While non-bank credit channels have always coexisted with traditional banks, they were historically small dots in the overall economy. That changed after the Great Recession, when new regulations limited banks' ability to make traditional loans to middle-market U.S. businesses (generally defined as companies with EBITDA, or earnings before interest, taxes, depreciation and amortization, between $10 million and $100 million and which are generally considered too small to access capital in the broader common market in a cost-effective manner). “Shadow banking” emerged with independent asset managers funded by equity from institutional investors, replacing banks as providers of first-lien secured commercial loans.
The growth in direct middle market loans originated by asset managers is partly explained by the growth in middle market private equity. These loans are called “sponsor backed”. Private equity sponsors often prefer to borrow from asset managers rather than traditional banks because asset managers offer faster speed, certainty of execution and greater financing flexibility.
Performance update
Every quarter, Rock water provides an update on the progress of private loans in “US Direct Lending Report.Its analysis is based on the Cliffwater Direct Lending Index (CDLI), an asset-weighted index of approximately 14,800 direct origination middle market loans totaling $315 billion as of December 31, 2023. The CDLI is used globally by institutional investors and asset managers assets as an index. of choice to understand the return and risk characteristics of US middle market debt. Launched in 2015, CDLI was reconstructed in 2004 using publicly available quarterly SEC filings requested from business development companies whose primary asset holdings are US middle market corporate loans. Importantly, the SEC's disclosure and transparency requirements eliminate common survivorship and self-selection biases found in industry universe benchmarks and other indexes.
The following table provides performance data for the fourth quarter of 2023 as well as historical returns:
CDLI produced a total return of 2.95% in the fourth quarter, bringing its total return after four quarters to 12.13%. Interest income rose to 2.99%, which was somewhat offset by 0.08% in realized losses for the quarter. Unrealized gains stood at 0.03% for the quarter, representing the conversion of prior unrealized losses to realized losses and a reversal of spread widening. For the subsequent five and 10 years, the total return was 9.09% and 8.84%, respectively. Since its inception on September 30, 2004, CDLI has produced an annual return of 9.46%, unlevered and gross fees.
Yield to Maturity/Current Yield
While most CDLI direct loans have a stated maturity of five to seven years, refinancing and corporate actions reduce their average life to approximately three years. The three-year CDLI yield fell slightly from 12.29% on September 30, 2023, to 12.20% at the end of the year, mainly due to a slight tightening of spreads. Over the same period, the yield to maturity for the Morningstar LSTA US Leveraged Loan 100 Index fell slightly from 9.68% to 9.63%, and the yield to maturity on the Bloomberg High Yield Bond Index rose from 8.50% to 8.88%.
Diversification
CDLI industry weights as of December 2023
CDLI is highly diversified by industry group with weights not dissimilar to the market capitalization weights for the Russell 2000 Equity Index, but for the absence of a banking sector.
Credit risk
Fourth quarter losses reduced returns by 0.05%. For the year, however, they added 0.06% in returns. For the trailing five years, 10 years, and since inception, total losses were 0.85%, 1.35%, and 1.28%, respectively.
The following table shows the 19-year history (2005-2023) of credit losses for CDLI compared to high-yield bonds and leveraged loans:
The exhibit shows that average annual realized credit losses for middle market loans (1.02%), represented by CDLI, were slightly higher compared to leveraged loans (0.94%), but well below loan losses for high-yield bonds (1.48%) for the entire 19-year period.
evaluations
Direct loans to CDLI are valued quarterly using 'fair value' accounting rules, while the prices of high-yield bonds and bank loans are determined by the market. Despite the various pricing sources, the chart below shows that the direct credit rating follows the high-yield bond and bank loan markets, albeit with somewhat less volatility.
Historical returns to CDLI
The following exhibit compares CDLI's calendar year returns to high yield bonds, syndicated loans and investment grade bonds. The asset class with the highest calendar year return is highlighted.
Seniors Only Direct Loan (CDLI-S)
CDLI-S consists only of senior loans within CDLI. It was created in 2017 to address the comparative performance of senior middle market loans and the entire universe of middle market loans represented by CDLI. CDLI-S follows the same construction methodology as CDLI, but only includes loans held by managers of business development companies that have an investment style that Cliffwater has clearly defined as focusing on senior secured loans. Cliffwater generates the same quarterly performance and portfolio data for CDLI-S that is available for CDLI, except that the start date is September 30, 2010, for CDLI-S compared to September 30, 2004, for CDLI. The shorter historical streaks for CDLI-S are attributable to the post-2008 introduction of most senior-only direct lending strategies. As with CDLI, CDLI-S should not suffer from the biases (crowding and survival) found in other databases because all source data come from required SEC filings.
As seen in the table below, CDLI-S loans are generally represented by larger, sponsored borrowers with a history of lower realized losses and a lower non-accrual status rate.
The tables below compare the performance of CDLI and CDLI-S since CDLI-S's inception in September 2010. As you might expect, while CDLI-S delivered attractive returns (8.23%) despite much lower loan losses, performance was below that of CDLI (9.76%), as ex-post risk and return were correlated.
fees
In it 2023 Fee Survey for middle market corporate lending investment management services covering 58 of the largest direct lending firms managing $924 billion in direct lending assets, Cliffwater found:
Management fees and administrative expenses for direct lending of private funds averaged 3.94%, up from 3.56% in their 2022 study. The 3.94% average of fees and expenses consists of 1.96% in management fees, 1.50% in interest carried (performance fee) and 0.48% in administrative expenses. The 0.38% year-on-year increase in the cost of direct credit was mainly due to higher benchmark interest rates and wider credit spreads, increasing carried interest. Management fees and carried interest schemes remained relatively unchanged year-on-year.
The study group of 58 firms used average leverage of 1.12 times, held 87% first-lien loans and lent to borrowers that were 82% backed by sponsors, with an average EBITDA of $74 million. The manager's use of portfolio leverage and greater exposure to lower middle market or non-sponsor borrowers were associated with higher fees, while greater exposure to first-lien sponsor-backed loans was associated with with lower rates.
Fees (excluding administrative expenses) as a percentage of net assets varied considerably among managers, ranging from 2.64% (10th percentile) to 4.32% (90th percentile).
To get into the asset class, consider Cliffwater Corporate Loan Fund (CCLFX) because it compares favorably with the industry's high tariffs. Its expenses are much lower than the average fund, it charges net assets (not gross) and charges no incentive fees. Other reasons include a strong due diligence process in the selection of managers, high credit standards (focusing on senior secured loans backed by private equity firms) and broad diversification among managers with long histories in specific industries.
Updated performance of CCLFX against daily liquid funds
From July 2019 to December 2023, the fund returned 9.15% per year. By comparison, liquid loans, represented by the SPDR Blackstone Senior Credit ETF (SRLN), the largest fund of its kind with AUM of 5.7 billion dollars, with a return of 3.81% per annum; index fund focused on secured variable rate bank loans, the Invesco Senior Loan ETF (NCDs) with $7.4 billion in AUM, returned 3.62%; and investment-grade bonds, represented by the iShares Core U.S. Aggregate Bond ETF (AGG) with $104.2 billion in AUM, returning -0.13% per year.
For investors who don't need liquidity for at least part of their portfolio (which is true for most investors), this is a worthwhile trade — while not exactly a free lunch, it's at least a free stop on the tray of sweets. For example, consider the retiree who takes no more than the required minimum distribution (RMD) from their IRA account. Even at age 90, the RMD is not even 10%, and interval funds are required to meet liquidity requirements of at least 5% every quarter. For such an investor, the illiquidity premium is worth considering.
Investor Takeaway
Investors seeking higher yields and relatively low risk, and who are willing to sacrifice liquidity, will find attractive opportunities in range funds that invest in underwritten and sponsored middle market loans.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes and should not be construed as specific investment, accounting, legal or tax advice. Some information is based on data from third parties and may become out of date or be replaced without notice. Third-party information is believed to be reliable, but its accuracy and completeness cannot be guaranteed. The opinions expressed herein are their own and may not accurately reflect those of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-617