It seems that every investment shop out there is coming to market with a private credit fund. In fact, as I write this column, two more firms — an asset management firm and a global investment bank — issued press releases touting the launches of their first private debt vehicles.
Institutions and individual investors alike have flocked to the asset class. Estimates from various sources indicate that the private credit industry today has total assets under management of about $1.2 trillion. This represents pretty strong growth — nearly 25 percent per year for more than two decades. Despite the slowdown in broader credit markets, private credit funds raised $45 billion in the first quarter, a pace that would make 2022 the biggest fundraising year ever, surpassing the record totals from last year. Even with high-yield issuance down roughly 65 percent year-over-year from the first quarter of 2021, investor demand for private credit remains robust — so much so that critics may be asking: Is private credit a bubble?
There’s a pretty good reason for the high demand: strong returns. Alternatives investment specialist consultant Cliffwater has been actively involved in private credit since 2004 and oversees the most comprehensive index in the sector, the Cliffwater Direct Lending Index, or CDLI. Comprising $223 billion in assets and 8,000 individual underlying loans, the CDLI is a reasonably good approximation of the sector. And the performance is indeed compelling.
From 2008 to the end of 2021, the CDLI has generated annualized returns of about 9.2 percent. This compares very favorably with the returns put up by traditional fixed-income markets, including investment-grade bonds and levered loans. The CDLI has outperformed the next best sector, high-yield bonds, by nearly 200 basis points per annum.
It’s important to point out that the returns for the CDLI are net of credit losses. Cliffwater estimates that the average coupon to the loans in their index over this horizon has been about 10.2 percent, with about 1 percent of net credit losses per year. This means that, adjusted for risk, private credit investments have historically generated substantial excess return compared with public debt instruments, compensating investors for taking on illiquidity.
However, some criticisms of the asset class are indeed warranted.
First, the spread between public and private debt has narrowed considerably over the first half of 2022. Whereas high-yield spreads have blown out wider to start the year, direct lending continues to become more competitive, with spreads coming in as a result. Unlike high-yield bonds, which are fixed-rate securities, direct lending notes are floating-rate and their coupon references an underlying reference rate, such as SOFR or LIBOR.
Despite these reference rates moving up by 100 to 150 basis points owing to the Fed’s rate increases, Cliffwater puts the current yield on the CDLI at just 7.7 percent. Yields have come down amid increased competition because the spread has narrowed more than the reference rate has widened. Today junk bonds yield about 6.5 percent, so the excess return expected in the private market is likely to narrow going forward, considering that yields have already tightened.
But looking at expected losses, private credit still compares favorably with junk bonds.
Leverage for the typical direct lending structure is higher than what you often find for high-yield bonds. Many direct lenders today are willing to lend to private equity–sponsored companies at five or six times EBITDA. According to Cambridge data, a full one-third of buyout debt transactions are done at north of six times EBITDA. On the other hand, BB bonds have an average leverage closer to 3.5 times EBITDA. So it is possible that the companies that direct lenders finance could run into financial difficulty sooner than the high-yield–funded ones; leverage ratios are highly correlated with subsequent default rates.
Nonetheless, junk bonds are subordinated debt, which means if a company does go into bankruptcy, there are often many creditors ahead of those bonds in the cap stack. Private credit tends to be in a senior position, and though many larger transactions are done “covenant light,” private credit transactions are more customized than bond issuances. Many direct lenders are still able to obtain traditional covenant protections.
Private debt has over time had lower default rates than high-yield bonds, but both sectors are currently performing well above trend. According to Fitch, high-yield default rates rose to just 0.6 percent in May, well below the long-run normal default rate of roughly 3 percent. According to data from Cliffwater, the non-accrual rate for the CDLI is currently at 1.05 percent and the long-run average for private debt is closer to 2 percent. But during the global financial crisis, default rates on junk bonds spiked out to 12 percent, whereas private debt defaults peaked at just half that.
But default rate is only half of the credit loss story; recovery rates are equally important. Private loans have historically recovered 50 to 60 percent of par given a default, whereas junk bonds, in part because of their subordination, recover only 40 to 50 cents on the dollar on average.
Taking 1 minus the recovery rate and multiplying that by the default leads to the annualized credit loss rate, or the expected amount of principle that will be lost per annum. If we assume reversion to the mean for default rates and recovery rates for both sectors, we can calculate assumed loss ratios for each. We can look at downside scenarios for each as well. In both cases, private debt holds up well in comparison with high-yield, with loss ratios roughly half those of the public comparables.
Subtracting this annualized loss rate from the entry-level yields allows us to arrive at an expected return, a method that has historically been pretty accurate when compared with subsequent realized returns. Higher returns in private credit relative to broad high-yield exposure still appear realistic; direct lending doesn’t look like fool’s yield yet.
But “yet” is the operative word. Continued asset growth, increased competition, narrowing of spreads, higher debt levels, and riskier capital structures mean that investors need to continually reunderwrite their exposures to establish realistic parameters around future risk and return. When private credit no longer demonstrates a sufficient yield premium net of expected credit losses, it will be time to reduce allocations.
Let’s take one last look at some more credit market statistics to help elucidate how close that time may be. Today, with activity in the large, syndicated bank debt market slowing and junk bond issuance all but dead for the time being, direct lenders are the only game in town for financing leveraged-buyout transactions. But private credit is still little more than a drop in the bucket of total U.S. debt markets.
Even at $1.2 trillion, private credit is the smallest subsegment of the credit space, accounting for just 2.2 percent of the total $55 trillion-plus in assets in the asset class. Further, with approximately $2.5 trillion in private equity dry powder alone, it doesn’t appear to me that private credit is even close to bubble territory. With 50-50 debt-to-equity ratios, this private equity dry powder will need to find twice as much financing as the entire private credit industry. It’s hard to imagine how such a small corner of the debt market, with such a broad universe of potential investments, can be a real source of systemic concern.
And as valuations come down in private markets and managers become more conservative with underwriting standards — as happens in almost all market corrections — private credit is still positioned to be a solid source of income and excess return for investors with some liquidity to spare.
Christopher M. Schelling is columnist for II and most recently the director of alternative investments for Venturi Private Wealth. As an institutional investor, he has allocated roughly $5 billion and met with more than 3,500 managers across hedge funds, real assets, private credit, and private equity.