings within 75 calendar days following the calendar quarter‐end.
Eligibility reviewed at quarterly eligibility dates (75 calendar days following the calendar quarter‐end).
Weighting. Asset‐weighted by reported fair value.
Rebalancing. As of calendar quarter‐end.
Reported quarterly index characteristics. Total asset return, income return, realized gains (losses), unrealized gains (losses), and total assets.
Location.
www.cliffwaterdirectlendingindex.com
.
The CDLI is consistent with other private‐asset indices in its quarterly reporting cycle, fair value asset valuation, and asset weighting. The loans are valued quarterly following SFAS 157 guidance. Returns are unlevered and gross of both management and administrative fees.
US MIDDLE MARKET DIRECT LOAN PERFORMANCE
Exhibit 2.1 provides CDLI returns from its September 30, 2004 inception through December 31, 2017. All returns are based upon quarterly data and are gross of fees and expenses.
EXHIBIT 2.1 Cliffwater Direct Lending Index performance.
Trailing periods ending December 31, 2017
Q4 2017 (%)
Past four quarters (%)
Past five years (%)
a
Past 10 years (%)
a
Sep 2004 inception (%)
a
Income
2.52
10.16
10.81
11.52
11.15
plus
Net realized gains (losses)
−0.44
−1.75
−0.81
−1.71
−1.05
plus
Net unrealized gains (losses)
−0.05
0.33
−0.40
−0.46
−0.33
equals
Total return
b
2.02
8.62
9.50
9.21
9.70
aAnnualized return.
bReturn subcomponents may not add exactly to total return due to compounding effects.
Theoretically, the CDLI is investable indirectly through public or private BDC share purchases. However, the primary CDLI return series excludes the application of leverage and imposition of fees, both management and administrative, which for some institutional investors can be negotiated based upon objectives and size of investment. The CDLI return series should be useful to potential investors as a building block upon which to customize returns series for expected fees and desired leverage. Later in this chapter are pro forma, net‐of‐fee returns using the CDLI return series and leverage.
Importantly, SEC filing and transparency requirements eliminate common biases of survivorship and self‐selection found in other industry universe and index benchmarks. And finally, loan assets in the CDLI are managed for total return largely by independent asset managers, unlike similar assets within insurance companies where statutory and other regulatory requirements can result in non‐performance objectives.
Total returns are divided into the three major components investors use to assess performance for credit‐driven securities: income, unrealized gains (losses), and realized gains (losses). Income return is comprised of contractual interest payments and, to a lesser degree, price discounts direct lenders might receive when they originate loans. Unrealized gains (losses) represent changes in loan values, as determined by valuation agents, and are generally a reflection of movement in overall market spreads or change in assessment of specific loan credit risk, akin to a loan‐loss reserve. Finally, realized (gains) losses are predominately losses and are the product of loan‐specific defaults and recoveries, which result in a write‐down of loan principal.
Exhibit 2.2 plots the performance of the Cliffwater Direct Lending Index and its components. Visualizing performance in this way helps understanding what generates return and what detracts from performance over time.
EXHIBIT 2.2 Components of direct lending returns, September 2004 to December 2017.
The heavy line in Exhibit 2.2 plots the cumulative (growth of $1.00) CDLI return, consisting of gross yield (top diagonal line) plus net realized gains/losses and plus net unrealized gains/losses. The vertical axis uses a log scale. A log scale is useful for plotting cumulative returns over long periods of time because a constant rate of return produces a straight line. For example, the CDLI income return over the 13.25‐year period appears as a straight line. This suggests that direct lending income (yield) has remained relatively constant over the period. Casual inspection also shows that direct lending income return drives total return over time, reduced periodically by net realized and unrealized losses. For the entire CDLI history, the direct loans in the Index returned 9.70%, annualized, with current income equal to 11.15%, unrealized losses equal to −0.33%, and realized losses equal to −1.05%. These returns are consistent with the investment thesis underlying most fixed income strategies that investors should try to maximize yield while minimizing losses (realized and unrealized) in principal.
YIELD ON DIRECT LOANS
Exhibit 2.3 shows the rolling, four‐quarter income return (yield) on direct CDLI loan assets. From 2004, income has been fairly stable within the US middle market, with income ranging roughly between 10 and 12% and averaging 11.15%. Higher income is associated with periods of recession while lower income is associated with periods of economic expansion.
EXHIBIT 2.3 Direct loan income as percent of loan asset value, rolling four quarters.
With direct loans, not all income is traditional interest income. Asset managers that originate corporate direct loans also receive fees for arranging and servicing the loans. These fees come in the form of discounts at origination. A typical example might be a loan origination where the lender is due $100 par value at maturity in five years but provides the borrower only $98 in financing. The lender receives a 2% discount for arranging the loan. Principal value remains at $100 while net asset value at origination is set at $98. Accounting treatment for the $2 discount, called the original issue discount (OID), can vary, with some reporting OID as income at origination and others amortizing it over the life of the loan. Understanding the accounting treatment of OID can be important because income can appear to spike during periods of high origination or prepayments.
OID‐income generation for direct loans can be measured from the Statement of Cash Flows in the BDC quarterly SEC filings by looking at amortization of discounts. Over the past five years, during which current CDLI total income return averaged 10.69%, OID contributed 0.36% (36 basis points) per year. With direct loans averaging a five‐year maturity at origination, the 0.36% annual amortized OID yield would be equivalent to a 1.8% price discount to principal value at origination.
Another, less well understood source of income is payment‐in‐kind (PIK) income. Instead of quarterly cash interest income, PIK income represents a non‐cash increase in principal. PIK income is generally associated with subordinated debt or lower quality borrowers that may have limited free cash flow in the short term. PIK income is also reported in the Statement of Cash Flows in quarterly SEC filings. Over the last five years during which current CDLI total income return averaged 10.69%, PIK income contributed 0.41% (41 basis points) per year. In the case of senior loans, the CDLI database reports only six basis points in annualized PIK income over the last five years. Consequently, the higher yields reported for some direct loan strategies may be of lower quality because some fraction is in the form of non‐cash income.
NET GAINS (LOSSES)
While the CDLI income return component largely drives long‐term total return, net gains (losses) can significantly impact returns over shorter time periods and can be very important in differentiating individual manager (lender) performance.
Net gains (losses) are defined as the periodic change in loan valuation. It is the equivalent of a price change for traded securities. Net gains (losses) are frequently divided into two components, realized and unrealized.
Realized gains (losses) represent the component of valuation change that reflects completed transactions. In the case of a portfolio of loans, such as the CDLI, realized gains (losses) mostly come in the form of realized losses generated by write‐downs of loan principal that result from borrower default. The amount of the write‐down depends upon the value of the post‐default collateral or new principal amount.
Unrealized gains (losses) represent the component of valuation change that is sourced by a change in market price or, in the case of a portfolio of loans, such as the CDLI, a change in fair value not attributable to a transaction.2
It is instructive to review the mechanisms by which gains and losses for direct loans typically are generated, as well as the linkage between realized and unrealized gains and losses.
Loan values are established quarterly based upon a fair value assessment as to what the loan is worth. Fair value takes account of the probability and size of future loan impairments based upon individual loan circumstances.
Price changes in the broader, traded credit markets, including high‐yield bonds and bank loans, help guide expectations for future loan impairments and fair values.
Quarterly changes in fair value create unrealized net gains (losses) that cause fair value to differ from cost (par) value. Most likely, fair value will be below cost value to reflect some probability of impairment.
3
Unrealized losses from reductions in fair value usually occur in advance of actual loan impairments as the certainty of loss increases as default approaches.
A subsequent default event triggers a realized loss that is a permanent reduction in the cost (par) value of the loan.
The realized loss (from a default or restructuring) replaces the existing unrealized loss through an offsetting unrealized gain. The new unrealized gain equals the prior unrealized loan loss if the default event and realized loss was correctly anticipated.
Over time, investors observe a build‐up in net realized losses, as defaults accumulate. These realized losses are comparable to loss rates
4
reported by rating agencies and banks for high‐yield bonds and bank loans.
Unrealized losses will generally build in the early stages of a credit downturn and reverse in the later stages as realized losses from defaults replace them.
This background should help put the realized losses and unrealized gains reported for the CDLI over the quarter and trailing year in better context.
NET REALIZED GAINS (LOSSES)
Exhibit 2.4 shows rolling four quarters and cumulative realized gains (losses) for all direct CDLI loans. Unlike current income, realized gains (losses) for direct loans are not consistent and positive but episodic and mostly negative, corresponding (with some lag) to the general US business cycle or industry specific events. For the entire 13.25‐year period, cumulative realized losses equaled −13.07%, or − 1.05% annualized.
EXHIBIT 2.4 Net realized gains (losses) as a percentage of loan assets, rolling four quarters and cumulative returns.
Direct loans in the CDLI experienced modest realized gains over the period prior to the 2008 global financial crisis (GFC). These gains were largely associated with equity and warrants that sometimes come with direct loans, particularly pre‐2008 when most direct loans were subordinated and had lower yields, but came with more equity participation. This was also a period following the 2000–2002 recession where the equity markets were experiencing a sharp rebound. In the current direct lending environment, where lending is senior in orientation with little equity participation, the occurrence of net realized gains for direct lending generally would be very unlikely.
The second period covering the GFC is of great interest because it is a period that investors now use to stress test different asset classes. Also, because direct lending is a newer asset class, it is the only time period that can be used to study likely maximum‐loss scenarios.
Cumulative realized losses for direct loans caused by the GFC totaled −10.20%, covering the years 2008–2010. Realized losses are not confined to 2008 because defaults in 2009 and 2010 likely resulted from the economic recession that began in 2008 and extended through June 2009.
The third period extends from 2011 to 2015 when realized losses continued to ebb, with the final three years, 2013–2015, reflecting an unusual period of almost no realized losses. But for the Euro crisis during this period, it was marked by a slow but steady US business expansion and a climbing stock market.
The final, fourth period begins in 2016, with the oil crisis and a continuing period of retail disruption. Realized losses have been slightly above the historical average and only recently have begun to slow again, with the pick‐up in the economy in 2017 and into 2018.
