“The timid man yearns for full value and asks a tenth. The bold man strikes for double value and compromises on par.” —Mark Twain, Following the Equator (1897)
As Mark Twain reminds us, psychology plays a pivotal role in the business of lending. It also highlights for us there is more to understanding risk than simply looking at loan covenants, which can seem like historical relics used by lawyers, not astute investors. In recent years, private credit has grown as a distinct institutional asset class beyond loans to middle-market private companies. Private equity “dry powder” has now grown to $1.1 trillion1, and that has provided a catalyst for M&A activity that often results in private credit needs expanding even further and faster. In any private market transaction, credit is now a larger portion of the pie than equity. Private credit has matured as segments beyond traditional sponsored lending have grown as independent segments with unique risk and return attributes. This development has increased the complexity of deals and created a need for improved risk analysis to thoroughly understand the credit risk being undertaken. Strong economic growth in the United States has generated growth opportunities for smaller firms and family offices, and that trend has resulted in an increased need for opportunistic credit and the development of a new segment of the private market not involving private equity sponsors.
Most of private credit is directly originated, as there is no additional layers of fees between the investor and the borrower, other than those associated with the fund structure itself. Credit originated with middle-market companies often includes an Original Issue Discount (OID) component, with the loan being issued at a discount to par (i.e., 97) and then being repaid at par upon maturity. The OID can range between 2–6 basis points (bps), which are amortized over the life of the loan, thereby increasing the potential for yield. Loans may also have payment-in-kind (PIK) features. With PIK, part of the coupon (e.g., 2%–3% out of 8% coupon would be considered PIK) will be added to the principal instead of paid out in cash.
As borrowers seek out emerging credit solutions, they often turn to asset managers that understand bespoke underwriting. The complexity of bespoke underwriting often allows directly originated securities to offer higher yields than similarly rated loans that are broadly syndicated. The S&P LSTA Leveraged Loan Index comprises more than 1,400 syndicated leverage loans that are held in open-ended mutual funds, loan ETFs, and collateralized loan obligations (CLOs). This index has delivered 4.5% of total return, on an average annualized basis, since 20102, compared with a 10.1%M3 annualized total return for the CDLI (Cliffwater Direct Lending Index) over the same period. The CDLI measures the performance of U.S. middle market loans. The market in loans continues as much on technical flows driven by growth of retail vehicles that allow real time arbitrage on interest rate fears. Investor behavior is becoming a key driver of risk in that segment of credit.
While it is clear to us that directly originated private credit has offered historically higher total returns, the natural question is, “What level of additional risk is being taken?” Surprisingly, the direct lending index has historically had a similarly low level of volatility (2.05%4 for the CDLI vs. 1.25%5 for leveraged loans). There are several reasons for this. First, private credit prices are often based on valuations that incorporate the fundamental credit quality of a company, as well as market conditions. The result is that price changes are not typically driven by “risk-off” sentiment in markets as much as they are by real, underlying credit performance. Additionally, private credit assets are typically exposed to lower capital middle-market companies, which tend to operate in more defensive sectors of the economy such as healthcare, industrials, and transportation.
Traditional measures of risk—such as volatility and value at risk (VaR)—are not as useful when evaluating private credit, in part, because of the lack of secondary market trading, where participants can trade securities and volume can fluctuate day to day. Valuations are performed quarterly or monthly, and this frequency results in lower volatility measures. When credit returns skew to the downside, a VaR measure would understate the potential loss. However, evaluating risk by looking at rates of default and recovery demonstrates the risk levels with private credit are similar to those of leverage loans. For example, the majority of private credit is first-lien senior secured (debt that is often secured by collateral that can be used to pay back the loan if the borrow cannot through other means), and the net leverage (or borrowing) through that part of the capital structure can link the loan to a given rating level. A first-lien loan with 3–4x leverage could be linked to a “shadow rating” or to an unofficial rating by a credit agency of BB—as S&P LSTA Leveraged Loan Index BB-rated loans are currently averaging 3.81x leverage.
In the current climate, with leveraged loans having a default rate of 1.6% and an expected recovery rate of 70%–80%, the estimated expected loss is 32–48 bps. With a 2009-level default rate of 10.8%, that increases to 220–320 bps of permanent expected loss. In a scenario with lower recovery levels, such as 50%–60%, and a 2009-like rate of defaults, the expected loss would increase to 432 to 540bps.6
In 2008, the secondary market for loans declined as much as 30%7, however, ultimate recoveries have proven to be higher in the long run, averaging 75% for first-lien loans, 52% for second-lien loans, and 45% for high-yield bonds, according to S&P.8 The Cliffwater Direct Lending Index had its largest decline in the fourth quarter of 2008, at –6.7%. Private credit has historically been less volatile in downturns as values are primarily based on fundamental credit quality.
One measure of risk that is helpful when evaluating private credit is the amount of spread, or yield that is received, per unit of leverage (we call it STL—Spread per Turn of Leverage). This is a concept similar to the Sharpe Ratio that enables public market equity investors to analyze risk-return tradeoffs. For middle-market companies who issue first-lien debt at 4–6x earnings before interest, taxes, depreciation, and amortization (EBITDA), the spread per unit of leverage in each deal can be compared with the leveraged loan market. Using the Cliffwater Direct Lending Index as a measurement for private credit, it offers 131 bps per unit of leverage, on average9.
For example, the balance sheet of a company with a first-lien originated term loan may look like what is illustrated below, with 4.5x net leverage. If the term loan was issued at par, paying LIBOR plus 500 bps, the spread per turn of leverage would be 111 bps. Comparatively, B-rated leveraged loans that are broadly syndicated offer 76 bps of spread per unit of leverage10. Using STL as a measure of intelligent risk in the example, the term loan has characteristics of a well-informed investment.
Of course, there are other aspects of risk that are important to credit underwriting, including the ability of a company to generate cash flow to pay its interest obligations, the quality of its collateral, considerations for the sector that the company operates in, as well as the idiosyncratic prospects of its business.
As private credit globalizes and evolves, we believe STL is a more robust and intelligent measure of risk in private credit. In our view, its usefulness as a tool to evaluate risk will likely become even more pronounced as we enter the late stages of a credit cycle and credit risks heighten.