While non-bank credit channels have always co-existed with traditional banking, those channels were historically small points in the overall economy. That changed after the Great Recession, when new regulations limited banks' ability to make traditional loans to middle-market businesses in the US (generally defined as companies with EBITDA, or earnings before interest, taxes, depreciation and amortization, between 10 million and $100 million and which are considered by many to be 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 secured and first-lien 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 referred to as “sponsor backed”. Private equity sponsors often prefer to borrow from asset managers over 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 performance analysis is based on the Cliffwater Direct Lending Index, or CDLI, an asset-weighted index of approximately 15,600 middle market loans with direct originations totaling $337 billion as of March 31, 2024. The CDLI is used globally by investors institutional and asset managers as the index chosen 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 by 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 other industry universes and index benchmarks.

CDLI produced a total return of 3.02% in the fourth quarter, bringing its total return after four quarters to 12.49%. Interest income was 2.93%, which was somewhat offset by -0.23% in realized losses for the quarter. Unrealized gains stood at 0.32% 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 9.14% and 8.85%, respectively. Since its inception on September 30, 2004, CDLI has produced an annualized return of 9.50%, net of fees and gross.

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, and has remained roughly flat. 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 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

Realized and unrealized losses reduced returns by 0.05% in the fourth quarter. For the year, however, they added 0.06%. 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

CDLI direct loans are valued quarterly using “fair value” accounting rules, while high-yield bond and bank loan prices 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. It highlights the asset class with the highest return of the calendar year.

In addition to the highest return over the past 10 years and the entire 19-year period, the CDLI was the top-performing index in 13 of the 19 years.

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 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 would expect, while CDLI-S delivered attractive returns (8.31%) despite much lower loan losses, performance was below that of CDLI (9.81%), as ex-post risk and return were correlated.

fees

In its 2023 fee survey of investment management services for middle market corporate lending covering 58 of the largest direct lending firms managing $924 billion in direct lending assets, Cliffwater found that fees management and administrative expenses for private direct lending funds averaged 3.94%, up from 3.56% in their 2022 study. This average was 1.96% in management fees, 1.50% in carried interest (performance fee ) and 0.48% in administrative expenses. 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 0.38% year-on-year increase in the cost of direct credit was mainly due to higher benchmark interest rates and wider credit spreads, which boosted interest rates. Management fees and carried interest schemes remained relatively unchanged year-on-year.

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 enter the asset class, consider Cliffwater Corporate Loan Fund (CCLFX), with $19.6 billion in assets under management at the end of May 2024, because its management fee is much lower than that of the average fund; charges on net assets (not gross); does not charge any incentive fees. Other reasons include a very strong due diligence process in the selection of its 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 (with more than 3,600 loans its average loan size is only $5 million).

CCLFX Performance vs Liquid Daily Funds

From inception in July 2019 to May 2024, the fund returned 9.3% annually. For comparison, liquid loans, represented by SPDR Blackstone Senior Credit ETF (SRLN), the largest fund of its kind with assets under management of 6.6 billion dollars, with a return of 4.2% per year; index fund that focuses on secured variable rate bank loans, Invesco's Senior Credit ETF (NCDs) with $8.3 billion in AUM, returned 4.0%; and investment grade bonds, as represented by iShares Core US Aggregate Bond ETF (AGG) with $108 billion in AUM, returned -0.4% YoY.

For investors who don't need liquidity for at least part of their portfolio (which is true for most investors), this is a very worthwhile trade – while not exactly a free lunch, it's at least a free stop in dessert tray. . For example, consider the retiree who takes no more than the required minimum distribution 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.

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 the author or co-author of 18 books on investing, including his latest, Enrich your future: the keys to a successful investment