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June 2021 | Issue 235
Opinion Direct lending
Having multiple sources of data for investors is particularly helpful in opaque markets like private debt
Randy Schwimmer
Head of capital markets and origination Churchill Asset Management
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Our columnist looks at the new Lincoln International Senior Debt Index and finds total returns of 154.3 since 2014
Compared to private equity and real estate, private debt is a relatively recent entrant to the world of asset management. But the market has grown rapidly over the past decade. In 2007, just before the great recession, private debt AUM measured less than $200 billion. Today the universe of illiquid credit is $900 billion, with growth estimates of 50% over the next five years.
Practitioners in the space have noted the shortage of credible benchmarks against which to compare managers’ performance. We’ve previously recognised one superb one, the Cliffwater Direct Lending Index (CDLI). Representing over 6,000 directly originated middle market loans totalling about $100 billion, the CDLI uses data and filings from BDCs going back to 2004.
Now another has debuted: the Lincoln International Senior Debt Index. It’s created from Lincoln’s quarterly valuations of 2,400 private companies primarily owned by private equity funds and levered with debt financing provided by direct lenders. Besides price, spread, and yield to maturity, the index measures how quarterly differences in total return are impacted by changes in interest rates and credit.
Having multiple sources of meaningful data for investors is helpful, particularly in an otherwise opaque market such as private debt, and given the credible benchmarks in similar markets, such as broadly syndicated loans (S&P/LSTA 100, Refinitiv LPC 100) and high yield bonds (Ice BofA, S&P 500).
Putting the Lincoln index through its paces
Your correspondent recently road-tested the Lincoln index to assess the performance of the direct lending market. Compared to broadly syndicated loans, total returns are less volatile, but also provide higher total returns. These never fell below 0%, thanks to interest income offsetting any capital gain declines (except for covid’s impact in Q1 2020).
On average, loans in the direct lending market yield about 4% greater returns than broadly syndicated loans. The higher returns are a result of a greater illiquidity (secondary trading for middle market loans is episodic at best), as well as the perception of higher credit risk (small middle-market companies have less scale and more limited access to capital than their large-cap counterparts).
We looked at the average yield investors could expect from middle market loans. It turns out to be somewhat less than 10%, including first-lien, second-lien and uni-tranche. Yield composition changes over time, being a function of spread and Libor floors. In a near-zero rate environment, it highlights the stabilising effect of floors, particularly when Libor dropped below 1%. In effect, it’s a fixed rate despite being a floating rate instrument.
Comparing the total return of illiquid loans relative to their broadly syndicated cousins, the Lincoln Index ended at 154.3 at year-end 2020 (from 100 in 2014) versus 125.4 for the S&P/LSTA Index. Virtually all the difference is attributed to income returns. Since 2016 the Lincoln Index return was 9.6%, while large caps were 5.5%. Compounding this 4% yield difference over time is meaningful.
How does the price (or fair value) of a portfolio of direct lending loans compare to the broadly syndicated loan market? While the correlation between the Lincoln Senior Debt and S&P/LSTA indices is high (about 86%), prices (as measured by fair value) of the Lincoln Index exhibit much lower volatility.
If you want liquidity, you have to pay for it
Broadly syndicated loan (BSL) investors have more opportunities to exit and monetise their investment. But there is a cost, particularly if markets are volatile: the significant capital outflows from retail loan funds in the first half of 2020 resulted in dramatic price declines.
On the other hand, the illiquidity premium for direct lending loans is reflected via their higher interest rate, and investments in direct lending funds are generally structured with limited investor redemptions. The upside is that Lincoln’s middle market loan values held their own during the first six months of 2020, demonstrating that form of debt is much less correlated to broader market moves than BSL loans.
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Global credit funds & CLO's
June 2021 | Issue 235
Published in London & New York.
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