By LARRY SWEDROE
The Global Financial Crisis led to increased bank regulation and a reduction in banks’ risk appetite. The reduction in bank lending fuelled rapid growth in private debt (PD) investments. The Federal Reserve’s zero rate policy also contributed to growth in PD funds as investors, challenged by a low yield environment in traditional credit markets, sought higher returns. Preqin, a leading provider of data on alternative assets, reported that by 2020 PD assets under management exceeded $1 trillion and now represent about 12 percent of the aggregate value of private capital funds, approximately match the size of real estate funds ($1.15 trillion), and have outgrown infrastructure ($0.8 trillion) and natural resources ($0.2 trillion) funds.
Until recently private debt funds were generally organised as partnerships in which the investor becomes a limited partner (LP), and the asset manager, which also invests in the partnership, is the general partner (GP). Partnerships are illiquid investments because investors cannot withdraw funds until the fund is terminated, typically eight to 10 years after inception. The introduction of interval funds several years ago changed that situation, as interval funds, such as Cliffwater’s Corporate Lending Fund (CCLFX) and Stone Ridge’s Alternative Lending Risk Premium Fund (LENDX), provide limited liquidity (a minimum of 5 percent per quarter). Their introduction provided access to this asset class for a wider range of individual investors and usually at lower cost than the typical 1.5 to 2 percent annual fee plus an incentive fee of 15 to 20 percent, the latter paid at the end of the lifetime of a fund and calculated on a return exceeding a preferred return to LPs (usually around 6 to 8 percent per annum).
How have private debt funds performed?
Pascal Böni and Sophie Manigart contribute to the literature with their October 2021 study, Private Debt Fund Returns and General Partner Skills, in which they examined net-of-fees PD fund performance, performance persistence and a general partner’s ability to time the market. They evaluated relative performance against an investment grade (IG) and a high-yield (HY) bond market benchmark as well as against an equity market benchmark (S&P 500). Their database consisted of 448 PD funds listed in Preqin managed by 94 GPs and covered the period 1986-2018.
The authors noted: “The most prevalent investment strategies followed by the PD funds are investing in direct lending, distressed debt, or mezzanine. Direct lending, a strategy followed by 24.6% of the PD funds in the sample, is the practice of non-bank lenders extending loans to small and medium-sized businesses in return for debt securities. Distressed debt (30.6%) represents lending to companies that have filed for bankruptcy or have a significant chance of filing for bankruptcy soon. Mezzanine (28.6%) includes investments in debt subordinated to the primary debt issuance and senior to equity positions. Special situations (12.7%) covers several areas including distressed and mezzanine, where loan decision or grade is defined by criteria other than underlying company fundamentals. Venture debt is the least prevalent strategy (3.6%); it comprised private debt provided to venture capital backed companies to fund working capital or expenses.”
Following is a summary of their findings:
The average (median) PD fund provided an internal rate of return (IRR) of 9.2 (8.5) percent net of fees to LPs.
There was a large dispersion between top quartile funds, with an IRR of 23.3 percent, as compared to the bottom quartile funds, with an IRR of -3.6 percent.
PD funds achieved a net investment multiple of 1.3. However, there was a wide dispersion of returns with top quartile funds (1.8X), significantly higher than that of bottom quartile funds (just 0.98X).
PD funds outperformed versus the IG, HY and S&P 500 benchmarks by 8 percentage points, 6 percentage points and 6 percentage points, respectively. Again, there was a wide dispersion of returns.
There was a relatively equal outperformance for distressed debt, mezzanine and special situations funds of 8 to 10 percentage points, while direct lending funds outperformed the market by 4 percentage points.
Launching PD funds during NBER recessions increased outperformance.
Consistent with the findings on private equity, there is persistence of performance in PD funds—prior fund performance is a significant and economically important predictor of future fund performance.
Outperforming PD funds were smaller on average, used more time to deploy committed capital and were managed by GPs with a lower number of funds.
The best performing GPs anticipate changes in credit market conditions (i.e., credit spreads, illiquidity and volatility) and possess valuable market timing skills.
Their findings led the authors to conclude: “Our empirical findings, based upon a worldwide comprehensive sample of PD funds, show that including PD funds in an investor’s portfolio has the potential to increase returns on average.” They added: “GPs with superior skills generate superior returns, which are partly explained by their superior market timing skills.”
Before considering what the takeaways should be, it is worth mentioning that while skill differences can explain the wide dispersion in returns that were found, it is also possible that, at least in some cases, the wide dispersion could be the result of mixing strategies.
Investor takeaways
The evidence demonstrates that investors who can accept the lack of daily liquidity, and earn an illiquidity premium, should consider PD funds as an alternative to public debt funds. Another benefit of PD funds is that they are typically floating-rate loans (with most having minimum base rates) that minimise, if not eliminate, the duration/inflation risk of public funds that buy fixed-rate term loans. With that said, the evidence of a wide dispersion of returns between top and bottom quartile performers demonstrates the importance of performing deep due diligence when selecting a fund sponsor, and choosing one with a long track record of persistent above-average performance.